Investing in the Brazilian Ethanol Industry – Key Legal Aspects

Introduction

Concerns with energy security, oil prices and climate change are driving strong interest in biofuels in general and in ethanol in particular.  Brazil, a traditional player in the sugarcane industry, is particularly competitive in the production of ethanol, which it has been using on a commercial scale for over 30 (thirty) years not only as an additive to gasoline but also as pure fuel (E100).  Brazil’s strengths in this area are related to low production costs, low environmental impact – as concerns alternative sources and the production of sugarcane ethanol – and, looking ahead, land availability.

Brazil’s competitiveness has been attracting significant amounts of foreign direct investment in the ethanol industry.  This text discusses relevant legal aspects in connection with such investment inflow.

Title to Rural Real Estate Property

Ethanol businesses in Brazil are typically vertically integrated, with industrial plants and some proportion of sugarcane production under the same business and third parties supplying the balance.  As sugarcane is perishable, title to land around industrial plants is key to the competitiveness of greenfield plants.

The Brazilian Federal Constitution guarantees Brazilians and foreigners resident in the country the right of property (Article 5).  Article 190, specifically with regard to the acquisition of rural real estate property, provides that the law shall regulate and restrict the acquisition or lease of rural real estate property by foreign individuals or legal entities and shall establish those cases in which the authorization of the National Congress shall be necessary.

Law No. 5.709, dated October 7, 1971, regulated by Decree No. 74.965, dated November 26, 1974, establishes the rules relative to the acquisition of rural real estate property by foreigners resident in the country and by foreign legal entities authorized to conduct business activities in Brazil.  The acquisition of rural real estate property in the national territory is prohibited, however, to foreign individuals not resident in the country and/or foreign legal entities not authorized to conduct business activities in Brazil.

With regard to foreign legal entities authorized to conduct business activities in Brazil, the main restrictions are:  (i) the acquisition of the real estate property is conditioned on the implementation of a project which shall be related to the corporate purpose of the company (Article 5 of Law No. 5.709/71) and whose nature shall be, alternatively:  (a) agricultural, (b) related to cattle raising, (c) industrial or

d) concerning land settlement; and (ii) the project must be previously authorized by the Ministry of  Agriculture, following its review by the relevant federal authority, depending on the type of activity.²    

With regard to foreign individuals residing in Brazil, the main restriction concerns the limit on the size of the real estate property that can be acquired, which cannot exceed 50 (fifty) undefined exploration modules (“MEI”),³  in continuous or discontinuous areas.  Should the real estate property be of an area less than or equal to 3 (three) MEI, the acquisition will not require any authorization or license.  The acquisition will depend, however, on the previous authorization of the National Institute of Land Settlement and Agrarian Reform (“INCRA”):⁴  (i) when the acquisition is of a rural real estate property between 3 (three) to 50 (fifty) MEI; as well as (ii) when the acquisition of more than 1 (one) real estate property, regardless of the area, is made by a single individual.  With regard to areas greater than 50 (fifty) MEI, the acquisition of the real estate property is dependent on Presidential approval by Decree (Article 3 of Law No. 5.709/71 and Article 4 of Decree No. 74.965/74).

Until Constitutional Amendment No. 6, dated August 15, 1995, the same restrictions regarding foreign individuals were applicable to Brazilian companies under foreign control – i.e., Brazilian companies with foreign individuals or legal entities entitled to the majority of the company’s voting capital shares and residing or headquartered abroad, as established in Law No. 5.709/71.  However, following this constitutional amendment there ceased to be a differentiation between Brazilian companies controlled by foreigners and those controlled locally. 

Following the entering into force of Constitutional Amendment No. 6, the Attorney General of the Republic of Brazil issued a legal opinion (Opinion No. AGU/LA-04/94), binding upon the Brazilian Federal Government, stating that the particular provision of Law No. 5.709/71 restricting the acquisition of rural real estate property by local companies under foreign control no longer has effect.  Brazilian court precedent corroborates the understanding of the Federal Attorney General that the acquisition of rural real estate property by Brazilian companies controlled by foreign individuals or legal entities is not subject to any restrictions in addition to those that are applicable to Brazilian companies.

There is an additional general limitation regarding the acquisition of rural real estate property by foreigners which is applicable to both individuals and legal entities.  The total area owned by foreigners of different nationalities shall not exceed 25% (twenty five percent) of the area of each of the municipalities wherein such area(s) is(are) located.  Should 2 (two) or more foreigners of the same nationality be entitled to ownership of real estate property in the same municipality, the total area owned by them cannot exceed 10% (ten percent) of the area of the municipality.  However, should the real estate in question be part of a project considered priority to the development of the country, the President of Brazil may authorize foreigners by decree not to be bound by these restrictions.

Tax Efficiency

Two aspects concerning the tax efficiency of investments related to this industry are discussed below.  First, regulations regarding Private Equity Funds (“FIP”).  Second, taxation at the state level. 

FIPs: tax-efficient vehicles for non-portfolio foreign investment

Investments in Brazilian companies via FIPs, created under Brazilian Securities and Exchange Commission – CVM Instruction No. 391, dated July 16, 2003, have become particularly tax-efficient since changes were introduced to the applicable tax rules in July 2006, and this vehicle has indeed been increasingly used by foreign investors.   

The FIP may acquire shares, debentures, subscription bonds and other convertible securities of public or private companies, and is required by applicable regulation to participate in the decision-making process of the company. 

As private companies are not registered with the CVM, in order to be eligible to receive investments from a FIP they must adopt certain minimum corporate governance practices.  Among other requirements, corporate disputes of the company must be resolved through arbitration and the company must submit its financial reports for audit on a yearly basis by CVM-registered independent auditors.

The FIP must have an administrator authorized by the CVM, as well as written regulations relative to investment policy, quotaholder rights, capital calls and redemptions.  The FIP may issue more than 1 (one) class of quotas, subject to different voting rights and fees.  Thus, the same vehicle can accommodate investors of distinct particularities.  Nonetheless, FIP quotaholders, regardless of the class, will always have the right to an undivided interest in the fund’s portfolio, which cannot be segregated among classes of quotas.     

Especially for foreign investors, the FIP receives a favorable tax treatment on the basis of recent legislation.

The withholding income tax rate applicable to earnings from FIP investments is reduced to zero when the earnings are paid to an individual or collective beneficiary domiciled abroad, as long as, cumulatively:

i)  the FIP investment was made in accordance with National Monetary Council rules (Resolution No. 2.689, dated January 26, 2000);

ii)  the beneficiary, individually or together with related parties, does not hold 40% (forty percent) or greater of the quotas issued by the FIP, nor has the right to receive more than 40% (forty percent) of the income generated by the FIP;

iii)  the FIP’s portfolio does not, at any time, consist of more than 5% (five percent) bonds or fixed-rate financial instruments, except for convertible debentures and bonds issued by the Brazilian government; and

iv)  the beneficiary is not domiciled in a tax haven.⁵

Where all such conditions are not met, earnings generated by the FIP will be subject to withholding income tax at a rate of 15% (fifteen percent), so long as the fund meets the diversification requirements and complies with the investment rules established by the CVM and, further, has a portfolio at least 67% (sixty seven percent) comprised of shares of corporations, convertible debentures and subscription bonds.⁶

Both the 0% (zero percent) and 15% (fifteen percent) rates are relatively low.  Additionally, the requirements indicated in subitems (i) and (iv) above being present, the capital gains from the sale of FIP quotas will be free from income tax should the sale be made via a stock exchange or similar entity.

Thus, it is possible, depending on the particular case, to reduce to zero the Brazilian taxation on any and all return a foreign investor might have on investment in operational companies via a FIP. 

State tax regimes

Other factors being equal – including export logistics – the “competitiveness” of state tax rules is, naturally, key to investment decisions.  A few states that feature favorable logistics and availability of land – such as Goiás, Mato Grosso and Tocantins – have been competing for the bulk of investments directed at greenfield projects.

Sales of goods are subject to value-added tax (ICMS) levied by states.  Even though there are legal constraints and political arrangements in place directed at limiting the degree to which states can look to tax incentives as a means of attracting investment, this is still common practice – and will be until certain constitutional amendments, which have long been in the agenda of Congress, are finally enacted. One type of tax incentive that is most commonly adopted by states is the so-called presumed credit regime, whereunder the taxpayer is granted a tax credit equivalent to a fixed percentage of total sales or of total tax obligations, which can then be used to offset actual tax obligations.

Also, states are increasingly resorting to incentives that are financial in nature, generally in the form of indirect tax discount.  The State of Goiás, for instance, has adopted a program under which the taxpayer may defer up to 73% (seventy three percent) of its tax obligations, with a grace period of 12 (twelve) months for the payment of outstanding amounts.  In addition, at the end of such grace period the taxpayer may reduce its tax obligations by applying certain allowed discount factors provided for under the relevant rules, which may result in 100% (one hundred percent) relevant tax discount.  The State of Goiás also has an aggressive presumed credit regime specifically applicable to the sugarcane industry.

Some of the state tax incentives in force have a doubtful legal basis. Investors should, thus, seek legal advice in their regard to avoid being affected by possible adverse later developments such as the revocation of the relevant rules by court decision.

The Regulatory Environment

The recent boom in the ethanol industry and related developments have significantly altered the environment under which the Brazilian sugarcane industry operates.  This includes prospects for ever-growing demand for ethanol, with corresponding pressure on domestic supply; increasing importance of bioelectricity – i.e., surplus power resulting from co-generation using bagasse from sugarcane and sold to the electric energy grid; and prospects for the development of second generation (cellulose) ethanol.

Such developments already call for a review of the legal and regulatory framework under which this industry operates in Brazil.  Among the relevant issues to be revisited are the formation of strategic fuel reserves, called for under relevant legislation since 1991 but never implemented to date; and a regulatory framework for the marketing of ethanol in the domestic market.  The combination of both initiatives would amount to a means of mitigating the risk of government interference with export contracts.  The agenda also includes the consolidation of the legal framework for the marketing of surplus electricity, the review of the institutional framework relevant to this industry and many other relevant issues.

Brazilian producers are currently initiating discussion on this regulatory agenda with the federal administration.  It would be in the interest of foreign players to join early in the process.
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^{1 The two former are partners with Levy & Salomão Advogados.  The second was formerly Executive Secretary of the Brazilian Interministerial Council on Sugar and Ethanol (CIMA). 
2 The relevant agency is the Ministry of Development, Industry and Foreign Trade relative to industrial projects (Article 5, §1 of Law No. 5.709/71).
3 The National Institute of Land Settlement and Agrarian Reform (“INCRA”) is responsible for establishing the undefined exploration module for each region of the country, being able to modify the same whenever there is a change in the economic and social conditions of the region.  For example, in certain cities within the countryside of the State of São Paulo, 3 (three) MEI corresponds to 300,000 (three hundred thousand) square meters.
4 Said INCRA authorization is conditioned to the authorization of the relevant agency with regard to the exploration project, should the real estate property be of an area larger than 20 (twenty) MEI.
5 A jurisdiction that does not impose income tax or imposes income tax at a maximum rate less than 20%.
6 In the case of FIPs that do not comply with the diversification requirements and other conditions established under Law No 11.312/06 and the CVM regulations, the withholding income tax applies according to the same regressive rates of 22.5%, 20%, 17.5% and 15% applicable to Brazilian fixed income funds in general.}