Nélio Weiss		Philippe Jeffrey

On December 16 2009, Brazil's executive branch published Provisional Measure (PM) 472 which, among other provisions, introduces thin capitalization rules. Although the PM 472 has entered into force as of December 16 2009, the Brazilian Congress initially had 60 days to veto the provision, modify it, or convert it into law. As the Congress did not act within this initial 60-day period, the PM has been extended for an additional 60-day period.

A proposed bill of law, which will have the effect of converting into law the provisions of the PM 472, is currently under discussion at the national congress. We summarize below its main provisions that would clarify and/or modify the initial thin capitalization provisions included in the PM 472.

Thin Capitalisation Rules – When the beneficiary of the payment is not resident in a tax haven jurisdiction

Initially, the PM 472 had set forth that interest paid or credited by a Brazilian entity to a related party (individual or legal entity) which is not resident or domiciled in a tax haven jurisdiction may only be deducted for income tax purposes if (i) the interest expense is viewed as necessary for the activities of the local entity, (ii) the amount of debt granted by the related party does not exceed twice the amount of its participation in the net equity of the Brazilian entity, and (iii) the total amount of the Brazilian entity's debt does not exceed twice the amount of foreign related parties' participation in the Brazilian entity's net equity.

One of the questions the PM 472 did not answer was how to apply the test in case interest is paid to a related party that has no share participation in the net equity of the Brazilian entity (for example a foreign sister company). The proposed bill of law intends to correct this omission by setting forth that in such case, the 2 to1 (participation) ratio would be reduced to 50% of the total net equity of the Brazilian entity. Accordingly, if a related party with no participation in the net equity of the entity lends money to the Brazilian entity and the amount of debt exceeds 50% of the net equity, the portion of interest related to the excess amount would not be deductible for Brazilian tax purposes.

Thin Capitalization Rules – When the beneficiary of the payment is resident in a tax haven jurisdiction

The PM 472 also included similar provisions applicable to interest paid or credited by a Brazilian entity to an individual or legal entity (whether or not a related party) resident or domiciled in a tax haven or favorable tax regime jurisdiction. In these cases, the interest expense would only be deductible for Brazilian income tax purposes if (i) the expense is viewed as ordinary and necessary as referenced above, (ii) the amount of the debt does not exceed 30% of the Brazilian entity's net equity, and (iii) the total amount of the Brazilian entity's debt with any foreign party resident or domiciled in a tax haven jurisdiction does not exceed 30% of the entity's net equity.

The proposed bill of law is revoking the application of the second test. That is, in case of a debt arrangement with a party resident or domiciled in a tax haven (or favorable tax regime) jurisdiction, the amount of interest would only be deductible if the expense is viewed as ordinary and necessary and the total amount of the Brazilian entity's debt with all foreign parties resident or domiciled in a tax haven jurisdiction does not exceed 30% of the entity's net equity.

As it is currently unknown whether the proposed bill of law will be approved as is and because it is an evolving issue with potentially significant implications to multinationals with operations and/or investments in Brazil, taxpayers should be monitoring any development closely.

Nélio Weiss (nelio.weiss@br.pwc.com), & Philippe Jeffrey (philippe.jeffrey@br.pwc.com)