A number of causes could be raised along with the unprecedented crises and corruption scandals that affected both the congress and the Brazilian government, but this article intends neither to address such causes nor to present the many positive factors arising from the crises that will certainly benefit the country in the long run.
In the short term, many opportunities may be found in the Brazilian markets including, for obvious reasons, mergers and acquisitions involving distressed assets, among which overleveraged companies that failed to meet financial covenants, causing the acceleration of their financial debt and the need to renegotiate with creditors.
The purpose of this article is to briefly address certain key Brazilian tax impacts that investors should pay attention to when targeting a transaction involving Brazilian companies under financial distress.
Recognition of income arising from the renegotiation of debt
In general, a number of different factors are balanced in a renegotiation of debt between debtors and creditors and depending on the level of financial distress and the potential of recovery of the debtor may involve:
(a) a discount on the face value of the original debt to reduce the level of indebtedness and both allow the continuity of the business and the partial recovery for the creditor (or an ‘explicit haircut’);
(b) an ‘implicit haircut’, whereby the original debt is re-profiled with a substantially duration increase and/or a reduction on the interest rate originally agreed by the parties. From a valuation perspective, such implicit haircut may be structured to emulate the financial impact of an explicit haircut (at least at the renegotiation date). While the nominal value of the original debt is not impacted, the re-profiling of the debt may cause substantial a reduction in its fair value (overtime the debt will accrue back to its face amount, but debtor benefits from an immediate relief on its the indebtedness);
(c) a debt for equity swap (‘debt/equity swap’), by which the original debt is exchange by equity instrument issued by the debtor.
While no extraordinary accounting knowledge is needed to conclude that the explicit haircut gives rise to the recognition of income arising from the portion of the liability cancelled with the renegotiation of the debt, the recognition of income derived by both an implicit haircut and a debt/equity swap may sound counterintuitive for those who are not entirely familiarised with the complex set of rules provided by the applicable International Financial Accounting Standards (IFRS) also adopted in Brazil.
As for the implicit haircut, International Accounting Standard No 39 (IAS 39) address the subject as follows:
“40. An exchange between an existing borrower and lender of debt instruments with substantially different terms shall be accounted for as an extinguishment of the original financial liability and the recognition a new financial liability. Similarly, a substantial modification of the terms of an existing financial liability or a part of it (whether or not attributable to the financial difficulty of the debtor) shall be accounted for as an extinguishment of the original financial liability and the recognition of a new liability.
41. The difference between the carrying amount of a financial liability (or part of a financial liability) extinguished or transferred to another party and the consideration paid, including any non-cash assets transferred or liabilities assumed, shall be recognised in profit or loss.”
Pursuant to IAS 39 Application Guidance, paragraph AG62 for ”the purpose of paragraph 40, the terms are substantially different if the discounted present value of the cash flows under the new terms, including any fees paid net of any fees received and discounted using the original effective interest rate, is at least 10 per cent different from the discounted present value of the remaining cash flows of the original financial liability. If an exchange of the debt instruments or modification of terms is accounted for as an extinguishment, any costs or fees incurred are recognized as part of the gain or loss on the extinguishment. If the exchange or modification is not accounted for as an extinguishment, any costs or fees incurred adjust the carrying amount of the liability and are amortised over the remaining term or the modified liability”.
In addition to that, paragraph 43 of IAS 39 determines that a financial liability should be measured by its fair value upon its initial recognition. As a result, positive difference between the carry amount of the original liability and the fair value of the re-profiled debt would be recognised by the debtor as income affecting its profit and loss account (P&L).
In fact, impacts on the P&L of the renegotiation resulting in an implicit haircut (upon the closing of the renegotiation) are equivalent to those arising from explicit haircut, but tax impacts may be materially different as further discussed herein.
A similar accounting impact may arise in case the renegotiation is made by means of a debt/equity swap, according to the International Financial Reporting Interpretations Committee (IFRS Interpretations Committee) interpretation No 19 (IFRIC 19) that deals with the extinguishment of financial liabilities with equity instrument as follows:
“5. The issue of an entity’s equity instrument to a creditor to extinguish all or part of a financial liability is consideration paid in accordance with paragraph 41 of IAS 39. An entity shall remove a financial liability (or part of a financial liability) from its statement of financial position when, and only when, it is extinguished in accordance with paragraph 39 of IAS 39.
6. When equity instruments issued to a creditor to extinguish all or part of a financial liability are recognised initially, an entity shall measure them at the fair value of the equity instruments issued, unless that fair value cannot be reliably measured.
7. If the fair value of the equity instruments issued cannot be reliably measured then the equity instruments shall be measured to reflect the fair value of the financial liability extinguished. In measuring the fair value of a financial liability extinguished that includes a demand feature (eg. a demand deposit), paragraph 47 of IFRS 13 is not applied.
(…)
9. The difference between the carrying amount of the financial liability (or part of a financial liability) extinguished, and the consideration paid, shall be recognised in profit or loss, in accordance with paragraph 41 of IAS 39. The equity instruments issued shall be recognised initially and measured at the date the financial liability (or part of that liability) is extinguished.
(…)
11. An entity shall disclose a gain or loss recognised in accordance with paragraphs 9 and 10 as a separate line item in profit or loss or in the notes.”
While both debt/equity swap and implicit haircut may cause similar income recognition impact in the debtor P&L as a result of fair value measurement of the new instrument (debt or equity as the case may be) and the de-recognition of original debt, in terms of ongoing level of indebtedness debt/equity swap and implicit haircut produce different impacts.
Unlike in the case of the Implicit Haircut, from the perspective of the debtor, income recognised under a debt/equity swap has a definitive nature, as well as the liability is definitively de-recognised.
Income realised under an implicit haircut has a temporary nature, given that the face value of the liability is maintained and the re-profiled debt will accrue back to its original face amount, giving rise to financial expense accrued over the new term of the debt with nominal value equivalent to the income previously recognised.
Therefore, one can conclude that P&L impact of debt/equity swap is actually equivalent to the one derived by an explicit haircut. In other words, debt/equity swap could be categorised as a particular type of explicit haircut, whereby the creditor agrees to receive the equity instrument as a payment in kind of the debt that is usually greater in value than the fair value of such equity instrument.
Bearing in mind the accounting impacts that may arise in a renegotiation of debt, we may now move on to address the associated tax impacts.
General Brazilian corporate tax considerations
Profits of Brazilian companies are subject to corporate income taxes (CIT), namely, corporate income tax (IRPJ) and social contribution tax on net profits (CSLL).
Such taxes are calculated on the basis of the actual profit method (APM) or the presumed profit method (PPM). Certain companies may choose between these two methods, while other companies, depending on their turnover and other characteristics stipulated in the law, must use exclusively the actual profit method.
IRPJ is due at the rate of 15% in addition to a surplus rate of 10% for taxable income exceeding BRL20,000 per month. CSLL is charged at the rate of 9%, except for financial institutions, which are subject to a 15% rate. The combined CIT rate is approximately 34%.
Given that under the PPM cost and expenses are generally non-deductible, companies under financial distress could be expected to elect the APM, so that to allow tax deduction of net operating losses. Under the actual profit system, tax losses may be carried forward with no time limitation, but offset is capped at 30% of the taxable income declared in subsequent periods (30% CAP).
The contribution to the social integration programme (PIS) and the social security financing contribution (COFINS) are taxes levied on monthly gross income earned by Brazilian companies and calculated in accordance with the cumulative or the non-cumulative regime, which permits tax credits on some costs and expenses expressly determined by law.
For companies that elected the APM, PIS and COFINS are levied at a combined 9.25% rate, and a reduced 4.65% rate is applicable to financial income.
Accounting recognition, in accordance with IFRS, is the starting point for the assessment of CIT, PIS and COFINS. As a rule, taxpayer should follow the accounting, unless there is a particular adjustment provided by the tax laws.
Tax impacts on income arising from the renegotiation of debt
Restructuring debt through either an explicit haircut (including in the form of debt/equity swap) or an implicit haircut may result in tax impacts to the extent that either may generate accounting income under the IFRS as addressed in the previous sections.
Explicit haircut income is generally subject to CIT and tax impacts may be mitigated by expenses and losses accrued during the same period. Amount of tax to be paid may be reduced by tax loss carry forwards subject to the 30% cap.
As to PIS/COFINS, one may argue that explicit haircut income should be categorised as financial income subject to 4.65% rate, and not to the regular 9.25% rate.
Because the income arising from the implicit haircut derives from a difference between the face value of the original debt and the ‘new’ debt recognised at its fair market value it would be possible to argue that a particular tax deferral provision should be applicable.
As a matter of fact, Brazilian tax law determines that gains resulting from the fair value measurement of assets and liabilities should be taxed upon accounting recognition, unless the correspondent amount is booked in a specific subaccount associated with the liability.
That being the case, for CIT purposes such income should only be included in the taxable basis when the lability is liquidated or written-off, moment in which the relevant subaccount should also be written-off.
Even though it is true that under the accounting rules previously discussed income is recognized in connection with the extinguishment of the original debt, it is also true that such income is recognised “as a result of” the fair value measurement of the re-profiled debt. If the re-profiled debt were to be booked in accordance with its face value (instead of being recognised at fair value), than no income would ever be recognised, allowing the argument for the tax deferral.
When re-profiling the debt, certain features may be considered to avoid, as much as possible, mismatches between the tax recognition of the implicit haircut gain and the deduction of the higher financial expense to be recognised overtime.
If the nature of such income as resulting from the fair value measurement of the debt prevails, than it would be possible to rely on a particular provision of the tax law that exclude fair value gains from the PIS and COFINS tax basis.
However it is important to emphasize that the tax provisions that deals with fair value measurement gains are quite recent ones and that at this point, there are no court precedents or further guidance from tax authorities on the matter.
As the tax exposure could be material depending on the level of haircut achieved in the restructuring, this is a matter to be carefully reviewed by the relevant parties. Also, there are many other tax implications that may arise in a distressed M&A and that could vary a lot depending on the structure of the deal. Investors in distressed M&A should dedicate enough time and efforts for the structuring phase to avoid inheriting unnecessary tax liabilities.
