On May 12 2011 the Brazilian Internal Revenue Service issued Ordinance 1.154 on the principles of thin capitalisation. The principles had been previously established on June 6 2010 by Law 12.249; the new ordinance consolidates the applicable rules and procedures.
These rules apply to money borrowed by a Brazilian company from a foreign related party - namely, a foreign controlling party or a party under common foreign control.
Thin capitalisation allows the borrowing party to pay interest to the related party lender instead of paying dividends. Payments of interest qualify for corporate income tax deduction, while payments of dividends do not.
Following similar trends in other countries - such as the United States, the United Kingdom, Australia and Argentina - the Brazilian regulation attempts to discourage thin capitalisation and incentivise pure capital increases.
Provided that the related party is not located in a privileged tax regime, the following principles dictate the debt and corresponding interest eligible for borrower income tax deduction (ie, the debt limit):
- If the lending related party directly holds an equity interest in the borrower, then the debt limit amounts to twice the related party's equity interest;
- If the lending related party does not directly hold an equity interest in the borrower, then the debt limit is twice the borrower's net worth; and
- If loans are granted by a group of related parties, some of which hold a direct equity interest in the borrower and others of which hold no such interest, then the debt limit is twice the sum of the equity interests held by the group as a whole.
When the loan exceeds the applicable thin capitalisation debt limit, a deduction for the interest paid is available only where the loan can be proved necessary to generate borrower revenue.
Moreover, when the loan exceeds the applicable thin capitalisation debt limit, only the amount of interest paid proportional to the debt limit amount can be deducted for the purpose of Brazilian corporate income tax.
If the lending related party is located in a privileged tax regime, then the debt limit is equivalent to 30% of the borrower's net worth.
Thin capitalisation debt limits also apply to traditional bank loans incurred by borrowers and guaranteed by foreign related parties.
As long as the capital raised is used to make loans, the thin capitalisation rules do not apply to international capital raised by Brazilian commercial banks, investment banks and other financial institutions.
The purpose of the new ordinance is to provide investors and other economic agents with welldefined rules. However, such rules are very detailed and require case-by-case analysis.
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.