Brazil’s Newest Tax Haven

If someone asked you to name a few places considered to be tax havens you’d likely come up with a list of exotic, off-shore locations such as the Cayman Islands, the Bahamas and the British Virgin Islands. If you’d ask a few Brazilians, or at least well-heeled Brazilians for whom tax avoidance sometimes seems to be a national pastime, the same question they’d likely provide you with a similar list of exotic, off-shore locations. However, this may soon change. On June 23, 2008, Brazil’s Congress published Law 11,727/2008, which amends the country’s transfer pricing regulations and expands the legal definition of countries with favored taxationotherwise known as tax havens or fiscal paradises. As a result, when Brazil’s tax authorities update the country’s list of blacklisted jurisdictions with favored taxation it’s widely expected to include the very exotic, off-shore location of the state of Delaware.

That’s right Delaware the second-smallest state in the United States may soon be designated as a tax haven or at least a jurisdiction with the characteristics of a tax haven by the Brazilian Internal Revenue Service. Whether designated an actual tax haven or simply a jurisdiction with the characteristics of one, the consequences would be same. Remittances or payments of interest, royalties and service fees to companies or persons in the state of Delaware would be subject to 25% withholding tax rather than the general 15% tax rate. In addition, taxes on capital gains from the sale of the shares of Brazilian companies by nonresidents located in Delaware would be increased. And payments made to non-related parties located in Delaware would be subject to transfer pricing regulations applicable to payments made to related parties, also resulting in higher tax rates.

At this point, you’re probably wondering why Brazil would want to designate Delaware, of all places, as a tax haven. First, let’s consider how Brazil changed the definition of tax havens; then we’ll take a look at why Brazil might have expanded this definition in a way many commentators expect to result in Delaware being designated as a low-tax jurisdiction or at least a jurisdiction with the characteristics of one.

Historically, Brazil has defined tax havens or jurisdictions with favored taxation as countries and locations that did not tax income or taxed it at a maximum rate of up to 20%. In legislation that will take effect on January 1, 2009, Brazil’s Congress expanded the definition of jurisdictions with favored taxation to include jurisdictions whose laws do not permit access to information about a legal entity’s owners, that is who its shareholders or equity participants are, how much equity they own, and the identity of its nonresident beneficial owners to whom income is attributed.

In short, if a country or location does not permit access to information about a company’s shareholders or equity participants, the amount of equity they own and the identity of its nonresident beneficial owners, such jurisdiction may be designated as privileged fiscal regime. While it may seem odd to label a jurisdiction that doesn’t actually have low tax rates as a tax haven or as a jurisdiction with the characteristic of one, a closer look at one of the differences between the laws governing Brazilian and Delaware legal entities may provide some insight into Brazil’s recent decision to broaden the definition of tax havens.

To create a Brazilian “sociadade limitada,” the most common form of legal entity used in Brazil, with characteristics that are similar to a U.S. limited liability company or LLC, you must file a document called a “contrato social” at the commercial registry in the state where you want to form the “limitada.” You must also list each of the equity participants, known as quotaholders, in the “contrato social.” In addition, if a quotaholder wants to transfer her equity participation in the “limitada,” called quotas, to another quotaholder or to a third party, the “contrato social” must be amended and the amendment must be filed at the commercial registry. Once filed, the “contrato social” and each amendment thereto becomes a public document. So, if you want to know who company’s quotaholders are or how many quotas they own, all you have to do is to head over to the commercial registry and look it up.

By contrast, when you create a Delaware LLC you’re not required to list the equity participants, known as members, in the document used to form the LLC. Nor are you required to file, register or disclose a copy of the LLC Agreement in which the members and their equity participation in the LLC are designated. In short, there is no public registry of such information. So, unless the members of the LLC choose to disclose their identity, how much equity they own or the identity of its nonresident members, there is no easy way to access such information. While a U.S. government agency, such as the IRS or the Securities Exchange Commission, could cause or require the LLC or its members to disclosure such information, it would be the exception to the rule, rather than the rule to do so.

So, while Brazil allows for access to information about legal entities and their equity participants, Delaware does not. Okay, but why should this matter to Brazil or cause it to expand the definition of tax havens so as to include Delaware? Well, it seems that Delaware LLCs are popping up all over the place in Brazil as partners and equity participants in Brazilian companies. And in many cases the members of these Delaware LLCs have turned out to be Brazilian investors and Brazilian investment funds. As a result, it seems that the Brazilian authorities have taken notice.

There are many reasons why someone, including a Brazilian investor, might elect to use a Delaware LLC as an investment vehicle, including the limited liability protection given to members and the availability of pass-through taxation. However, the Brazilian government’s focus seems to be on what it considers to be the less than transparent nature of the Delaware LLC, which does not allow access to information about its members, their equity participation or income attributed to nonresident beneficial owners, some of whom may well be Brazilians.

Apparently, the Brazilian government believes that Brazilian investors and investment funds are setting up Delaware LLCs as part of a tax planning scheme which allows them to conceal their participation in Brazilian companies with the intent of avoiding taxation. Or it’s possible that the Brazilian government simply doesn’t like the idea that it can’t access information about the investment activities of it citizens who are using Delaware LLCs, the identity of non-Brazilians investing in Brazil though such vehicles or the distributions made by such LLCs to their Brazilian members. Or perhaps the Brazilian government simply saw the rising popularity of Delaware LLCs as an opportunity to generate additional tax revenues, irrespective of the fact that neither Delaware nor the U.S. would otherwise be considered to be a low tax jurisdiction. It is however worth noting that due to the availability of pass-through taxation, profits generated by LLCs are only taxed when attributed or distributed to its members. In addition, if the LLC is not engaged in business activities in the U.S., profits attributed or distributed to its nonresident members are generally not subject to U.S. taxation.

So, will Delaware be designated as a tax haven? Until the Brazilian IRS updates its list of blacklisted jurisdictions with favored taxation, which it is expected to do by the end of this year, no one can say with any certainty. However, many commentators believe that it was specifically with the Delaware LLC in mind that the Brazilian Congress decided to broaden the definition of tax havens to include jurisdictions which do not allow access to information about the shareholder composition of legal entities, their equity participation and the identity of nonresident beneficial owners to whom income is attributed.

The irony in all of this may well turn out to be that the Brazilian government’s sudden interest in the state of Delaware appears to have been driven solely by the increased use of Delaware LLCs as an investment vehicle, rather than features of Delaware law applicable to legal entities that are some how particular to Delaware. The fact of the matter is that Brazilian investors and investment funds could just as easily choose to use LLCs created in another U.S. state, such Nevada or Wyoming, which are well known for not having any state or corporate tax, and whose laws are no more friendly toward those wanting access to information about the membership composition of LLCs than those of the state of Delaware.

Who knows, if Brazil’s treasury does decide to blacklist Delaware, and Brazilian investors and investment funds begin to use LLCs from other U.S. states, perhaps Brazil will find itself in the awkward position of having to blacklist these states as well. However, for now Delaware, often referred to as the “First State” since it was the first U.S. state to ratify the constitution, seems destined for another first - the first U.S. state to be designated as a tax haven. It may even become the first place well-heeled Brazilians think of when asked to name a few tax havens.