Brief Comments on the Provisional Measure n. 806, of October 30, 2017
In an extra edition of the Official Gazette ("DOU Extra") of October 30, 2017 and under the allegation of adjustment of the public accounts for 2018, the Provisional Measure ("PM") n. 806, of 30 of October 2017 ("MP nº 806/2017"), which provides for the collection of Income Tax ("IT"), including withholding tax ("WT"), on Investment Funds ("IFs"), in particular on IFs constituted as a closed condominium (ie "IFs Closed") and IFs in Participations ("IFPs"), directly impacting the market of these IFs.
Here, we describe, in summary, the main changes of the PM nº 806/2017 and their possible impacts to the IF market, without the pretension of exhausting all of its reflexes in the practical world, but in the attempt to draw attention to the great points that can impact the day-to-day activities of investors and market participants.
1) New WT Impact Moments in the Closed IFs in General - (Articles 2, 3, 5 and 6 of the PM nº 806/2017)
As stated in the "Explanatory Memorandum" of the Provisional Measure No. 806/2017, under the allegation:
- reduction of existing distortions between the applications in IFs; and
- increase in federal revenues through the taxation of accumulated income from closed-end IF portfolios, which, in the words of the Executive Secretary of the Ministry of Finance, Eduardo Refinetti Guardia, "are characterized by a small number of quotaholders and strong tax planning".
The PM nº 806/2017, in its articles 2 and 3, establishes that the Closed IFs, which do not permits the redemption of quotas during the term of their duration, will suffer the WT, not only on the occasion of the redemption or amortization of their quotas, but also, in a manner of a six-month basis, on the last business day of May and November of each year, under the system known as "come-quotas" (eat-quotas), hitherto applicable only to IFs constituted as an open condominium ("IFs Open").
Regarding the creation of this new tax generating fact, it is worth mentioning an excerpt from the aforementioned Exposition of Motives:
"(...) Today the tax rule provides for the incidence when the shareholder receives income by means of amortization of quotas or in redemption only. The new rule to be established by the PM defines the incidence in the pre-amortization or redemption phase as the income is earned, as in open-ended investment funds. Article 3 establishes, for the investments made in these funds, in relation to the following generating facts, rule of calculation and semi-annual collection, besides the rules for the hypotheses of amortization and redemption of quotas. (...) ".
I. WT Accumulated Gains
In this context, according to the terms of the Provisional Measure No. 806/2017, the quota holders of IFFIs Closed will be subject on May 31, 2018 to the WT on the income corresponding to the positive difference between the equity value of the quota ascertained on this date, May 31, 2018, including the income appropriate to each shareholder, and the respective cost of acquisition, adjusted by the depreciation.
Accordingly, pursuant to article 2 of the Provisional Measure 806/2017, the income and gains earned by the closed-ended IF portfolio (ie until May 31, 2018) accumulated and not distributed to the quota holders will be taxed by the WT ("WT Accumulated Gains"), in advance1, according to the rates defined in article 1 of Law 11,033, dated December 21, 2004 and article 6 of Law 11,053, dated December 29, 2004.
In this way, the Closed IFs will be subject to the WT Accumulated Gains in relation to the entire retained earnings / retained earnings at the level of their portfolio, and not only on the valuation of the last six months (or any other lower period). Particularly with respect to this "retroactivity" of Article 2 (WT Accumulated Gains), that is, application to past income (ie already earned by the portfolios of the Closed IFs), it is worth noting that in the view of our firm there are arguments for the judicial discussion about the constitutionality of this device, due to violation of the constitutional principles of non-retroactivity and the grace period of the Tax Law.
II. WT Semiannual
Regarding the income earned / accumulated by the quota holders of the Closed IFs, after the WT and from June 1, 2018, in line with article 3 of the PM no. 806/2017, will be the quota holders of these IFs Securities subject to WT in the following cases:
- "Semi-Annual Income Tax", incident on the last business day of the months of May and November of each year; or
- WT at the time of eventual amortization or redemption of quotas as a result of the expiration of the duration or the closing of the Closed IF, if occurred at an earlier date.
The basis of calculation of the above mentioned above corresponds to the positive difference between: the equity value of the quota, including the amount of the income appropriate to each shareholder in the calculation period, and its (a) acquisition cost, adjusted for any depreciation, or (b) the value of the quota on the date of the last incidence of the Semi-Annual Income Tax (WT)
III. Related to the rate applicable to the WT on inventory and the half-yearly WT of the closed IFs
Particularly in relation to the rates to be applied in this new moment of incidence / event generating the WT (whether in relation to the Accumulated Gains, taxed on May 31, 2018 by the WT Accumulated Gains, or to the income to be accumulated as from June 2018, taxed by the Quarterly Income Tax (WT)), it is worth noting that, insofar as Articles 2 and 3 of the Provisional Measure 806/2017 establish that the rates defined in article 1 of Law 11,033 of December 21, 2004 and article 6 of Law 11,053, dated December 29, 2004, there is room for understanding by applying:
- of the regressive rates that vary between 22.5% (twenty-two and five tenths percent) to 15% (fifteen percent); or between 22.5% (twenty-two and five tenths percent) to 20% (twenty percent), depending on the term of the investment (by the quota holder) and the average term of the Closed IF portfolio (ie the " Regressives "); or
- the fixed rates of 15% (fifteen percent) or 20% (twenty percent), depending on the average term of the Closed IF portfolio, applied in the semi-annual taxation of the Open IFs (the "Fixed Rates").
This is due to the fact that the aforementioned legal provisions (Article 1 of Law 11,033 / 2004 and Article 6 of Law 11,053 / 2004) contain in their text both the Regressive Rates, which vary depending on the average term of the portfolio and the term of the investment and which are applicable on the occasion of the redemption of the quotas of the IF, and at the Fixed Rates, depending on the average maturity of the portfolio and which are applicable in half-yearly taxation.
In our opinion, however, considering that:
- in the hypothesis of article 2 of Provisional Measure No. 806/2017 (WT Accumulated Gains), we are faced with a "false distribution" of income, the most coherent would be the application of the Regressive Rates, which are subject to the redemption of open IF quotas, depending on the term of the investment (by the quota holder) and the average term of the Closed IF portfolio; and
- in the case of Article 3 of Provisional Measure 806/2017 (Six-month WT), we are faced with an anticipatory / semi-annual taxation (and not on the occasion of the redemption or amortization of quotas of the Closed IF), application of the Fixed Rates of 15% (fifteen percent) or 20% (twenty percent), depending on the average term of the Closed IF portfolio.
In this context, particularly with respect to WT Accumulated Gains, this "fictitious distribution" may imply in the understanding of the Tax Authorities that the term of the investment (by the quota holder) in the Closed IF should begin again after this assumption of distribution.
IV. Closed IFs and / or Excluded Investors
In addition, it is worth mentioning that PM nº 806/2017 listed, in its article 5 and as explained in the Statement of Motives2, investment vehicles / funds that are expressly excluded from this new incidence hypothesis (subject to their respective rules of incidence established in tax legislation), they are:
- Real Estate Investment Funds ("REIF");
- Credit Rights Investment Funds ("CRIFs") and Investment Funds in Quotas of CRIF ("IFQs-CRIFs");
- Investment Funds in Shares ("IFSs") and Investment Funds in Quotas of IFSs ("IFQs-IFSs");
- Investment Funds consisting exclusively of investors not residing in Brazil ("Exclusive IFs INRs");
- Close IFs in general, whose regulations provide, on the date of publication of PM no. 806/2017 (i.e., on October 30, 2017), in a non-extendable manner, the settlement on December 31, 2018; and
- IFPs, qualified or not, in accordance with the regulations established by the CVM, particularly CVM Instruction No. 579/2016, as investment entities (ie "IFPs / Investment Entities" and "IFPs / Non Investment Entities" ").
Finally, specifically with regard to excluded investors, we highlight that: (a) Article 6 of PM no. 806/2017 expressly excluded from the WT on Inventory, WT Semestral and WT Reorganization Events (the latter mentioned in item 2, below) the financial and similar institutions listed in item I of article 77 of Law No. 8,981 of January 20, 1995; and (b) in our opinion, the INRs non-resident in Favored Tax Jurisdictions, due to the existence of specific rules governing their taxation (ie the "Special Taxation Regime" in Law No. 8.981, 1995), should also not suffer the incidence of this new system of taxation applicable to the Closed FIs (WT Semester), even if its investment is not in an Exclusive IF INR.
2) WT in Events of Spin-off, Merger, Merger or Transformation of the IFs (Article 4 of the PM nº 806/2017)
Concerning the events of "Fission", "Acquisition", "Merger," or "Transformation" of IFs (collectively the "Reorganization Events"), hitherto without express legal tax treatment (ie contained only in Article 13 of the Normative Instruction of Brazilian Internal Revenue Service No. 1,585, dated August 31, 2015), Article 4 of PM No. 806/2017 establishes that, as of January 1, 2018, the execution of any of the Events mentioned above will be treated as a hypothesis of WT ("WT Reorganization Events"), and the income corresponding to the positive difference between the equity value of the income appropriate to each shareholder, and the respective cost of acquisition, adjusted by any depreciation occurred, or the value of the quota on the date of the last tax incidence.
It is worth remembering that currently, the Reorganization Events of IFs (whose normative rule contained in Article 13 of Normative Instruction No. 1,585 / 2015, did not expressly mention the Transformation event) only imply tax consequences if cumulatively, the following " Conditions":
- the equity of the merged, spun-off or merged IF is transferred at the same time to the successor IF;
- there is no availability of funds to the shareholder at the event, nor transfer of title ownership; and
- the composition of the new IF portfolio does not lead to the application of a tax regime that provides for lower rates than the extinguished IF.
Thus, with the publication of article 4 of PM no. 806/2017, the performance of the IF Reorganization Events (expressly including the Transformation), regardless of compliance with said Conditions, should be treated as a hypothesis of WT incidence, and the WT Reorganization Events be retained by the IF administrator on the date of the Event. We emphasize that such rules apply in theory to any type of IF, regardless of whether it is constituted as an open or closed condominium.
3) Changes in the IFP Market (Sections 7 to 9 and 11 of PM No. 806/2017)
I. General Comments
In line with the changes made to the IFPs market, especially with regard to the operation and accounting of these IFPs, the instructions of the Securities and Exchange Commission ( "CVM") No. 578 and No. 579, both of 30 August 2016 ( "CVM No. 578/2016" and "CVM No. 579/2016"), the PM No. 806/2017 set different "charging schemes" for qualified IFP or not, according to regulations established by CVM, particularly CVM Instruction 579/2016, as investment entities (ie IFPs / Investment Entities and IFPs / Non-Investment Entities).
In this context, it should be noted that CVM Instruction No. 579/2016, aiming at the economic essence of the legal form, requires that, based on a systematic evidence, the IFP administrator qualifies him as an IFP / Investment Entity or an IFP / Non-Investment Entity.
This characterization of what is effectively an IFP / Investment Entity, however, requires a substantial and subjective analysis of each structure. Below we present the main characteristics of each type:
A. IFP / Investment Entity
- IFPs that fall under the provisions of Articles 4 and 5 of CVM Instruction No. 579/20163 and basically bring characteristics of the IFs business model, as its purpose of investment, its management analysis methodology, its strategies divestment, quantity of quotaholders, invested companies, among others;
- IFPs in which the profit distributions declared and accrued by investees are recognized as income.
B. IFP / Non-Investment Entity
- IFPs that do not fall under the provisions of articles 4 and 5 of CVM Instruction 579/2016; and
- IFPs in which the profit distributions declared and accrued by the investees reduce the book value of the IFs.
II. Change in the Taxation System of IFPs / Investment Entities
In line with the General Comments presented above and with the changes introduced in article 2 of Law 11.312 / 2006 by article 7 of PM no. 806/2017, the IFPs / Investment Entities are subject to a new moment of WT incidence: a known as "presumed distributions" (ie amounts considered as distributed) from resources obtained by the IFPs / Investment Entities in the disposal of each of their investments, regardless of the treatment to be given to these resources by the respective IFP portfolio, as defined in regulation (eg reinvestment of resources).
Therefore, in line with paragraph 7 included in article 2 of Law 11,312 / 2006, the incidence of this WT will occur as soon as the amounts distributed (effectively or considered / assumed as distributed, taken together) surpass the total capital paid in the IFPs / Investment Entities.
III. Change in the Taxation System of IFPs / Non-Investment Entities
The IFPs / Non-Investment Entities (or, simply, "Patrimonial IFPs"), in turn, are no longer subject to the general exemption rule of the portfolio, becoming subject to the tax regime applicable to legal entities (ie, the Social Contribution on Net Income and Contributions to the Social Integration Program and Social Security Financing, depending on the systematics / methodology of calculation that are subject / opted), for exercising Holding Companies' typical activities, in the view of the Ministry of Finance, becoming the administrator of these IFPs responsible for compliance with IFPs main and accessory tax obligations.
In this context, the main question that arises is the tax treatment to be given to the income distributed by Patrimonial IFPs assimilated to legal entities exclusively for tax purposes (ie, IFPs x dividends or other forms of profit distribution).
In addition, pursuant to article 9 of PM no. 806/2017, the income and gains earned / accrued by the IFPs / Non-Investment Entities that have not been distributed to the quota holders until January 2, 2018, are considered paid or credited to their quotaholders on this date and are subject to WT tax at the rate of 15% (fifteen percent) - "WT Accumulated Gains IFP", and the administrator, on the date of WT, must reduce the quota quantity of each shareholder in corresponding to the WT calculated on January 2, 2018.
Particularly with respect to this retroactivity of Article 9 regarding the incidence of the WT On IFP Accumulated Gains (ie accumulated earnings in the past), through a fiction / presumption of distribution by IFPs / Non-Investment Entities to their quota holders, it is worth mentioning that in the view of our firm there are arguments for the judicial discussion of the constitutionality of this device, due to violation of the constitutional principles of non-retroactivity and the priority of the Tax Law.
IV. Composition of Shareholders' Equity of IFPs for Tax Purposes
In addition, it should be noted that PM No. 806/2017 expressly revoked Paragraph 4 of Article 2 of Law
11,312, of June 27, 2006 ("Law 11,312 / 2006"), which established that, for tax purposes, the IFPs should maintain a minimum of sixty-seven percent (67%) of its shareholders' equity invested in shares of corporations, convertible debentures and subscription warrants, which entailed a distortion between the tax rule and the IFPs operating models market.
In this context, it should be noted that this distortion was aggravated by the publication of CVM Instruction 578/2016, which made it possible for IFPs to invest in new assets (eg, non-convertible debentures, securities representing companies).
Therefore, as a result of said revocation, IFs that maintain at least 90% (ninety percent) of their shareholders' equity invested in shares, subscription warrants, simple debentures, other securities convertible or exchangeable in shares issued by companies, open or closed, as well as securities representing participation in limited companies, subject to the limits for each asset set forth in CVM Instruction No. 578/2016.
4) Term of PM No. 806/2017
In line with the above, in our opinion, PM No. 806/2017, inasmuch as it creates new moments of incidence of WT in investments in IFs and, consequently, new triggering events of WT, to be enforceable in 2018, must have had necessarily been, pursuant to article 62, § 2 of the Federal Constitution, converted into law (ie approved by the Congress) in 2017, which did not happen.
In fact, the need to convert PM No. 806/2017 into Law in 2017 is set out in the text of its Statement of Reasons, verbatim:
"(...) 18. The urgency and relevance of the edition of this PM is justified since, with respect to the principle of anteriority, the changes demand publication and conversion into Law still in 2017 to take effect in 2018 and the fiscal situation demands increase in the tax basis ".
The Tax Consulting and Capital Markets teams of Velloza Advogados are available to clarify any questions about PM nº 806/2017 and how it may relate to your individual situation.
Written by: Fernanda Junqueira Calazans, Elisa da Costa Henriques and Leonardo Augusto Andrade
1 Explanatory Memorandum: "(...) 3.1 In this sense, art. 2º establishes the incidence of the tax on the accumulated income until May 31, 2018 by the portfolios of investment funds constituted as a condominium. Although the basis for reaching past earnings, the system, already adopted for the other funds, will act as an advance of the tax that would be due on the occasion of the amortization of quotas (during the term of the fund) or redemption (in liquidation of the fund) . (...) ".
2 Explanatory Memorandum: "(...) Art. 4 provides for a rule for cases of reorganization of investment funds and articles 5 and 6 clarify that in specific cases the rules currently in force are maintained ".
3 "Article 4. Investment funds qualified as Investment Entity shall be those funds which, cumulatively: - obtain funds from one or more investors for the purpose of transferring the development and management of an investment portfolio to a qualified manager, who must have full discretion in the representation and takeover of decisions for the investees, not being obliged to consult the quota holders for such decisions and also not to indicate the quota holders or parties related to them as representatives in the investees; II - commit themselves to investors with the purpose of investing the resources solely for the purpose of return through appreciation of the invested capital, income or both; III - substantially measure and evaluate the performance of their investments, for management model purposes, based on fair value; and IV - define in their by laws objective and clear strategies to be used for the divestment, as well as the assignment of the manager to propose and carry out, within the term established in the strategy, the divestment, in order to maximize the return to the quota holders.
Single paragraph. The provisions in item I do not disregard the cases in which the quota holders deliberate on proposals submitted by the manager, through an investment committee, in relation to the decisions inherent in the composition of the fund's portfolio.
Article 5 In assessing the conditions set forth in the previous article, the manager must additionally consider the existence of the following typical characteristics of an investment entity: I - have more than one investment, directly or indirectly; II - have more than one shareholder, directly or indirectly; III - have shareholders who do not influence or do not participate in the management of the investees or are not parties related to the managers of these entities; IV - to have investment in entities in which the quotaholders had no direct or indirect corporate relationship prior to the investment of the fund.
Single paragraph. The absence of any of these typical characteristics does not necessarily disqualify an entity from being an investment entity. "
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.