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
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
(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
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
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
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
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
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
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
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
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
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.