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Recent Brazilian case law favors taxpayers on premium amortization

14 December 2011
by Ana Luiza Martins & Pedro Costa Prado

According to Brazilian tax legislation¹, a taxpayer that adopts the equity pickup method for purposes of evaluating an investment held in a controlled or affiliated company shall split the cost of acquisition of such investment in (i) net equity value; and (ii) premium (ágio) or discount (deságio).

 

In other words, the difference between the cost of acquisition and the invested company’s net equity value must be accounted for  in the investing company accounting books  as premium (ágio), if positive, or as discount (deságio), if negative.

 

The premium or discount entry shall indicate its economic reasons, among the following: 

 

(a) Difference between the invested company’s fixed assets book value and its market value

(b) Profitability amount based on earnings forecast in future years ("future profitability") and

(c) Goodwill (fond de commerce), intangibles and other economic reasons  

 

As part of the Brazilian government's strategy to attract investors to the privatization process in the late 1990s, Section 7 of Law No. 9.532/97² expressly provided that in a merger/spin off transaction, the premium paid in the acquisition of investment may be amortized for income tax purposes depending on the specific economic reason that justified the acquisition of the investment. Such amortization is considered as a deductible expense for calculation of the Corporate Income Tax ( IRPJ ) and Social Contribution on Net Profit ( CSLL ).

 

The tax treatment of the premium amortization is based on its economic reasons. The future profitability economic reason is the most advantageous for tax purposes, due to its five-year amortization term after the merger/spinoff.³

 

Recent case law involving premium amortization

 

In view of the tax advantage indicated above, the great majority of acquisitions since the enactment of Law No. 9.532/97 were based on future profitability. The considerable number of transactions structured on this model attracted the attention of the Brazilian Federal Revenue Service, which challenged several commercial transactions and corporate reorganizations involving premium amortization and its tax deductibility.

 

Although in some cases the tax authorities have only challenged formal aspects of the premium – such as the appraisal that should justify its economic reason – the most relevant cases are actually those that involve a disregard of the transaction, primarily based on an alleged lack of substance, and the concepts of simulation or sham, “abuse of rights,” “abuse of form” and “lack of business purposes” (i.e. under the argument that the corporate reorganization would be solely meant to generate tax savings).

 

However, recent decisions of the Administrative Court of Appeals have validated transactions involving premium created in the acquisition of investments during the process of privatizing companies in Brazil. Two cases that resulted in a favorable outcome to the taxpayers are worth highlighting:

 

(i) the Santander case, involving the Banco Santander (Brasil) S.A (Santander, or the current corporate name, Banco do Estado de São Paulo S.A – Banespa), the Brazilian controlled company of the Spanish Bank, and

(ii) the Telemar case, involving Tele Norte Leste Participações S.A. (Tele Norte Leste), a Brazilian telecom company

 

In the case involving the Santander Group, the main issue was whether the premium paid in the acquisition of Banespa (a state-owned bank) by a foreign entity could be “internalized” (transferred to Brazil) by means of certain corporate transactions in order to benefit from the deductibility of amortization expenses by a Brazilian legal entity.

 

The Brazilian Federal Revenue Service challenged the transaction, mainly under the arguments that the premium could not be “internalized” and the downstream merger, utilizing a vehicle company, was solely meant to generate tax savings at the Banespa level, due to amortization of the premium paid in the acquisition of its own shares.

 

In the trial on October 21, 2011, the Administrative Court of Appeals cancelled the tax assessment, stating that the time elapsed between the incorporation of the legal entity in Brazil and its merger into Banespa (ten months) would not be sufficient to characterize the use of that entity as a "vehicles company" formed with the sole intent of providing a bona fide aura to an irregular situation.

  

The court also stressed that even though the company had been incorporated to achieve a certain purpose, it could not be labeled a “vehicle company” because it did not intend to perform a simulated act, hide or cover up a tax-triggering event. Furthermore, the court also concluded that the premium does not necessarily need to be segregated among the other economic reasons.  In other words, the tax legislation does not impose a specific order of price allocation among the economic reasons.

 

In the transactions involving Tele Norte Leste, during the privatization process of telecom companies, the premium paid in its acquisition by Telemar was transferred to a holding company by means of a share contribution, and such holding company was lately merged into Tele Norte Leste (in a downstream merger). The Brazilian Federal Revenue Service challenged the deductibility of the premium amortization expenses at Tele Norte Leste level under the argument that it was a simulated transaction.

 

Also in this case, the Administrative Court of Appeals cancelled the tax assessment in     a trial on October 19, 2011, concluding that the tax authorities had not analyzed the whole picture of the transaction but only a single aspect.

 

Conclusion

 

Although the full content of the decisions mentioned above is not yet available to the public, it is possible to conclude that the Brazilian Administrative Court of Appeals has validated the tax deductibility of premium amortization in very complex corporate transactions.

 

It is also true, however, that the cases under analysis involve transactions which actually were deemed to entail valid business and corporate purposes, other than pure tax efficiency.  This indicates that the Brazilian Administrative Court of Appeals may not validate the premium in every M&A transaction.

 

 

 

1 - Section 384 and 385 of the Brazilian Income Tax Regulations (Decree No. 3,000/99).

 

2 - Reproduced in Section 386 of the Brazilian Income Tax Regulations (Decree No. 3,000/99).

 

3 - If the premium is based on future profitability, the amortization will occur within a period of at least five years (1/60 ratio each month at the most) following the merger/spin off.

Source: DLA Piper's International Tax Newsletter