Brazilian companies can compensate their shareholders both with dividends or paying interest on equity (“juros”). The former is, under certain conditions set out in the Federal Law 9249 of December 26, 1995, deductible for the Brazilian paying company. This post is about the taxation of interest on equity paid by Brazilian companies to their Spanish shareholders.
Until 2014 the Spanish Tax Office and the High Tax Court, had held that interest paid on equity by Brazilian subsidiaries to their Spanish shareholders should be treated as interest by the latter and, as such, were fully taxable under the Spanish Corporation Tax, albeit with the matching credit of 20 % granted in the Tax Treaty between Spain and Brazil-.
However, in a judgement dated February 2014, the National Court overruled the Tax Court views and considered that interest on equity paid by Brazilian companies should be assimilated to dividends. This criterion has now been confirmed by the Supreme Court, in its recent ruling dated March 16, 2016.
The Supreme Court judgement is grounded on the fact that interest on equity works pretty much like a distribution of profits since both “come from the existence of profits of the Brazilian subsidiary and the title that entitles to its perception is the ownership of share capital through the possession of shares”. Interests on equity do not remunerate amounts ceded under a loan agreement, nor are they calculated on the outstanding principal of a loan. Therefore, income derived from the collection of said interest may benefit from the exemption from double taxation on dividends from foreign sources under the participation exemption regime of the Spanish Corporation Tax.
The Supreme Court further confirms that this income meets the requirements for the application of the participation exemption regime, namely, the need for taxation at source of the profits out of which dividends (or interest) have been distributed. Thus, it is sufficient that the subsidiaries that distribute the interest are, in general, subject to taxation on their profits in Brazil. In addition, the ruling adds that the existence of the Double Taxation Agreement with Brazil presupposes compliance with the requirement of taxation at source. The Supreme Court gave no relevance to the fact that the interest is deductible for the paying company.
However, in January 2015 the new Corporate Income Tax Law – Law 27/2014-, came into force and, following BEPS guidelines, established a anti-abuse clause whereby the application of the exemption to foreign source dividends will not be applicable where the distribution generates a tax deductible expense in the paying entity. Since this is normally the case with interest on equity paid by Brazilian companies, the exemption will no longer be applicable.
This new treatment could raise doubts as to whether the domestic rule could contravene Article 23.3 of the Double Taxation Agreement between Spain and Brazil, which establishes the exemption for dividends from Brazilian sources. In short, if the Supreme Court has said that interest on equity should be treated as dividends and dividends are exempt under the Tax Treaty, not granting the exemption could be an infringement of the Tax Treaty, which clearly prevails over the domestic rule.
The Tax Office has tried to deal with this complex matter trying to conciliate the Supreme Court decision with the Tax Treaty and, at the same time, denying the application of the exemption in Spain of these interest. In two rulings dated 27 June 2016 (V2960 / 2016 and V2962 / 2016), the Tax Office has stated these criteria:
- Interest on equity, for the sole effect of the application of the Spanish-Brazilian Tax Treaty, have the consideration of interests. Therefore, in accordance with the matching credit established in article 23 of the Tax Treaty, the tax payer can claim a tax credit of 20%.
- Notwithstanding the above, and regardless the qualification of this income for the purposes of the Spanish-Brazilian Tax Treaty, the Tax Office confirms that under the Supreme Court’s criterion, with regards to the Spanish domestic legislation, interest on equity will have the legal nature of a distribution of profits, this is, dividends.
- The Spanish shareholder will not be entitled to apply the exemption provided for foreign source dividends since its distribution generates a tax-deductible expense in the paying entity and must therefore be included into the Spanish taxable base of the shareholder.
In short, the income received by the Spanish shareholder of a Brazilian company as interest on equity as from 2015 onwards will be fully taxable income but the tax payer could deduct 20% of the taxable amount. Since the tax rate in Spain is currently 25 %, the effective tax in Spain on this income would be 5%.
Other crucial point to bear in mind is that interest on equity received in 2012, 2013 and 2014 was fully exempt – the new Corporation Tax Law was not in force- so any company which treated this income as an interest and paid a 5 % effective tax can claim the refund of this tax.