One of the most powerful tools for U.S. investors in cross-border tax planning is the ability to make a “check-the-box” election. Pursuant to the entity classification regulations under U.S tax code Section 7701, certain business entities are permitted to choose their classification for U.S. federal income tax purposes by making a check-the-box election.
In this context, the eligibility of a foreign entity to make a “check-the-box” election is indeed a very important factor taken into account by U.S. investors in decision-making, to the extent the ability to have those foreign entities treated as a corporation, partnership, or a disregarded entity affects many aspects of U.S. taxation.
A foreign eligible entity is relevant when its classification affects the liability of any person for U.S. federal tax or information purposes. For example, a foreign entity’s classification would be relevant if U.S. source income is paid to the entity, and the amount to be withheld by the withholding agent would vary depending upon whether the entity is classified as a partnership or a corporation. The classification of a foreign eligible entity also becomes relevant on the date that an obligation arises to file a tax return or information return for which the classification of the entity must be determined. For instance, the classification of a foreign entity becomes relevant on the date that a U.S. person acquires an interest in that entity that will require the U.S. owner to file a Form 5471, Information Return of U.S. Persons with Respect to Certain Foreign Corporations.
Considering that the typical approach used by private equity firms to invest in Brazil since 2003 has been through Private Equity Investment Funds (“FIPs” - Fundos de Investimento em Participações), this article is intended to demonstrate that FIPs meet the necessary requirements to be eligible to make a “check-the-box” election—mainly after the enactment of Law No. 13,874/2019—by presenting (i) an overview of the FIPs regulation and taxation pursuant to Brazilian legislation; as well as (ii) the U.S. laws and regulations on the subject matter that support our conclusion.
Brazilian Private Equity Investment Funds—Overview, Regulation, and Taxation
As pointed out above, a FIP is an investment vehicle that provides foreign investors with an efficient vehicle for investing in the Brazilian private equity market. It is not a legal entity, but rather a closed-end investment fund incorporated by investors as a co-ownership vehicle for the purpose of investing in securities.
FIPs are generally limited to investing in the shares, debentures, and warrants issued by Brazilian Corporations (S/As) and, under certain circumstances and up to certain limits, Brazilian Limited Liability Companies (Limitadas). In general, the FIP’s investors (quotaholders) are only entitled to redeem their ownership interests in a FIP (quotas) at the end of the FIP’s term. However, the FIP itself may, consistent with the FIP’s charter, sell underlying investments and distribute or reinvest sale proceeds throughout the life of the FIP.
Brazilian law requires FIPs to actively participate in the management of any company in which the FIP invests. Unlike U.S. private equity funds, which are managed by general partners, FIPs are managed by independent legal entities accredited with the Brazilian Securities Exchange Commission (CVM).
Although FIPs are transparent for Brazilian tax purposes, the Brazilian companies below a FIP will continue to be subject to the regular corporate taxation in Brazil, charged at a 34% rate, as well as to the Contributions to the Social Integration Program (PIS) and to the Financing of the Social Security (COFINS) levied at a 9.25% rate under the non-cumulative system. The PIS/COFINS cumulative system, levied at a 3.65% rate, remains applicable for certain entities, such as financial institutions and companies under the deemed profit system (lucro presumido). Currently, no Tax on Financial Exchange and Insurance Transactions (IOF) is levied on any FIP investment or divestment by foreign or local quotaholders.
However, the taxation of income generated by a FIP portfolio is deferred until the FIP income is paid to its quotaholders. Further, any income derived by a foreign investor is generally exempt from Brazilian income and capital gains tax if certain requirements are met.
To the extent a foreign investor holds less than 40% of the FIP (economic, political, and governance rights), any income (dividends, capital gains, interest, etc.) arising from the FIP should be exempt from Brazilian taxes.
There are a number of conditions that a FIP must fulfil in order to be exempt from Brazilian taxes. In summary, they include: (1) 90% or more of the portfolio must consist of shares, convertible debentures or warrants issued by Brazilian companies; (2) FIP quotaholders (individually or together with related parties) must not hold 40% or more of the total quotas issued by the FIP; and (3) direct foreign quotaholders of the FIP cannot be located or domiciled in a tax heaven.
Normative Ruling No. 1,634/2016 requires the disclosure of information with respect to “ultimate beneficial owners.” Such owners include individuals and certain entities that, directly or indirectly, hold, control, or “significantly influence” an entity, as well as individuals and certain entities on whose behalf a transaction is undertaken. In its turn, “significant influence” is deemed to exist when the individual or other investor, directly or indirectly, holds 20% or more of the entity’s stock or has exercised or exercises “preponderance”—that is, power over decisions, or to elect the majority of the entity’s executives—despite not controlling the entity. One of the main concerns and current discussions arising from Normative Ruling No. 1,634/2016 concerns the investments through FIPs as its owners would need to disclose their ownership structure. A key question for both the holding entities and the Brazilian companies (i.e., either the portfolio company or Brazilian companies under the FIP) will be the level of disclosure.
As mentioned above, if investments of the FIP are sold, there is no immediate tax levied, which is only potentially triggered when the quotas are amortized or liquidated (at a 15% rate levied on quota-holders not qualifying for the FIP benefits above mentioned).
If the capital gains are effectively reinvested in the FIP, the 15% taxation is deferred, to the extent such reinvestment is allowed by the FIP’s bylaws.
Since 2014, a 0% Brazilian capital gains tax applies to the direct sale or amortization of the FIP quotas held by foreign investors that hold no more than a 40% interest in a FIP amongst the other requirements above listed. Prior to this, such 0% taxation was limited to transactions involving the withdrawal of the FIP income, being any gains involving the direct sale of the FIP quotas subject to the 15% Brazilian capital gains tax.
In August 2016, CVM issued Ruling No. 578, providing new regulations for the Brazilian FIPs, which brought several changes and innovations to the FIP market, making them more attractive and favorable investors. For example, this included (1) the expansion of assets permitted as investments (e.g., non-convertible debentures and investments abroad); (2) the possibility of advance for future capital increase; and (3) the objective liability attributed to the administrator and manager of the FIP, bringing even more control and governance to the quotaholders. The ruling also revoked prior CVM Ruling No. 391/03.
Additionally, CVM Ruling No. 578/2016 allows FIPs to (1) invest in Brazilian Limitadas; (2) invest, directly or indirectly, in foreign entities (up to 20% of its net equity), which shall allow its use as an investment hub; and (3) have 33% of its portfolio consisting of non-convertible debentures, except for infrastructure and research, development, and innovation FIPs, to which there is no limitation. Before such change, the FIP could invest or own stakes only in Brazilian S/As. Except for infrastructure and research, development, and innovation FIPs, to which there is no limitation.
In spite of the aforementioned changes in the FIP rules, the tax legislation still provides that at least 67% of the FIP portfolio should consist of Brazilian (not foreign) S/A convertible debentures or S/A subscription bonds.
More recently, as addressed below, Brazil enacted Law No. 13,874/2019 allowing investment funds to confer limited liability to its investors, which in practice rules out the chances of a FIP being subject to piercing of the corporate veil, to the extent liabilities can at most be attributed to the administrator and manager of the FIP, but not to its investors.
Limited Liability to FIP’s Investors Provided by Law No. 13,874/2019
In September 2019, Brazil enacted Law No. 13,874, known as the “Economic Freedom Right Act” (Law. No. 13,874/2019), which amended the Brazilian Civil Code in order to strengthen the legal framework for investment funds—regulated by CVM—and bolster investment by foreign investors in Brazil. Before the enactment of Law No. 13,874, the legislation applicable to Brazilian investment funds was not unified and, thus, required application of both the Civil Code and other legislative sources for purposes of clarifying issues relating to the legal status of such funds.
Such uncertainty resulted in increased costs and litigation for investment fund managers. However, under Law No. 13,874/2019, investment funds are now treated as a “condominium”, which in essence is defined as a collective investment vehicle that facilitates ownership of a pool of assets by its investors.
Relevant amendments under the new legislation include:
- Limited liability to investors. Investment funds may confer limited liability to investors through a change to their bylaws;
- Limited liability to service providers. Investment funds may confer limited liability to service providers through a change to their bylaws. This change may reduce fees and costs associated with service providers, since limiting their liability creates a more stable legal framework; and
- Share classes with different rights and obligations. Investment funds may create share classes with different rights and obligations, as well as segregated equity for each share class.
Based on the various characteristics of FIPs described above, together with the new guidance enacted under Law. No. 13,874/2019, it is our understanding that FIPs are eligible to elect their classification (i.e., “check-the-box” election) for U.S. federal tax purposes under the tax code and the corresponding Treasury Regulations.
U.S. Law and FIP’s Eligibility for a Check-the-box Election
As mentioned in the Introduction, the ability to elect the tax classification of a non-U.S. eligible entity provides U.S. taxpayers the powerful option of electing how to treat their non-U.S. subsidiaries for U.S. federal tax purposes. Whether such election is made may affect both the timing and ultimate U.S. taxation of the non-U.S. income earned.
Section 7701 and the corresponding check-the-box Treasury Regulations permit “eligible entities” to choose their tax classification for U.S. federal income tax purposes. In general, this election is available to both U.S. and non-U.S. entities that otherwise meet certain requirements under the Treasury Regulations.
Although under Brazilian law FIPs are not considered separate legal entities, for U.S. federal tax purposes, whether a non-U.S. organization is an entity separate from its owners is a matter of U.S. federal law and does not depend on whether the non-U.S. organization is recognized as an entity under non-U.S. law. Treasury Regulation Secion 301.7701-1(a).
As mentioned above, Treasury Regulations provide that an eligible entity can elect its classification for U.S. federal tax purposes. Treasury Regulation Section 301.7701-3(a). An eligible entity is a business entity that is not classified as a corporation under Treasury Regulation Sections 301.7701-2(b)(1), (3)-(8). Note that FIPs are not deemed to be classified as corporations (i.e., per se corporations) and are not otherwise classified as corporations under these Treasury Regulations.
For these purposes, a business entity is any entity recognized for federal tax purposes that is not properly classified as a trust under Treasury Regulation Section 301.7701-4 or otherwise subject to special treatment under the Code.
There are various types of trusts described under Treasury Regulation Section 301.7701-4, including, for example, investment trusts. However, an investment trust will not be classified as a trust if there is a power under the trust agreement to vary the investment of the certificate holders. Treasury Regulation Section 301.7701-4(c)(1). Since a FIP has the power to sell underlying investments and either distribute or reinvest sale proceeds throughout the life of the FIP (i.e., the FIP has the power to vary the investment of the quotaholders), it seems to us that a FIP should not be characterized as a trust under the U.S. tax code and Treasury Regulations.
Based on its aforementioned features, it appears that a FIP is more likely to be characterized as a business entity rather than a trust. In this regard, the FIP structure resembles much more of a limited liability company (LLC), whereby the owners are not personally liable for the company’s debts or liabilities. LLCs are hybrid entities that combine the characteristics of a corporation with those of a partnership or sole proprietorship. While the limited liability feature is similar to that of a corporation, the availability of flow-through taxation to the members of an LLC is a feature of partnerships (and not an LLC). The LLC structure is not recognized under federal tax law; therefore, an LLC’s filing status is determined by the check-the-box rules.
In view of the above, given the FIPs characteristics, we understand that FIPs would probably fall within the concept of “business entities” and could be therefore eligible to a “check-the-box” election for U.S. federal tax purposes.
Main reasons for that are—pursuant to U.S. law—(1) an “eligible entity” for a check-the-box election is a “business entity” that is not classified as a corporation; (2) a FIP is not per se a corporation and is not otherwise classified as a corporation under U.S. law. Moreover (3) a “business entity” is any entity recognized for federal tax purposes that is not properly classified as a trust; and (4) a FIP should not be classified as a trust for U.S. tax purposes.
Pursuant to Treasury Regulation Section 301.7701-3(b)(2)(i)(B), Brazilian Limitadas are eligible to make a “check-the-box” election, and thus be treated as disregarded entities for U.S. federal tax purposes. Considering the understanding exposed herein, in the sense that FIPs are also eligible to make a “check-the-box” election and be treated as disregarded entities for U.S. federal tax purposes, it is possible to achieve an entire pass through structure up to the level of the investors in a scenario where a FIP is investing in Limitadas. In this structure, the FIP shall not be eligible for the tax exemption granted to foreign investors, as previously mentioned in Topic II.
However, in a scenario where a FIP is investing in both Limitadas and S/As, we have a hybrid scenario. But the FIP may still elect to be treated as a disregarded entity for U.S. federal tax purposes, although the S/As are not eligible to make a “check-the-box” election for being per se corporations. The implications arising from the implementation of such hybrid structure will be certainly a story to be seen in the future.
This column doesn’t necessarily reflect the opinion of The Bureau of National Affairs Inc. or its owners.
Celso Grisi is a partner in the tax practice of Mayer Brown at the São Paulo Office. He holds an LLM in International Taxation from The University of Michigan Law School and a master’s degree from the University of São Paulo Law School. He has worked for two years at PricewaterhouseCoopers in New York, particularly advising hedge funds on structuring their Latin America investments and divestments.
Maria Carolina Grecco Bazzanelli is an associate in the tax practice of Mayer Brown at the São Paulo Office. She holds an LLM in International Taxation from the New York University Law School and has worked as a foreign associate in the Tax Transactions & Consulting practice in Mayer Brown New York Office, where she focused her practice mainly on cross border transactions.