The recently issued Provisional Measure No. 806/2017 (MP 806) establishes new rules regarding the taxation of Private Equity Investment Funds (FIPs). They apply to:
- investors in FIPs qualified as investment entities, who are now taxed via Withholding Income Tax (IRRF) on the sale of assets of the fund, on the grounds of a fictitious distribution of income, at a 15% rate; and
- FIPs not qualified as an investment entities (Equity FIPs), which will be taxed as legal entities and their earnings and income not distributed by January 2, 2018, will undergo a fictitious distribution and will be taxed at a 15% rate.
In Brazil, FIPs are the main vehicle for investments in private equity and venture capital, which involve different phases of equity investments. This type of investment presupposes low liquidity and medium and long term returns. Its main characteristic is the contribution of funds (including in investment rounds) and an exit after increase of market value.
The modalities of investment funding are: (i) the traditional funding (in the form of capital); (ii) mezzanine (subordinated debt investments, hybrid financing instruments, including debentures convertible into shares or other forms and subscription rights); and (iii) public investment in public equity (PIPE) (substantial investment in listed assets with very low liquidity and introduction of professional management and corporate governance to recover liquidity of this asset).
It is the nature of this instrument to reinvest capital in new businesses without distribution of income to shareholders. The purpose is to raise the market value of the asset for a possible sale, either in the promotion of new business or in the recovery of illiquid assets. Its characteristic is illiquidity.
The CVM rule limits FIP's investments in liquid assets to 10% of net equity. The remaining 90% must be invested in (i) shares; (ii) subscription warrants; (iii) simple debentures; (iv) other securities convertible or exchangeable into shares issued by publicly or privately held companies; or (v) titles and securities representing participation in limited liability companies.
The new rules create a fiction of income for the investor by counteracting the logic and reality of the investment. In conjunction with other elements of the law, this has motivated a re-evaluation of structures, often with the objective of suppressing funds or converting them into investment entities.
The transition rule
The transition rule submits gains and income earned by Equity FIPs that are not distributed by January 2, 2018, to the IRRF tax. In so doing, it imposes IRRF on the results recognized by FIP only for accounting purposes, arising from the equity method or adjustments to the fair value of the investment.
The Brazilian Federal Revenue Service’s guidance recognizes this fact by suggesting that administrators sell assets or require contributions from unitholders to pay the tax. That is, it requires the fund to create a liquidity that it does not possess, therein presupposing a power that the administrator does not have.
The unconstitutionality of the new rules
In MP 806, both distribution of income to the FIP investor in the sale of the investment and the distribution of past gains/yields of Equity FIPs are fictitious events. It taxes the expectation of a gain, and not the economic or legal availability of income.
The fictitious distribution tax was considered unconstitutional by the Federal Supreme Court (STF), in Extraordinary Appeal RE 172,058/SC, which dealt with the Net Income Tax (ILL). It was understood that, as long as shareholders do not have the power to dispose of income, there is no acquisition of legal or economic availability.
In addition, the taxation of Equity FIPs’ undistributed earnings/yields reaches past earnings. This matter was also the subject of review by the STF in Unconstitutionality Lawsuit (ADIN) 2,588/DF, which rightly understood that the rule of distribution of profits obtained abroad in the past (accumulated on the balance sheet) violated the principles of anteriority and non-retroactivity, thereby deciding that this rule was unconstitutional.
These precedents apply to MP 806 and are the expected destination for this set of rules if the text is converted into law by the National Congress.