Back to Taxes Committee publications

H Philip Schneider

Schneider, Pugliese, Sztokfisz, Figueiredo and Carvalho, São Paulo

philip.schneider@schneiderpugliese.com.br

 

Pedro Bini

Schneider, Pugliese, Sztokfisz, Figueiredo and Carvalho, São Paulo

pedro.bini@schneiderpugliese.com.br

 

Introduction

In a global market, derivatives for hedge purposes are commonly used by companies to provide protection against price and currency variations, thus mitigating the risks caused by endemic political and economic turmoil. Additionally, they may also be used as an instrument of coordination among entities of the same economical group, centralising their operations in order to achieve the reduction of transactional costs, synergy and maximisation of its efficiency.

In this context, companies around the world, while hedging their commercial positions, typically search for boards of trade with significant liquidity (ie, significant volume of trades). Companies domiciled in Brazil are no different: they carry out their hedge trades in highly liquid markets.

Although, with regards to offshore hedges, one may not envisage any differences between third countries and Brazilian practices, in Brazil such transactions generate conflicts of interpretation on the application of the Brazilian tax law regarding the deduction of offshore hedge losses, which may cause legal uncertainty and tax disputes with the Brazilian Tax Authorities.

Taking into consideration the Brazilian legal and regulatory framework, this article addresses: (1) the Brazilian rules concerning the deduction of offshore hedge losses; and (2) recent case law, in which the Brazilian Administrative Council of Tax Appeals (‘CARF’) analysed tax assessments related to the use of foreign hedge centres.

Brazilian tax legislation on hedge losses

Regarding losses related to onshore hedge transactions, Brazilian tax legislation[1] defines hedge transactions as operations designed exclusively to protect companies against risks inherent to price or rate fluctuation. In order to be qualified as such, the transaction must be (1) related to the operational activities of the legal entity; or (2) intended to protect the rights or obligations of the legal entity. Consequently, trades that do not meet this definition are deemed to be of a speculative nature, and hence do not qualify as hedge transactions for fiscal purposes.

Besides the qualification of hedge transaction for tax purposes, Brazilian law provides clear differentiation on treatment of losses, thus: (1) losses generated by hedge transactions are entirely deductible from the tax basis of corporate income tax; and (2) losses generated by speculative transactions are deductible, subject to some limitations (eg, limitation up to the gains on equivalent derivative transactions).

As for offshore hedges, it is important to stress that, as a general rule, losses from transactions carried outside of Brazil are non-deductible for corporate tax purposes. Exception to such non-deductibility rule is provided by Article 17 of Law No 9.430/1996, which determines that hedge transactions performed directly by taxpayers in an offshore stock exchange will be deductible. However, the literal interpretation of ‘directly’ raises an operational difficulty: what if the regulator of the offshore market imposes an intermediary for accessing the offshore exchange? Would the general rule apply in this case? Would the losses be considered non-deductible for corporate tax purposes?

Such literal interpretation has been brought before CARF, the highest federal administrative tax court, due to a challenge by the Brazilian Tax Authorities with respect to the deduction of losses of offshore hedges carried out by the taxpayer via a hedge centre.

Recent case law addressing hedge centres

The Brazilian Tax Authorities issued an additional tax assessment against a taxpayer alleging the violation of Article 17 of Law No 9.430/1996: the use of a hedge centre to enter into hedge transactions in an offshore exchange was not considered to be carried out directly by the taxpayer.

In its defence, the taxpayer argued that Article 17 of Law No 9.430/1996 should not be interpreted literally, since such interpretation would create significant limitations on offshore hedges. Indeed, in that case, the local regulator strongly recommends and imposes: (1) the use of the hedge centre by multinational groups in order to avoid any market price distortions/artificialities; and (2) the execution of the group orders through a qualified member (ie, clearing house subject to the regulator´s audit).

According to the taxpayer, Article 17 of Law No 9.430/1996 needs to be interpreted in context and aligned with the legislation and regulation of the exchange’s jurisdiction. Moreover, it has been argued that the purpose of article 17 is to avoid fraud from taxpayers and to ensure compliance on offshore hedges; pursuit of a literal approach may lead to violation of the legislation and/or regulation in the jurisdiction of the exchange.

The taxpayer therefore defended a broader interpretation of the concept of ‘exchange’, to mean not a legal entity, but a regulated environment comprising several players that negotiate pursuant to the arm’s length principle. In this case, the existence of a regulated market thereby avoids the practice of artificial and abusive hedge transactions.

CARF ruled in favour of the taxpayer’s claims and rejected the literal approach supposedly provided by Article 17 of Law No 9.430/1996. The judges held the interpretation of the Brazilian Tax Authorities to be unfeasible and in contradiction of the purpose of the law; which, in their opinion, is to authorise the deduction of hedge losses incurred in regulated exchanges, irrespective of whether executed directly or through hedge centres. CARF therefore granted the deduction of losses to the taxpayer, which resulted in the cancellation of the additional tax assessment issued.

CARF’s decision thereby mitigates legal uncertainty in Brazil and allows economic groups to use hedge centres abroad to consolidate hedge order, in compliance with local legislation and regulations.

Conclusion

Article 17 of Law no. 9.430/1996 provides that hedge operations performed directly by taxpayers in offshore exchanges are deductible and CARF has also recently recognised that taxpayers may use hedge centres abroad to consolidate and perform hedge orders of entities from the same economic group. In such cases, the taxpayer has to prove the following:

1. that the transaction is carried out in accordance with market practice (ie, at arm´s length);
2. the transaction is related to the operational activities of the legal entity, or is intended to protect its rights and obligations;
3. the taxpayer is compliant with the legislation and regulations of the offshore exchange; and
4. the financial transactions of the operation.

Back to Taxes Committee publications