Brazil Adopts Thin Capitalization Rules

Until very recently it was true to state that there were no rules on thin capitalization in Brazil which prevented foreign companies to use intercompany loans instead of direct equity investments in order to transfer funds to finance the activities of their Brazilian subsidiaries. However, this is no longer the case! By means of Provisional Measure (Medida Provisória – MP) No. 472, of December 15, 2009, the Brazilian tax legislation has been substantially amended and for the first time includes, among the various changes, the so-called "thin capitalization rules", which will be outlined below. At the end of this article, we will also comment another novelty contained in the same MP 472/2009 which is very relevant and needs to be highlighted - how a Brazilian resident may be free of its status as a local taxpayer for Brazilian tax purposes.

The new thin capitalization rules are primarily designed to determine how much of interest paid on corporate debt is deductible for tax purposes and consequently to prevent that Brazilian companies become undercapitalized as a result of the use of excessive indebtedness.

These rules are in full force and effect as from January 1st 2010 for corporate income tax purposes (IRPJ), but will only be valid regarding the social contribution on net profits (CSLL) 90 days after the publication of MP 472/2009 in the Official Gazette of the Union (Diário Oficial da União – DOU), which happened on December 16, 2009. The expression "income tax" as used herein comprises both the IRPJ and the CSLL1.

Before dealing with the applicable provisions of MP 472/2009, it is paramount to define the meaning of "related party", which includes any individual or legal entity resident or domiciled abroad (outside Brazil) whose capital stock characterizes its controller or affiliate as defined pursuant to Law No. 6.404, of December 15, 1976 as subsequently amended (the Brazilian Corporation Law – BCL). Affiliate (coligada) is a company in which the investor has a significant influence over it (article 243, § 1 of the BCL, as amended by Law No. 11.941, of May 27, 2009). One company will have significant influence over another when it holds or exercises the power to participate in decisions on financial or operational policies of the affiliate (article 243, § 4 of the BCL, added by Law 11.941/2009). Significant influence is presumed to exist when one company holds at least 20% of the voting stock of another, but does not control it (article 243, § 5 of the BCL, added by Law 11.941/2009). Controlled company (controlada) is a company in which another company, known as the controller (controladora), either directly or through other controlled companies, has the rights of a partner in the first company which permanently grants to the controller prevalence in voting the first company's corporate decisions and the power to elect the majority of its management (article 243, § 2 of the BCL). For tax purposes2, the following entities will be deemed to be related to the Brazilian company:

the parent company, when domiciled abroad; an offshore branch (filial)...