By Andrea Bazzo Lauletta and Flavio Mifano, Mattos Filho, Veiga Filho, Marrey Jr. e Quiroga Advogados
On October 4, 2010, the Brazilian Government issued a rule to increase the Tax on Foreign Exchange transactions (“IOF/FX”) from 2% to 4% for the inflow of funds in Brazil for several financial and capital market investments. On October 18, 2010 the rate was once again raised to 6%.
Such increases were based on the assumption that the inflow of resources into Brazil was taking the Brazilian currency to an undesired valuation, especially related to the acquisition of fixed income securities, which have high interest rates compared to international standards.
As a rule, the Brazilian Tax System ensures a known tax environment so that the taxpayers are able to carry out their business and transactions with a certain definition of the corresponding tax burden. In this context, the Constitution generally states that taxes can only be enacted or increased by a law duly approved by the National Congress and such an enactment and increase can only be put into effect after a certain period (after 90 days or as of the following year, as the case may be).
However, there are a few exceptions to the rule which are constitutionally authorized and used by the Government as mechanisms of macroeconomic policies. In these situations, a certain tax can be increased by an act of the Government, without prior approval and with immediate application. This is the case with the IOF/FX, which is due upon the conversion of foreign currency to Brazilian currency and on the conversion of Brazilian currency to foreign currency.
In this sense, the legislation provides a maximum rate of 25% for IOF/FX, but the Government has the constitutional right to increase or reduce the rate at any time. The rationale for this procedure is that IOF/FX is not only a way to generate revenues for the Government, but is mainly a mechanism for the Executive to interfere in the Brazilian economy and monetary policy according to its goals.
Based on that, although the IOF/FX generally had low rates historically (especially for inflow of funds in Brazil), the fact is that recently the Government felt it was necessary to control the appreciation of the Brazilian currency in comparison with the dollar and used the IOF/FX as one mechanism to achieve this goal.
Although the recent increases were initially meant to ease the inflow of funds for fixed rates investments, the new rules in fact increased the IOF/FX rate applicable to all investments carried out within Brazilian financial and capital markets to 6% (with an exception made for variable income investment transactions negotiated within the Brazilian stock, commodities and futures exchange (“BM&FBOVESPA”) and for purchase of shares of a public offering or shares’ subscription, as long as the shares are traded within the BM&FBOVESPA).
Therefore, as the 6% became the standard rate for the inflow of funds into Brazilian capital and financial markets, impacts of the new IOF/FX were much broader than anticipated.
The changes will generally affect all the expected return of investments in the Brazilian financial and capital markets, especially the short term ones since the IOF/FX will probably represent a cost too high compared to the expected return.
The IOF/FX as it is currently imposed is a penalty paid upfront if an investor wants to do financial transactions in Brazil. By reducing the inflow of these sorts of investments, the Government expects to restrain the appreciation of the Brazilian currency.
In the chart below we summarize some examples of investments into Brazilian financial and capital markets, and the corresponding IOF/FX rates:
However, the new rules secure the IOF/FX at a 0% rate for outflow of funds on the return of any financial and capital market investments of the foreign investor.
Moreover, the Government introduced new foreign exchange controls to avoid certain obvious tax planning by the investors. In this respect, the investor needs to identify upfront the nature of the investment to be done in Brazil in order to define the IOF/FX due.
Once defined, the migration to another type of investment might require a symbolic foreign exchange transaction, which basically corresponds to a hypothetical exit of the invested funds and a hypothetical new inflow of funds in Brazil, generating a new imposition of IOF/FX.
Therefore, with this symbolic foreign exchange transaction mechanism, the foreign investor is not able to initially acquire shares within BM&FBOVESPA (paying IOF/FX of 2%) and, after a sale of those securities, use the corresponding funds to acquire Government bonds (without paying the 6% rate). In this example, the investor would have to pay 2% first and, after, perform a symbolic foreign exchange to migrate to the investment in the Government bonds, paying an additional IOF/FX of 6%.
As a consequence, the requirements of symbolic exchange transactions for certain migrations of investments reduced the mobility of the foreign investors in the Brazilian financial and capital markets due to their high tax cost.
Despite all the changes in the IOF/FX, our experience is that investors are still doing business and transactions in Brazil. The main difference is that they are looking for different forms to carry them out and to achieve similar results with other structures. The investors want to minimize the impact of the IOF/FX on their transactions to continue to invest in Brazil. Thus, more than ever it is essential to have a well-thought out plan in order to appropriately structure the best investment in Brazil.
Additionally, there is a lot of speculation in the market about new tax adjustments due to the fact that currently the impact of the IOF/FX was not enough to achieve the monetary purposes of the Government.
However, over the long term, it is viewed negatively to implement other tax changes in a short period of time as it may give the perception to investors that the legal environment in Brazil is not stable. Investors do not like to invest in markets with no defined tax rules, especially if they note that the changes can happen at any time as the IOF/FX legislation exceptionally permits.