Originally published in the January 23 edition of World Tax Daily (Copyrights Tax Analysts – www.taxanalysts.com)
Brazil’s Law 11,638/2007, which amends several articles of the Corporations Act (Law 6,404/76), was published in the December 28, 2007, extra edition of Brazil’s official gazette and went into effect January 1, 2008.
The law introduces a set of complex requirements that change accounting rules and financial statements for Brazilian corporations and large companies not formed as corporations. Some of the changes, however, are not limited to accounting matters. Tax experts have not agreed on the extent of the law’s tax implications.
Further regulations by Brazil’s Securities and Exchange Commission (Comissão de Valores Imobiliários, or CVM) are pending and will be issued soon, as some of the changes must be complied with for financial statements for periods ending December 31, 2007.
Most of the changes introduced by Law 11,638/2007 seek to bring Brazil’s generally accepted accounting principles closer to international accounting standards. Among those changes are the creation of the statement of cash flows and a value added statement, which will give investors more information about a company’s financial state.
The law also changes rules concerning accounting criteria and methods; classification of assets (for example, the new requirement to create an intangible asset group); restrictions on the use of deferred asset accounts; structure and limitations of equity accounts; criteria for valuation of cash equivalents, including securities; criteria for valuation of intangible assets; assets allocated to long-term operations and long-term liabilities; amortization of items booked as deferred assets (revocation of the maximum 10-year limitation); profit reserves and reserves for tax incentives; and valuation of controlled and affiliate companies according to the equity method.
The law also subjects large companies not formed as corporations to many of its requirements, such as those concerning bookkeeping, financial statements, and the need for registered independent auditors. The requirements will affect many large companies formed as limited liability companies (limitadas), as they are by far the most popular form of legal entity. Until now, limitadas were excluded from following most Corporations Act requirements.
Under article 3 of Law 11,638/2007, for legal purposes, a large company is a company or group of companies under common control that, in the preceding year, had assets in excess of BRL 240 million (approximately $137 million) or annual gross income above BRL 300 million (approximately $171 million).
The law requires the valuation of assets and liabilities at market value for companies undergoing corporate restructuring, such as mergers, split-ups, and amalgamations. That requirement applies only when the companies are independent; that is, those that do not belong to the same economic group.
Before Law 11,638/2007, valuation at market value was optional, and almost all transactions were carried at book value. Valuation at book value allowed a significant amount of premium to generate, which could be amortized for tax purposes between 5 to 10 years. With the market value valuation requirement, the amount of amortizable premium will likely be smaller, as will the corresponding tax deductions. Prices for target companies may drop, as purchasers will be unable to recover part of the purchase price through premium amortization. However, depending on how the acquisition or restructuring is implemented, there might still be room for tax planning. The CVM has announced that it will issue regulations on the topic.
The new value added statement is intended to show the wealth created by the company and attributed to different relevant parties, such as shareholders, employees, and the government. It shows the wealth the reporting company has been able to generate by its own effort, including its management and employees. For tax purposes, the value added statement will be able to support the substance (or lack of it) of a corporate restructuring used as a tax planning tool. Because more tax courts are examining the economic aspects of tax planning when reviewing tax assessments, the value added statement may become an important instrument to oppose or support the legitimacy (substance) of a given transaction.
The new law prohibits companies issuing debentures from booking any premium arising thereof as a nontaxable reserve (as was the rule before Law 11,638/2007). Under the new rule, the premium should be added to taxable income and taxed accordingly.
Another interesting change is the new definition of deferred asset account. The original definition allowed a company to book as a deferred asset any prepaid expense that would help generate income during more than one fiscal year. Law 11,638/2007 changed the definition (article 179, Item V of the Corporations Act) to include only preoperational and restructuring expenses that effectively will help increase the company’s income in more than one fiscal year.
The change to the definition may have a tax impact for newly formed companies, as they will be unable to book some expenses as a deferred asset, but rather must deduct them during the first year of operations. Brazil limits corporate taxpayers’ ability to fully deduct net operating losses, as NOLs can only offset up to 30 percent of a company’s taxable income in a given year. Excessive expense deductions in the first year of operations will likely generate a tax loss at the end of that year, as businesses usually do not earn significant amounts of income in their first year. Consequently, the excess expenses will likely become a NOL, subject to a 30 percent profit offsetting limitation. If the taxpayer could book the expenses as a deferred asset, deduction would take place gradually over the years and would reduce the chance that those expenses become NOLs.
Corporations and large limitadas should immediately meet with their consultants to evaluate the potential impact of Law 11,638/2007 on their businesses.
David Roberto R. Soares da Silva