October 09, 2019

Ambiguities Surrounding the Use of FIPs Harming Private Equity Investment in Brazil

5 min

The typical approach used by private equity firms to invest in Brazil since 2003 has been through Fundos de Investimento em Participações (FIPs).1 Under Brazilian law, an investment in the quotas of a FIP is considered an investment in Brazil's capital markets. Pursuant to this regimen, foreign private equity investors using FIPs to invest in portfolio companies located in Brazil are afforded a preferred tax treatment. FIPs are not considered legal entities under Brazilian law, and, as a result, a quota holder in a FIP is viewed as owning a notional fraction of all assets held by the FIP itself. This structure has become increasingly popular with international and local private equity funds, pension funds, and strategic investors because of its flexibility and tax benefits.

Non-Brazilian residents are generally subject to taxation in Brazil on capital gains and dividend income related to a Brazilian portfolio company. For example, although the normal withholding tax rate on capital gains is 15%, the rate is reduced to 0% for investments through FIPs for a non-resident. Nonetheless, in order to receive the tax benefits of investing through a FIP, certain conditions must be met.2 The most notable of these requirements is that no single investor may own more than 40% of the quotas of the particular FIP and, by extension, the underlying portfolio company. This requirement was interpreted both formally and materially by international and local funds, which led to the typical structure whereby the fund in question would create three separate entities, each owning roughly 33% of the quotas in the FIP (in addition to having no single investor directly owning more than 40% of the FIP) and thus, by extension, the underlying portfolio company. In addition, the FIP was intended to be used mostly by private equity funds (i.e., not strategic investors). Over time, in fact, the FIP structure started growing with Brazilian and strategic investors because of its flexibility and tax treatment. Brazilians would often invest in FIPs through offshore funds or other offshore vehicles, and strategic investors would also use FIPs to structure their investments in Brazil.

In view of this trend, in 2016 the CVM enacted Instruction 579, establishing a dual classification based on the purpose of each fund, which would then be characterized as investment entities or non-investment entities, depending on their actual structure and strategy (i.e., if they are being used as proprietary holding vehicles or if the primary objective is the return on the investment by independent LPs). Such classification has accounting and tax impacts for the non-investment entities.

Over the last decade, tax authorities in emerging markets have increasingly moved away from a formal tax analysis and toward a more substantive approach. As this process has evolved, many of the standard tax structures used by foreign investors in emerging markets have come under increased scrutiny. In Brazil, as a result of the logical extension of applying a substantive tax analysis, rather than merely looking at the ownership percentage of quotas issued by the FIPs to determine whether the investment meets the 40% rule, the Brazilian tax authorities have announced that they will apply a "substance" test to any current and future FIP structure. What this means and how it will be applied going forward is not entirely clear. Ultimately it suggests that the Brazilian tax authorities want to make sure that no single limited partner in the Brazilian or international fund owns more than 40% of the LP interests, that no LPs are ultimately Brazilian tax residents, and that the final beneficiaries of the income generated at the FIP are not located in tax haven jurisdictions.

However, the Brazilian tax authorities are adopting a very aggressive approach to fund administrators in Brazil – which are responsible for the collection of taxes and for providing information regarding the foreign investors' investments in such funds – with severe penalties and the imposition of a tax rate of 35% on any payments to foreign investors, as if they were remitted to a non-identified beneficiary. Such amounts are charged when the fund administrators fail to clearly identify the final beneficiaries of the funds.

As a result, international and local funds that are considering investments in Brazilian portfolio companies are confused and concerned about how to proceed. While ultimately the Brazilian authorities and the Brazilian private equity industry must figure out clear rules on how the Brazilian tax authorities will interpret the FIP rules, perhaps they should consider permitting fund managers to certify that (i) no limited partner in the fund owns 40% or more of the fund's limited partner interests and (ii) no limited partner is a Brazilian taxpayer or resident in a tax haven jurisdiction, and allow the fund administrator to rely on such certification.

The enactment of certain rules in 2015 may result in a way to create such certification. Brazil's CVM has already enacted a rule whereby fund administrators must provide certain information regarding foreign investors.3 The Brazilian Revenue Service has also enacted a rule outlining the procedures Brazilian and foreign investors must use to identify final beneficiaries of Brazilian companies and funds.4

If a Brazilian fund administrator can successfully gather this information from its limited partner and the investment structure complies with the substantive conditions outlined in the beginning of this article, in principle the tax authorities should not have grounds to assess penalties against fund administrators or impose the 35% tax rate. Nevertheless, such a certification process would certainly create additional costs for fund administrators that will ultimately be borne by the investors, especially while there is no certainty regarding whether the tax authorities will accept such an approach.

  1. Resolution No. 4,373 of the Brazilian Monetary Council.
  2. These three main requirements are as follows: (i) No single investor may hold, individually or in the aggregate with affiliates, 40% or more of the FIP's quotas or the right to receive an amount greater than 40% of the total income of the FIP; (ii) except for Brazilian federal bonds, the FIP cannot hold bonds in an amount greater than 5% of the FIP's net assets; and (iii) the FIP must hold at least 67% of its net equity in the form of shares, convertible debentures, and warrants issued by Brazilian corporations. In addition, in order to benefit from the 0% rate, the investors shall not be resident in tax haven jurisdictions. The FIP must also register with the CVM.
  3. Ruling CVM No. 560/2015.
  4. Normative Ruling RFB No. 1.634/16, replaced by Normative Ruling No. 1.863/18.