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Tax structuring of real estate businesses in Brazil

1 April 2010
by Leonardo Homsy & Fernanda Junqueira Bastos

After the distress generated by the world financial crisis, which had a major affect in the real estate industry all over the world, mainly in the United States, the real estate industry in Brazil is increasingly regaining its strength.

There is high expectation of significant investments in the real estate development business for the next years, associated with governmental projects to overcome housing deficit and also with the construction and infrastructure needed for the World Cup in 2014. Such investments shall be even more widespread in the city of Rio de Janeiro, considering that this city will be hosting th Olympic Games in 2016. Thus, the purpose of this article is to provide a brief overview of the tax aspects relating to the main structures used for the development of real estate projects in Brazil, as well as of the real estate investment funds, which are becoming increasingly more popular.

Experience shows that in order to assure the most efficient tax results, real estate developers usually structure their businesses through local holding companies and specific purpose companies, the latter being operational entities subject to the tax regime known as “Deemed Profit”. More recently, the legislators introduced in the Brazilian legal scenario a special tax regime (“Regime Especial de Tributação”), referred to as RET, which presupposes for civil and tax law purpose the separation of the assets connected to the specific project from the developer’s equity, as if each project were a different entity. Investments in real estate funds have also become more popular in the past few years because the quotas provide higher liquidity than the real estate itself and the gains assessed through the fund suffer lower taxation or – in some cases – no taxation.

In order to have a specific purpose entity subject to the Deemed Profit regime, the gross revenue of the entity in the previous year must have been of R$ 48 MM at the most. The rates of the Income Taxes – “IRPJ” and “CSL” – are of 25% and 9% respectively. But in this regime, the calculation basis of each of the Income Taxes corresponds to respectively 8% and 12% of the gross revenues assessed in connection with the company’s core business in the period, in a way that the effective income tax rate on these revenues is 3.08% (no deductions are allowed). Specifically in regard to the real estate development activity, the legislation allows for the financial revenue deriving from the commercialization of real estate to be treated as though “intrinsically connected to the core business”, as long as arising from monetary reinstatement. Thus, these revenues may be taxed in the same percentage applicable to the main activities, at the effective rate of 3.08%. Other revenue not intrinsically connected to the corporate purpose, such as capital gains, income and net gains deriving from financial investments, etc. must be added to the calculation basis for the application of the full rates of the IRPJ and CSL. In addition, the companies which elect the Deemed Profit regime are subject to gross revenues taxes named PIS and COFINS at an aggregated rate of 3.65% on the revenues deriving from the sales. Thus, the overall burden in terms of income and revenues taxes for companies under the deemed profit regime corresponds to 6.73% of the gross revenues deriving from the sales of real estate properties.

The dividends paid by the operational company to the holding company are exempt from income taxes. Furthermore, the Brazilian legislation allows pure holding companies to defer the recognition of expenses with interest paid or incurred in relation to loans connected to financing for investments in controlled entities. The respective amounts shall integrate the investment cost for purposes of verifying the taxable gain or loss upon disposal or liquidation of the investment in the corresponding acquired subsidiaries. This feature of the Brazilian tax legislation may not always be beneficial in the real estate segment. An alternative to avoid the build up of losses (or to use the existing ones) at the holding company level is to have the holding company participating as co-developer together with its subsidiaries.

After episodes of bankruptcy of developers which lead to hundreds of unfinished projects, harming a considerable number of consumers, the civil legislation created in 2001 a new regime for the development of real estate construction projects. Through this regime, the land, accretions and other assets and rights connected to the project are kept separate from the equity of the developer. In other words, the real estate and assets connected to the project become linked exclusively to the obligations arising from the corresponding project (this applies to the financial resources necessary to the conclusion of the construction). The same legislation provides for the election of a committee of representatives which shall have free access to the construction and to the information necessary to control the rights/assets linked to the project.

The regime mentioned above is not mandatory. In this context, the tax legislation created in 2004 the Especial Tax Regime (“RET”) that may only be elected for projects in regard to which the real estate developer has isolated and linked the corresponding assets and rights. Currently, for each development project subject to the RET, the developer must make a unified payment comprising all of the taxes referred to above (IRPJ, CSL, PIS and COFINS), at the overall rate of 6%, calculated on the monthly revenue received in connection with each project. The monthly revenue corresponds to the total revenues assessed by the developer through the sale of the properties(residential apartments, commercial offices, etc.) which are the object of the project, as well as the financial revenues and monetary variations deriving from the transaction. Other revenues such as those deriving from financial investments are taxed separately (outside the RET) along with the other revenues of the developer.

The payment of taxes within the RET is definitive and does not entitle restitution. Likewise, it may not be offset with the taxes payable by the developer deriving from other projects. Currently, the outstanding taxes due by the developer within the RET may not be included in installment plans. Also, the assets and rights attached/linked to the Project submitted to the RET may not be used to pay debts of IRPJ, CSL, PIS and COFINS of the developer, except for those generated by the project itself. On the other hand, the rest of the developer’s assets may be used or foreclosed to pay tax debts assessed within the RET.

In 2009, the Federal Government created a program to overcome the housing deficit, providing for better purchase conditions to low income buyers and higher tax incentives to constructors and developers. Until 2013, the constructor hired to build the residences within the governmental program “Minha Casa Minha Vida” (in free translation: “My House, My Life”), may adopt the RET and make a unified payment of taxes (IRPJ, CSL, PIS and COFINS) corresponding to only 1% of the monthly revenue assessed in the specific real estate project. This is applicable for residences which commercial value does not exceed R$ 60 thousand (roughly US$ 35 thousand). The same treatment is applicable to revenues deriving from construction activities relating to these low income projects.

Normally, the developer’s activities are not subject to the services tax. However, when the developer is also the constructor of the project and carries out sales before the construction work is terminated, the legislation of some municipalities (which are granted with the power to charge the services tax) consider that the developer/constructor renders a service to the buyer and imposes the payment of the services tax. In this case, it is irrelevant whether the developer has elected the “RET” or the “Deemed Profit”.

It is also interesting to point out that the market has shown a growing interest in the real estate investment funds (the so-called Brazilian REITs). The purpose of these types of funds is not to develop real estate projects, but rather to assess gains through the rental or sale of properties.

When the real state investment fund complies with the specific rules, it is not subject to corporate taxes. An attractive characteristic of this fund is that the income and capital gains earned by it are exempt from income and gross revenues taxes, provided that it distributes at least 95% of the profits assessed on a cash basis, based on balances drawn on June 30 and December 31 of each year. However, the fixed and variable income and net gains derived from financial transactions carried out by the fund are subject to withholding income tax based on the same rules applicable to legal entities in general (22.5%-15%, depending on the term). But the tax withheld then may be offset by the fund when it distributes the income and capital gains to the quota holders, who are taxed at a 20% rate. The income and capital gains earned by quota holders upon sales or redemption of quotas are also subject to income tax at a 20% rate.

The legislation currently in force provides for an exemption in regard to income distributed by the fund to individuals if the quotas of such fund are negotiated exclusively in the stock exchange market or in the organized over-the-counter market, as long as the fund is formed by a minimum of 50 quota-holders and that the beneficiary individual holds quotas representing less than 10% of the quotas of the fund and less than 10% of the total income generated by the fund.

Private Equity Funds

Investments in real estate companies may also be made through private equity funds (so-called FIPs). In case of foreign investors registered under a special regime the Brazilian tax legislation provides for a benefit of 0% withholding income tax rate on gains, provided that the investment meets all of the following conditions: (i) the foreign investor cannot hold directly or indirectly (through related parties) more than 40% of the quotas of a FIP, or also be entitled to receive more than 40% of FIPs earnings; (ii) the FIP cannot have at any time more than 5% of its net worth invested in public debt securities, except for federal securities as well as others specified in the legislation; and (iii) the foreign investor of a FIP cannot be resident in a tax haven jurisdiction (Brazil has a black list of the so called tax havens). In any of these conditions are not met, a 15% withholding income tax will apply. It is noteworthy, however, that the inflow of amounts for investments in both real estate fund and FIP are currently subject to the Tax on Financial Transactions charged at a 2% rate. This charge was introduced last year as a means to avoid the appreciation of the Brazilian Real towards the American Dollar and may be reduced or increased by the government at any time.

This article addressed the main features of the different tax systems applicable to the development of real estate projects, as well as of forms of investment in real estate activities for non-residents.

As may be inferred from the above, real estate activities in Brazil are currently subject to quite beneficial tax treatments, which maximize after tax profits and are therefore a good opportunity for investment in the years to come. And for those not engaged and not interested in engaging in the real estate segment it is possible to invest through other vehicles also subject to considerable tax benefits.

Source: Practical Latin American Tax Strategies