Brazil: How To Trade With Brazilian Government Bonds

Many foreign banks without legal presence in Brazil are now contemplating the possibility to embark or have already embarked on an expanded role in investing in Brazilian government's bonds and providing a broking service to their respective clients.

A foreign bank does not require any type of local licence or other authorisation in Brazil in order to buy and sell bonds either as principal or as agent for clients, provided that these transactions are limited to bonds issued and placed in the international market (i.e., outside Brazil).

The involvement of the leading international institutions that carry out this kind of activity is normally made out of London, New York or any other international financial center and they usually act in the secondary market and not as a primary dealer. The clients for this business could be resident anywhere including Brazil, but will always be "professionals", that is banks, investment companies or other institutional investors, never private individuals. Brazilian financial institutions or other entities authorised by the Central Bank of Brazil (Bacen) to operate in the Brazilian jurisdiction are very regulated and subject to many limitations in their business, but they customarily buy and sell such bonds through off-shore vehicles.

When purchasing bonds from a broker rather than converting United States Dollars or any other foreign currency to Brazilian currency (the "Real") in order to pay for these bonds, the foreign bank may seek to enter into alternative arrangements. Prior to the settlement of its purchase of bonds, the foreign bank would agree to sell the bonds to a counterparty at the market price with a simultaneous agreement to repurchase equivalent bonds from the counterparty at a slightly higher price on a certain future date. The difference between the sale and repurchase consideration is the equivalent of interest paid for borrowing the Brazilian currency. This is the so-called repurchase transaction or "repo". The counterparty to this repo transaction might be the broker from whom the foreign bank is buying the bonds but this need not necessarily be the case.

Unless otherwise negotiated by the parties, such arrangements would not result in a legal transfer of title to the bonds initially from the broker to the foreign bank and then, under the repo transaction, from the foreign bank to the counterparty. According to our past experience in connection with similar transactions, the counterparty would only have a contractual obligation to resell equivalent bonds to the foreign bank on a certain future date and conversely the foreign bank would have a contractual obligation to purchase the bonds from the counterparty at that time. One of the major concerns of the foreign banks is to identify what would be the attitude of a court in Brazil vis-a-vis such arrangements. A court in Brazil would, in our opinion, accept such arrangements, without attempting to recharacterise these arrangements, provided that: (i) there is no fraud and (ii) the specific arrangements were not made with the purpose of adversely affecting the eventual creditors' rights of any of the parties.

If the foreign bank intends to invest in all types of debt instruments issued by the Brazilian government domestically or internationally, other considerations should be made. A foreign bank can invest directly in Brazilian government instruments as long as they are traded overseas.

In order to directly trade with government bonds in Brazil, the foreign bank would have to be expressly authorised to operate as a financial institution for Brazilian legal purposes and effects. Foreign financial institutions are not automatically authorised. If a foreign bank decides to operate locally, an establishment in Brazil would have to be set up according to the regulations of Bacen. This could occur in three manners: (a) by opening a branch of the foreign bank in Brazil; (b) by acquiring a Brazilian financial institution already operating; and (c) by incorporating a new financial institution in Brazil.

All these alternatives are long term ones and can involve a lengthy bureaucratic procedure with Brazilian authorities, which includes Bacen's prior analysis and approval, as well as a Presidential Decree. Alternatively, the foreign bank could trade indirectly in Brazil through an existing Brazilian financial institution. Such institution can set up and administrate a portfolio for the foreign bank in Brazil, consisting of government instruments.

With respect to the relevant tax aspects, it should be stressed that under Brazilian law any payment of interest or earning of any kind (other than principal) made by a Brazilian source is subject to a withholding tax at the standard rate of 15% (except if the creditor is domiciled in Japan, when the applicable rate is reduced to 12.5% by force of the tax treaty entered into by and between Brazil and Japan).

It is a common practice generally adopted in the Brazilian market, however, that this tax burden be contractually assumed by the issuer of the bonds. This is a standard provision which is included in almost all bond issue documents that we have seen. Furthermore, the securities issued by the Brazilian government may be exempt from such withholding tax, depending on the bond.

However, in the event the foreign bank were to hold bonds issued by the Brazilian government over an income payment date, even if a withholding tax is charged, income would be "grossed-up" so that the foreign bank would be entitled to receive the corresponding net amount free and clear of any Brazilian taxes. This "grossing-up" mechanism will apply on all interest payments made by the Brazilian government to the foreign beneficiary on the competent maturity date. Therefore, the prior sale or purchase of the bonds by a third party will not affect the "grossing-up" of the interest payment, provided that this tax burden is contractually assumed by the issuer of the bonds.

The above comments on withholding tax are only applicable in the case the clients of the foreign bank are domiciled and resident overseas for Brazilian tax purposes. However, if the clients are Brazilian residents, no withholding tax whatsoever would be due.

According to Brazilian tax legislation in force, interest paid on bonds issued overseas by Brazilian legal entities, in accordance with the rules set forth by Bacen can be exempt of withholding tax, based on the following criteria:

  • provided the bonds have a maturity date longer than a 96 month-period (item VII, article 1 of Federal Law nr. 9841 of August 13, 1997);
  • provided the interest paid on the bonds is from external public debt bonds (i) of the National Treasury related to loans or foreign credit transactions or (ii) related to loans or credit transactions carried out by the Federal government (Executive Power);
  • provided the interest paid on the bonds is produced by National Treasury Bonds (BTN) and National Treasury Notes (NTN), issued for voluntary exchange for Brazilian Foreign Debt Bonds, an object of exchange for foreign debt of the public sector, registered with Bacen, as well as to interest referring to Bonds issued by Bacen.

No other taxes might impact transactions involving Brazilian government bonds. Interest payments arising out of private bonds, however, could be subject to a federal contribution on financial transactions, known as CPMF tax, at the rate of 0,02%.

In summary, in order to minimize the possible tax impact, it is paramount to establish a procedure of always dealing with transactions related to bonds issued and placed in the international market by Brazilian governmental bodies or with a maturity date exceeding 96 months.

The content of this article is intended to provide a general guide to the subject matter. A specialist's advice should be sought in order to provide professional advice on a case to case basis which will meet specific circumstances.

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