Global Tax Alert | 18 March 2014

Spanish High Court rules Brazilian juros qualify for participation exemption

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Executive summary

The Spanish National Court (Audiencia Nacional) issued a resolution on 27 February 2014, declaring that income received by a Spanish entity from its Brazilian subsidiary in the form of Interest on net equity payments (juros sobre o capital proprio -JsCP-) can benefit from the Spanish participation exemption regime. The previous Central Tax Court's decision on this matter, disallowing participation exemption benefits on JsCPs, has been accordingly repealed.

This is the first time that a Spanish court of justice has issued a resolution on JsCP, a Brazilian hybrid instrument the return on which qualifies as dividend for Brazilian commercial and accounting law purposes, but which is allowed as an expense for tax purposes, subject to compliance with certain requirements.

This landmark case affects many Spanish multinationals (and foreign entities, holding Brazilian interests through Spanish entities), as it may have a direct and significant impact in the effective tax rate of profit repatriations made from Brazil to Spain.

Detailed discussion

Legal and tax characterization of the JsCP

The JsCP was created by Brazilian Law 9,249/95 to favor Brazilian entities resorting to equity funding rather than debt financing, thereby fostering financial solvency and improving credit rating. The main legal features of JsCP may be summarized as follows:

  • Only shareholders are allowed to receive income in the form of JsCP and in proportion to their participation in the Brazilian entity.
  • In accordance with Brazilian commercial law, shareholders of Brazilian entities are entitled to receive a minimum dividend, the payment of which is mandatory for the company. Payments in the form of JsCP can be seen as part of this minimum mandatory dividend.
  • Payments of JsCP generally need to be agreed upon at the general shareholders´ meeting.
  • JsCP can only be paid if the Brazilian entity has earned profits.
  • Payments of JsCP are registered in the financial statements as a dividend distribution.

Brazilian tax law allows for the deduction of JsCP, thus granting the same tax treatment as that applicable to interest payments, and imposes withholding tax on JsCP payments made to non-Brazilian resident recipients (dividend payments to non-Brazilian resident shareholders are not subject to withholding tax).

Spanish domestic participation exemption

Spanish domestic law provides for a 100% participation exemption regime for dividends and capital gains derived from qualifying subsidiaries. Where the conditions for the application of the participation exemption regime are not satisfied, Spanish domestic law also contemplates a tax credit system.

Prior to the Court's decision, there has been strong debate over whether payments of JsCP which generate a tax deductible expense for the distributing entity (i) made such distribution not a qualifying dividend for Spanish participation exemption purposes, and (ii) whether, even if the payment was to be considered as a dividend, it did not meet the “subject to tax test” (under prior legislation).

The Court now concludes that JsCP are dividends for Spanish participation (and tax credit regime) purposes, considering it irrelevant that there may be a tax deduction in Brazil on such distributions. Thus, the court does not need to go into an in-depth analysis of the Treaty.

Impact of the Spanish National Court's resolution

The Spanish National Court's resolution declares that income received by a Spanish entity from its Brazilian subsidiary in the form of JsCP should be treated as dividends which can benefit from the Spanish participation exemption regime and therefore repeals the decision from the lower court.

The National Court based its reasoning on several points. Although it acknowledges that for certain internal Brazilian purposes the JsCP are defined as interest, it highlights that such income does not derive from capital and that, from a Brazilian accounting perspective, the JsCP are not considered a financial expense and are accounted for as a profit distribution. The Court therefore concludes that the JsCP are very similar in nature to dividends.

The Court takes the view that, following the definitions contained in articles 10 (dividend) and 11 (interest) of the Treaty, given that the JsCP entitle their owner to receive a participation in the company´s profits and that this is a typical feature of a dividend, and not of a receivable, they should be treated as dividends also for Treaty purposes.

Finally, the Court highlights that the Spanish participation exemption regime requires compliance with the so-called “subject to tax test” (i.e., the Brazilian subsidiary must be subject to a tax identical or analogous in nature to the Spanish corporate income tax for dividends therefrom in order to benefit from the exemption in Spain) and that this test is deemed to be passed, under the current legislation, where the subsidiary is tax resident in a country with which Spain has signed a tax treaty that contains an exchange of information clause (such as is the case of Brazil).

Although this resolution might be still reversed in the Supreme Court, it is a strong indication that Spanish and foreign multinationals doing business in Brazil through a subsidiary should review the treatment of JsCP, or consider using this instrument to finance their Brazilian operations. It remains to be seen whether any potential change in Spanish law, whether in the furtherance of the OECD's Base Erosion Profit Shifting (BEPS) initiative or in the upcoming tax reform announced by the Spanish Government may affect the practical implications of this resolution.

For additional information with respect to this Alert, please contact the following:

Ernst & Young Abogados, Madrid
  • Laura Ezquerra
    +34 915 727 570
  • José Luis Gonzalo
    +34 915 727 334
  • Felipe García
    +34 915 727 331
Ernst & Young LLP, Spanish Tax Desk, New York
  • Cristina de la Haba
    +1 212 773 8692

EYG no. CM4270