By David Roberto R. Soares da Silva
Part 2 of this work addresses the income tax rules applicable to transactions involving foreign trusts and Brazilian resident parties, contemplated in the Complementary Law Project No. 145/2022 (PLP 145), submitted by lawmaker Eduardo Cury to Brazil’s House of Representatives in late 2022.
Part 1 reviews the definitions established in PLP 145, applicable law and jurisdiction, and the proposed tax treatment of property transfer taxes, namely the state inheritance and donations tax (ITCMD) and the municipal real estate transfer tax (ITBI).
PLP 145 addresses various income tax aspects, and therefore, they will be reviewed separately.
A. Transfers of assets and rights to the trust
For the transfer of assets and rights from the settlor to the trust, PLP 145 adopts the same rule applicable to the transfer of assets and rights to the capital of a legal entity, provided for in Article 23 of Law No. 9,249/1995. The settlor may transfer assets and rights to form the trust fund at the acquisition cost of the assets reported in their Income Tax Return or at the market value.
If the transfer occurs at acquisition cost, there will be no income tax; on the other hand, if it occurs at market value, the settlor must pay capital gains tax on any amount exceeding the acquisition cost (current tax rates between 15% and 22.5%). It is worth noting that the taxpayer (the settlor) must consider the tax opportunity in the case of the transfer of real estate, especially those that have been in the settlor’s possession for a long time and that may benefit from specific capital gains tax reductions or exemptions. If this is the case, the transfer of the property to the trust at market value may be advantageous because there could be a tax-free (or reduced taxation) step-up in the basis of the real estate, not to mention the tax exemption of ITCMD and ITBI on these transfers, according to PLP 145 (see Part 1 of this article).
The same treatment (transfer at acquisition cost or market value) applies to settlors who are not tax residents in Brazil, provided that the acquisition cost can be proven. However, the non-resident settlor will not be able to enjoy any capital gains tax reductions or exemptions on the transfer of real estate to the trust at market value, as this benefit is only available to Brazilian resident individuals.
B. Acquisition and declaration of rights over the trust’s assets by the beneficiary
Until they receive unconditional and immediate rights to any portion of the trust’s assets, potential beneficiaries should not declare any value or asset in their income tax return.
The obligation to declare will only occur when the beneficiary acquires unconditional and immediate rights to any portion of the trust assets or fund, at which point they cease to be potential beneficiaries and become effective beneficiaries. Note that this rule does not apply to cash distributions but only to the acquisition of the condition of an effective beneficiary of the trust.
An example of this situation is that of a settlor (Donald) who provides in the trust deed that, after his passing, the trust will have his three nephews (Huey, Dewey, and Louie) as beneficiaries in equal parts. In this case, according to our preliminary analysis, the three nephews should acquire the condition of effective beneficiaries of the trust and should declare 1/3 each of the trust’s assets originally reported by Donald. And at this moment, the ITCMD should be due, depending on the trust rules. So, if Donald’s trust was initially established with BRL 3 million (the original value Donald declared in this tax return), then Huey, Dewey, and Louie should report BRL 1 million each in their tax returns, even if the actual value of the trust fund is higher (due to profits and earnings accrued over the years, for example)
According to PLP 145, effective beneficiaries must report the right to such a portion of the trust’s assets in their tax return (asset reporting form) in the calendar year in which they acquire the condition of an effective beneficiary (Art. 12).
The accretion to wealth resulting from the acquisition of unconditional and immediate rights to some portion of the trust’s assets will be treated as a donation subject to ITCMD and exempt from income tax in the case of an individual. Where the beneficiary is a legal entity, the accretion to wealth should be taxed according to the corporate income tax rules applicable to donations.
C. Cash distributions
As for cash distributions, PLP 145 segregates the value of the “capital” originally transferred by the settlor to the trust from the positive results (income) realized by the trust. The value of the “capital” will be treated as a sort of capital reduction, not subject to income tax up to the limit reported by the effective beneficiary (see item B). The value attributed to income will be subject to income tax according to the monthly tax brackets in place at the time (the so-called Carnê-Leão, which rates are between zero and 27.5%) (Art. 13).
Going back to the Donald example, assume that his trust, originally formed with BRL 3 million, has BRL 3.6 million at the time of his passing (BRL 600,000 generated by income and gains since Donald created the trust). Huey, Dewey, and Louie will have to declare BRL 1 million each in their income tax returns. Now, imagine that the trust decides to distribute 50% of its assets in cash to Huey, Dewey, and Louie, totaling BRL 1.8 million.
According to PLP 145, Huey, Dewey, and Louie will receive BRL 600,000 each, whose tax treatment should be as follows:
- BRL 500,000 (50% of BRL 1 million declared by each beneficiary) will be considered as a “redemption” of the original capital of the trust and will not be subject to income tax; and
- BRL 100,000 (50% of 1/3 of BRL 600,000 = trust income) will be considered ordinary income subject to monthly income tax rates (Carnê-Leão).
In this case, Huey, Dewey, and Louie would each pay income tax of BRL 26,630.64 on the BRL 100,000 they would receive, according to the progressive tax table in effect in 2022. However, it is worth remembering that they would have already paid ITCMD on the BRL 1 million portion of the original capital when they became effective beneficiaries of the trust.
The PLP 145 clarifies that the income and any accretions to the trust’s assets will not be taxed at the effective beneficiary’s level until they are distributed in cash to the beneficiary. In practice, the PLP 145 allows for the tax deferral of the trust income until a cash distribution takes place in favor of the beneficiaries. This is similar, but not identical, to the (still) current tax treatment applicable to offshore profits distributions to Brazilian resident individuals.
Another interesting aspect relates to the treatment of distributions to beneficiaries “as a result of the termination (extinction) of the trust”, for which PLP 145 adopts a different treatment (Art. 13, §§ 5 and 6). In this case, PLP 145 determines that the cash distributions “will be fully credited to the redemption of the original capital of the trust, reducing the acquisition cost of the respective rights originally declared” by the effective beneficiary. Any excess cash distribution, in turn, will be treated as a capital gain and not as ordinary income.
Returning to the case of Huey, Dewey, and Louie, assume that at a later point after the first cash distribution, the trust is terminated and still maintains a BRL 1,8 million (BRL 1.5 million of the original capital and BRL 300,000 of income). The tax treatment upon the trust termination would be as follows:
- BRL 500,000 (remaining capital originally declared by each nephew) will be considered as full redemption of the original capital and will not be subject to income tax; and
- BRL 100,000 (1/3 of BRL 300,000 = trust income) will be considered as capital gain (and not ordinary income).
In this case, Huey, Dewey, and Louie would pay a flat BRL 15,000 each in capital gains tax over BRL 100,000 (instead of progressive tax brackets that applied in the first cash distribution), because the trust is being terminated.
However, this treatment of capital gain will only be maintained if a new trust is not created within 24 months from the termination of the first trust (Art. 13, § 7). The PLP 145 is not clear about who would be the settlor of this new trust, but it would be logical to think that it would be the same original settlor. This makes sense to prevent abusive practices of repeatedly forming trusts and then terminating them, treating accretions to the trust fund as capital gains (lower taxation) rather than ordinary income.
D. Delivery of trust assets or rights
Like the return of corporate assets to its shareholder (Law No. 9,249/1995, Art. 22), the PLP 145 allows the delivery of trust assets to the effective beneficiary to be made at the acquisition cost or market value, as long as it is not prohibited by the law governing the trust (Art. 14).
In the case of a transfer made at the acquisition cost, the assets or rights received by an effective beneficiary resident in Brazil will be declared or registered in the respective tax year at the same acquisition cost valued by the trust.
As for transfers made at market value, PLP 145 makes a distinction between the delivery of assets located in Brazil or abroad.
For assets located in Brazil:
- the difference between the market value and the acquisition cost of the assets or rights transferred by the trust to the beneficiary will be treated as capital gain to the trust and taxed by income tax according to the rules applicable to resident individuals (15% to 22.5%). The trust’s legal representative in Brazil is responsible for withholding and paying the tax;
- the assets or rights received by the effective beneficiary resident in Brazil shall be reported at the market value adopted by the trust;
- the difference between the market value of the assets and rights and the acquisition cost originally reported by the effective beneficiary resident in Brazil will not be taxed at the level of the effective beneficiary.
It is worth noting that, in item 1 above, PLP 145 considers that the trust realizes capital gain in Brazil and, accordingly, is subject to the capital gain tax rates applicable to resident individuals (15% to 22.5%), even when the trust is domiciled or governed by the law of a low-tax jurisdiction (tax haven) whose capital gain is usually taxed at 25%.
For transfers at the market value of assets located abroad, the effective beneficiary resident in Brazil should adopt the following treatment:
- for cash equivalents and other highly liquid assets:
- the acquisition cost (to the beneficiary) should be the value for which the assets were received;
- the positive difference between this cost and the original value of the rights corresponding to the trust capital shall be treated as capital gain by the beneficiary; and
- for other, less liquid assets: the acquisition cost should be the same as the original value of the rights corresponding to the redeemed capital (with no capital gain realization).
From the tax basis of these market value transfers, the beneficiary shall deduct the amount originally subject to ITCMD when he or she became an effective beneficiary of the trust.
In the subsequent sale of less liquid assets (item 2), any profit shall be treated and taxed as capital gains by the effective beneficiary.
E. Distribution of trust results
PLP 145 contains a specific section dealing with distributions of results (income) of the trust, even if they are made in assets or rights. The general rule is that these distributions shall be taxed as ordinary income subject to monthly income tax brackets (Carnê-Leão) (Art. 15, § 1).
However, if the distribution of results occurs in assets located in Brazil at market value, the treatment shall be as follows:
- the value of the acquisition cost the asset located in Brazil (as shown in the trust’s records) shall be treated as ordinary income;
- any amount exceeding the acquisition cost (item 1), shall be treated as capital gain.
F. Revocation of the trust
Upon the revocation of the trust with the return of the assets to the settlor, the tax treatment shall be as follows:
- for real estate, it may be necessary to pay the municipal real estate transfer tax ITBI (Art. 10, item II) – see Part 1;
- capital gain on the excess of the original capital received by the settlor, unless the settlor creates a new trust within 24 months, in which case the capital gain treatment will be changed to ordinary income.
G. Declaration of Brazilian capital abroad
Finally, PLP 145 brings a rule regarding the annual reporting of foreign assets to the Central Bank of Brazil (Declaração de Capitais Brasileiros no Exterior – DCBE). The effective beneficiary shall submit the DCBE as of the calendar year he or she acquires unconditional and immediate access to any portion of the trust’s assets as long as the such portion is equal to or greater than USD 1 million on December 31.
Final (preliminary) remarks about PLP 145
The rules proposed in PLP 145 are undoubtedly innovative and bring some legal certainty to transactions involving foreign trusts. The first step has been taken, but the path to the destination is still long and challenging.
In general, PLP 145 is very good but fails in some points.
The first point is the fact that the proposed rules are limited trust only, without considering its application to other similar fiduciary structures like foreign private foundations. Congress should consider including private foundations within the scope of PLP 145 to allow the same tax treatment to similar fiduciary structures with identical functions and purposes.
By not including foundations, there is a risk of opening an opportunity for planning since PLP 145 establishes the levy of ITCMD only for transactions involving trusts and not for foundations. In the absence of legislation including foreign foundations, distributions made by such structures could, in theory, be free of ITCMD as Brazil does not allow the use of analogy to create a tax obligation.
Another unclear point relates to transfers of assets to irrevocable trusts. The wording of PLP 145 seems to consider only revocable trusts. This aspect is important, as transfers to irrevocable foreign trusts could be considered as donations abroad subject to withholding tax (IRRF).
By transferring assets to an irrevocable foreign trust, the settlor loses access and control over the transferred assets (as in a donation) and becomes unable to reclaim them given the irrevocable aspect of the structure. Since the publication of the 2018 Income Tax Code, the Federal Revenue Department (FRD) has taken the position that donations made abroad are no longer exempt from IRRF. Thus, the establishment of an irrevocable trust with the transfer of assets to the trust fund could be interpreted by the FRD as a donation abroad subject to IRRF at 15% (or 25% if the trust is located in a low-tax jurisdiction).
We are still in the early stages of reviewing PLP 145, and certainly, other considerations will be made as studies and discussions evolve.
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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