Deducting Interest on Equity Capital: Brazilian and Belgian Tax Rules Compared
| Author | Jacques Malherbe; Gustavo G. Vettori |
| Pages | 1-38 |
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This paper will compare a particular set of tax rules1 from the Brazilian and Belgian tax systems that, on a first glance, appear to have the same structure and purpose. Such rules are particularly interesting to compare because, to the best of our knowledge, they exist only in these two tax systems.
To summarize them, they provide for the possibility of an income tax deduction, by a corporation, of a fictional interest payment, calculated by the application of a long term interest rate over the corporate equity capital.
In Brazil, they are referred to as “Juros sobre o Capital Próprio” (it translates to interest on equity capital, hereinafter “JCP”), and were enacted in 1995, by Law n. 9.2492. In Belgium, they are commonly referred to as “Notional Interest Deduction” (hereinafter “NID”), enacted by Law of 22 June 20053 and also found in Arts. 205bis to 205novies of the Belgian Income Tax Code4.
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Although the mechanisms are similar, it is necessary to proceed to a deeper analysis to determine if both sets of rules are comparable5. This paper will be aimed not only to outline such rules, but also to identify if: (i) they share a convergent underlying policy; (ii) they pose a similar solution to a similar problem; and (iii) there was any common or reciprocal influence on their drafting.
The Brazilian JCP rules entered in force in January 1st, 1996 and were part of a broader package of tax and non-tax changes aiming at important economic goals in that period. One of the major economic concerns was to cut back inflation, which had reached peaking 50% monthly rates in 19946. This goal was achieved by the “Real Plan”, an economic plan that, in a short lag of time, succeeded in reducing inflation to averaging 20% per year (1.7% monthly average in the first semester of 1995)7.
The economic plan had three key goals: (i) balancing the fiscal unbalance, in order to end the “inflationary tax”; (ii) accomplishing a monetary reform to restore thePage 3 functions of the national currency; and (iii) opening the economy with trade liberalization and a new foreign exchange policy8.
Thus, it was necessary to restore the national currency as a parameter for pricing, ending a massive culture of indexation of the economy, which caused inertial inflation. This was achieved by the adoption of a fictitious unit of account – the URV (which stands for “Unidade Real de Valor”) – that was initially paired to the Dollar and readjusted daily by a blend of price indexes to reflect current inflation. After the adoption of such unit, wages and other prices were progressively converted into it and other indexation mechanisms were abolished. The last step was to change the currency – by then, the “Cruzeiro Real” – into a new one, the “Real”, which was actually the URV issued as a “full currency”, and not only as a mere unit of account9.
Law n. 9,249 enacted part of the major tax reforms ongoing in this period. Besides the enactment of the JCP rules, it exempted from taxation the dividend distributions made by any Brazilian legal entity10 and, to stop inertial inflation, it prohibited the automatic indexation of any contract, including wages and rents11. Accordingly,Law n. 9,249 repealed the inflation adjustment of legal entities’ financial statements12 for tax and corporate purposes. It also reduced the corporate income tax rate13.
In order to understand how the JCP rules relate to this context, the next item will first analyze the basic mechanisms of the JCP payments and their taxation. Then, the following items will provide some justifications for the enactment of such rules and policy goals related thereto.
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Article 9 of Law n. 9,249 established the mechanism14 for the JCP payments, providing for its amount, limitations and tax treatment.
Accordingly, a legal entity15 can opt to pay interest on its own capital (i.e., JCPs), calculated by the application of a long term interest rate set by the government (TJLP – “Taxa de Juros de Longo Prazo”) over the entity’s equity (i.e., net assets16). JCPs can only be paid up to half of the amount of (whichever is higher): (i) the entity’s profits of the current year, before the JCP’s deduction; or (ii) the entity’s accumulated profits17.
Thus, to calculate the amount of JCP an entity can pay, one must first apply the TJLP rate over its net worth. The result will be limited by the highest between (i) half of the profits of the current year; or (ii) half of the accumulated profits.
On the one hand, the reasoning behind limiting the JCPs to the TJLP rate over the entity’s net worth shows that it has an interest nature, given that it is assumed that the TJLP should represent the return that the capital would earn in a long term financial investment18 made by the share/quota holders. On the other hand, thePage 5 limitations that refer to the profits of the company emphasize the dividend nature of the JCP and its relation to the Brazilian integration policy19.
Up to the aforementioned limits, JCPs paid by a legal entity can be deducted from its taxable income. Such income is taxed in Brazil by a 25%20 corporate income tax, plus a 9% social contribution. This amounts to a 34% rate over the corporate income. Thus, considering the corporate taxation alone, the deduction represents savings of 34% over the JCP paid.
Such payments are, however, taxable income of the recipients. First of all, regardless of who the recipient is, the JCP payments are subject to a 15% tax to be withheld by the payor.
If the recipient is an individual, such withholding is final, meaning that the JCP income is flatly taxed only by the withholding tax and does not mix with the rest of the individual’s ordinary income or deductions. JCP income earned by non-resident share/quota holders are also subject to the 15% flat withholding tax.
If the recipient is Brazilian a corporation, the JCP payments received will be included in the corporate taxable income, subject to the aforementioned 34% rate. The 15% tax previously withheld will be considered anticipation and will be credited against the recipient’s corporate income tax. Also, other social contributions with rates up to 9.25% might be levied over the JCP revenues of the recipient entity.
Finally, one should note that the deduction is linked to the corporate decision to pay the JCP and the corresponding taxation of the beneficiary. Thus, for Brazilian tax purposes, JCPs are treated as a special kind of interest payment and, as such, will be deducted from the payor’s income and included, at the same time, in the payee’s taxable income.
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Nonetheless, there is no money flow requirement. The payor is allowed to register the JCP payment as a liability or, by shareholders’ decision, the declared JCPs can be recapitalized21. In either case, the payor can deduct the JCPs, even though no actual payment has been made to the payee, and the payee will be taxed at the same moment the deduction is taken. Thus, regardless of the money flow, the payor’s deduction is fully linked to the payee’s taxation. This is a crucial aspect of the Brazilian mechanism that differs from the Belgian NID, as will be discussed below.
Given the mechanism described above, the JCP rules could be viewed as a method of integration22 of the corporate and individual income tax systems23. This approach is most likely to be accepted if one takes the position that JCP payments have the nature of dividend payments.
As a matter of fact, there are strong arguments to make a case for the qualification of the JCPs as dividend payments24, as they: (i) are only allowed if there are current or accumulated profits; (ii) do not arise from a debt obligation, but from equityPage 7 investments; and (iii) can offset the mandatory dividends required by the corporate law25.
However, if one considers that JCP payments account for inflation adjustments and opportunity costs, there are also strong arguments favoring the interest nature of such payments, as JCP deductions would in fact take out items from the corporate taxable income that are not part of its genuine profits.
Although this discussion is relevant, especially for purposes of qualification under tax treaties26, it will not be further analyzed here. For our purpose, it suffices to say that the JCP payments share characteristics with dividends and interest. Thus, it is equally important to analyze the rules in light of the Brazilian integration policy, emphasizing their dividend nature, and in light of interest taxation and inflation adjustment policies, emphasizing their interest nature.
As mentioned earlier, from 199627 on, Brazil has adopted a general integration policy that exempts from taxation all dividends distributed by Brazilian corporations28. Dividend distributions, however, are not deductible from the corporate income tax. The JCP rules, on the other hand, allow for the deduction, by the distributing corporation, of the JCP “distributions” to the shareholders. Thus, such rules could be viewed as...
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