Brazil’s new tax regime for financial investments, CFCs, and trusts held abroad

By David Roberto R. Soares da Silva

Through Provisional Measure No. 1.171/2023 (MP 1171), published in an extra edition of Brazil’s Official Gazette on April 30, 2023, the Lula Government substantially altered the way financial investments abroad, including those made through offshore companies and trusts, should be taxed. If approved by Congress, the new rules will take effect on January 1, 2024.

One can say that MP 1171 creates a special tax regime for various investments made abroad by Brazilian resident individuals, unifying how they should be taxed in Brazil. Art. 1 states that the new rules apply to income earned by individual residents in Brazil in financial investments, controlled foreign corporations, and trusts held abroad.

It is already possible to anticipate that, in practical terms, the new regulations eliminate the need for monthly calculation and payment of income tax on income and gains earned abroad by resident individuals.

Let’s go through MP 1171.

1. Tax rates

MP 1171 unifies the income tax rates on income from capital invested abroad in the form of financial investments, profits, and dividends from controlled foreign corporations (CFCs), and assets and rights under a foreign trust earned as of January 1, 2024. Thus, there will no longer be any distinction in taxation between foreign dividends, interest, coupons, etc. Currently, while dividends from CFCs are treated as ordinary income subject to the progressive income tax brackets (rates between zero and 27.5%, interest and other income from financial investments abroad are treated and taxed as capital gains with rates between 15% and 22.5%.

MP 1171 brings an important innovation: the elimination of the monthly income tax calculation on foreign-source income from financial investments, including CFC (the so-called Carnê-Leão regime). Beginning in 2024, they will only be calculated in the taxpayer’s Annual Tax Return (Declaração de Ajuste Annual, or DAA), separately from other income and capital gains (Art. 2).

Financial investments, CFC’s profits and dividends, and assets and rights under a trust will be subject to income tax in the DAA at the following tax rates:

In other words, MP 1171 creates a progressive table whose rates will be applied to annual foreign-source income. So, for example, an annual foreign-source income (subject to MP 1171) of BRL 60,000 would be subject to an overall tax burden of 14.75% (BRL 8,850), which could be represented as follows:

It is worth reiterating that not all capital investments are subject to the new rule, but only those considered financial investments under MP 1171. So, for example, rental income from real estate directly held by a resident individual will continue to be subject to the progressive tax rates and monthly Carnê-Leão.

The same goes for direct investments, for example, in startups and other companies not controlled by the taxpayer resident in Brazil. Their profits can be deferred until actual receipt, and the applicable rates will be those of the monthly progressive table.

Gains from other assets and rights that are not considered financial investments are still subject to 15% to 22.5% rates established by Article 24 of Law No. 8,981/1995, without the zero-rate band.

2. Financial investments abroad

MP 1171 defines what is considered income from financial investments abroad, subject to rates of zero to 22.5%.

“Financial investments” include, for example, bank deposits, certificates of deposit, investment fund shares, except for those treated as CFCs abroad, financial instruments, insurance policies, investment certificates or capitalization operations, credit card deposits, retirement or pension funds, fixed and variable income securities, derivatives, and equity participation, except for those treated as CFCs abroad.

“Income” is defined as the “remuneration produced by financial investments, including, for example, foreign currency exchange rate against the national currency, interest, premiums, commissions, premium, discount, participation in profits, dividends, and gains from secondary market transactions, including gains from the sale of stock of non-controlled entities on foreign stock exchanges”.

Before MP 1171, dividends from stocks traded on foreign stock exchanges were subject to the monthly Carnê-Leão (up to 27.5%), but the sale of these stocks was treated as capital gain (15% to 22.5%). Starting in 2024, both operations will be (1) treated as income under MP 1171, (2) taxed only in the DAA, and (3) by the new rates of zero to 22.5%, with the “exemption” band of up to BRL 6,000 annually.

3. Controlled foreign corporations

MP 1171 brings a new definition of controlled foreign corporations (CFC), subject to the new tax rules starting in 2024, including various forms of investment vehicles.

CFCs will be considered as companies and other entities, whether or not incorporated, including investment funds and foreign foundations, in which an individual:

1. Directly or indirectly, alone or together with other parties, including as a result of voting agreements, holds rights that ensure preponderance in the entity’s decisions or the power to elect or remove the majority of its directors; or
2. Directly or indirectly, alone or together with related parties, owns more than 50% of the capital, or equivalent, or the rights to receive its profits or to receive its assets in the event of liquidation.

MP 1171 also defines a related party to include:

1. The spouse, partner, or relative, by blood or marriage, up to the third family degree, of the Brazilian resident taxpayer;
2. The legal entity whose directors or administrators are spouses, partners, or relatives, by blood or marriage, up to the third degree, of the taxpayer;
3. The legal entity of which the taxpayer is a member, owner, or shareholder; or
4. The individual who is a member of the legal entity of which the taxpayer is a member, owner, or shareholder.

An open question, for now, is whether three friends or three cousins who are not partners in other companies would be considered related parties, but this will be a topic of another analysis.

However, not all CFCs are affected by the new tax rule. The new regime only applies if the CFC in question falls under one of the following situations:

1. It is located in a low-tax jurisdiction or is a beneficiary of a favorable tax regime; or
2. It generates active income that is lower than 80% of the CFC’s total income.

The item “a” includes all companies located in tax havens or subject to a favorable tax regime, as long as they are expressly listed by Brazil’s Federal Revenue Department (FRD), in this case, Normative Instruction No. 1.037/2010, as amended.

For item “b,” MP 1171 defines active income as that obtained through the exploitation of an economic or business activity, which may include, for example, the operational activities of startups, international trading companies, and even agricultural exploitation. Thus, if a CFC is not in a low-tax jurisdiction (item “a”) and has more than 80% of its total revenue classified as its active income (item “b”), the new rules of MP 1171 do not apply.

It is worth noting that MP 1171 explicitly excludes as revenue from the exploitation of an economic or business activity the following activities that generate passive income:

1. Royalties;
2. Interest;
3. Dividends;
4. Equity holdings;
5. Rent;
6. Capital gains, except for the disposal of equity holding or permanent assets held for more than two years;
7. Financial investments; and
8. Financial intermediation.

Thus, for example, if a taxpayer maintains a company in Uruguay for agricultural exploitation, the new rules of MP 1171 will not apply, in principle. However, suppose this Uruguayan company has financial investment income (for example, interest, dividends) greater than 20% of the total annual revenue. In that case, it will be reclassified as a CFC subject to MP 1171 since its active income from agriculture will be lower than 80%.

Once classified as a CFC under MP 1171, the taxpayer must adopt the following procedures starting in 2024:

1. Determine the CFC profits on an individual basis (per company), based on the annual balance sheet prepared in accordance with the accounting principles accepted in Brazil (IFRS);
2. Convert profits to US dollars using the closing exchange rate established by the Central Bank for the last business day of December;
3. Include these profits, in proportion to the taxpayer’s ownership, in the DAA, regardless of any decision regarding their actual distribution;
4. Submit these profits to income tax in accordance with the MP 1171 tax rates; and
5. Include the taxed profit in the Assets and Rights section of the DAA as an additional investment acquisition cost.

Regarding item 5, MP 1171 allows the taxed profit to be added to the cost of the CFC investment, ensuring that it will not be taxed again upon distribution.

Regarding losses incurred by the CFC, MP 1171 allows for their offset, provided that these losses are incurred starting from the entry into force of MP 1171, that is, losses incurred starting January 1, 2024. Past losses cannot be deducted from profits incurred starting in 2024. At first glance, this limitation makes sense as profits incurred until December 31, 2023, will not be affected by the new rules.

If the CFC holds a stake in a Brazilian company, MP 1171 allows for the exclusion of the portion of profits and dividends attributable to that Brazilian company. For example, if a CFC reports a profit abroad of BRL 1 million and BRL 250,000 of that amount refers to the profits of a Brazilian company that the CFC controls, the CFC’s taxable profit for the taxpayer’s DAA will be BRL 750,000, given that the deduction of the ‘Brazilian profit’ is allowed.

The taxpayer can still deduct from income tax the amount of foreign income tax paid abroad by the CFC and its subsidiaries up to the limit of the income tax due in Brazil. This is certainly good news. For example, assume a taxpayer holds 100% of a BVI that, in turn, holds 100% of a US company subject to income tax in the US. Suppose the US company pays the equivalent of BRL 300,000 in taxes in a given year. That year, the BVI reports a profit of BRL 2 million, the amount the Brazilian taxpayer must report in their DAA. Let’s see how this calculation would be:

In theory, the idea is wonderful. This is because the law does not require any formality or limit the utilization of taxes paid abroad by the CFC or its subsidiaries. But it is possible to bet that the FRD will do everything to limit the use of this tax paid abroad. Let’s wait and see.

4. Special rules for CFCs

For CFC profits earned up to December 31, 2023, the same rules currently in force continue to apply, i.e., these profits will only be taxed, according to the progressive table (monthly Carnê-Leão) at the time they are made available to the taxpayer. That is, the tax deferral continues to apply for pre-2024 profits.

The same rule applies to foreign companies that do not fall under the new rule, as was the case of the Uruguayan agricultural company (without financial income), which was mentioned above.

But MP 1171 defines what should be considered “profit made available” to the taxpayer. In this case, it will be the moment of:

1. payment, credit, delivery, employment, or remittance of profits (to the taxpayer), whichever occurs first; or
2. any credit operations conducted with the taxpayer or with a related person linked to them if the creditor (the CFC) has profits or profit reserves.

MP 1171 clarifies that the exchange rate variation of the investment in foreign subsidiaries, in any situation, will be treated as capital gain, to be taxed at the time of the disposal, write-off, or liquidation of the investment, including capital redemption.

In this case, a reservation must be made with the provisions of Normative Instruction (IN) No. 118/2000, which makes a distinction regarding exchange rate variation when the origin of the asset was in Brazilian reais or foreign currency. In the latter case, IN 118/2000 establishes that exchange rate variation is tax-free income, not capital gain. It is still too early to say if the new rule of MP 1171 is revoking the exemption previously provided in IN 118/2000.

5. Foreign trusts

For the first time, legislation regulates how foreign trusts will be treated for tax purposes in Brazil. In general, the MP 1171 disregards the existence of the trust, requiring the taxpayer to declare the assets held by the trust and to tax their income according to the new rules.

The MP establishes that assets and rights held in a foreign trust shall be considered as:

• remaining under the trust settlor’s ownership after the establishment of the trust; and
• passing to the beneficiary’s ownership at the time of distribution by the trust to the beneficiary or upon the settlor’s death, whichever occurs first.

In other words, even without going into detail regarding the revocability of a trust, MP 1171 establishes that the assets in a trust will be the property of its settlor. There are two exceptions, however, for which the MP 1171 considers the beneficiary as the owner of the assets and rights held in a trust: when there is an effective distribution of an asset or right by the trust to the beneficiary or when the settlor dies, whichever occurs first.

Starting in 2024, income and capital gains related to assets and rights held by a trust abroad shall be taxed by its owner (the settlor or beneficiary, as the case may be), in accordance with the rules established in MP 1171.

Thus, if the trust holds financial investments directly, the interest, dividends, and gains earned during the year must be computed by the settlor (or beneficiary, as the case may be) in their DAA and taxed according to the new progressive table created by MP 1171.

On the other hand, if the trust holds investments through a CFC, then its owner (settlor or beneficiary) must disregard the existence of the trust and tax the CFC profits according to rules of the MP 1171 applicable to CFCs in proportion to their participation.

An important point in MP 1171 regarding trusts is related to distributions made by these vehicles to beneficiaries. Starting in 2024, the MP provides that these distributions will have the “legal nature of a gratuitous transfer from the settlor to the beneficiary, consisting of a donation if made during the settlor’s lifetime, or a death transfer if resulting from the settlor’s demise.”

In other words, upon the settlor’s death, the beneficiary must report the original value of the trust assets as a tax-exempt income (like an inheritance or donations) in exchange for including the trust assets in their DAA. From there, the beneficiary must start taxing those assets (investments, offshore, etc.) according to the rules established in MP 1171.

The same should occur in case of a distribution of an asset by the trust to the beneficiary, even if the settlor is still alive. The beneficiary must report the asset received as a tax-free donation and start taxing the gains and earnings of that asset according to the new rules.

Another rule of MP 1171 regarding trusts is the obligation, starting in 2024, for taxpayers to declare the underlying assets held in the trust in their Assets and Right Statement of the DAA and no longer the trust itself. For taxpayers who already declare trusts and not their underlying assets, starting in 2024, the reporting of the trust itself must be replaced by reporting each underlying asset held by the trust with the allocation of the original (trust) acquisition cost among them.

6. Special step-up in basis for foreign assets

MP 1171 allows for a special step-up in the basis of foreign assets held by individual taxpayers by paying an exceptional tax of 10%. Still, this topic will be addressed in another article.

Final (and very preliminary) remarks

At first glance, MP 1171 is bold and well-crafted. Although no one likes to pay taxes, its text is structured to minimize the possibilities of judicial disputes. Among its merits are the following:

• Simplification and unification of the tax rates for financial investments held abroad by resident individuals;
• The end of monthly income tax calculation on foreign-source income and gains, giving taxpayers time to plan for their year-end tax payment;
• No retroactive effect, keeping pre-2024 CFC profits subject to the rules existing when these profits were generated;
• The possibility of utilizing taxes paid abroad by CFCs and their subsidiaries and affiliates;
• Confirming that trust distributions are considered donations or death transfers brings more legal certainty.

One point deserves special attention: foreign private foundations, mentioned only once in MP 1171. Although they are fiduciary structures like a trust, they differ from it because they have their own legal personality, which is why MP 1171 equates them to CFCs and not to trusts.

An unclear point that could be improved is the issue of irrevocable trusts and foundations. There are situations in which an irrevocable trust or foundation has a beneficiary resident in Brazil, but that beneficiary has no control or power over what, how much, and when to receive distributions. The text of MP 1171 is silent on this aspect, and this could potentially cause problems for beneficiaries who fail to declare trust assets or their status as a beneficiary due to ignorance of this condition or lack of information.

It is still too early to say if Congress will validate the rules. Let’s not forget that two past attempts to tax CFCs in Brazil were unsuccessful in 2013 and 2017. In these two attempts, it is worth remembering Congress was much less hostile to the Government, and even so, the proposals were not approved. We will see what happens in 2023 with a more hostile Congress to the government and with high polarization.

David Roberto R. Soares da Silva is an expert in tax, estate, and succession planning, founding partner of BLS Advogados, author of Brazil Tax Guide for Foreigners (2021), and editor and coauthor of Planejamento Patrimonial: Família, Sucessão e Impostos (2022),  Renda Variável: Tipos de investimentos, tributação e como declarar (2021), and Tributação da Economia Digital no Brasil (2020), published by Editora B18.

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