Pathway to overcome tax obstacles in insolvency proceedings

Obstacles imposed by the Brazilian Business Insolvency Act (Act 11,101/2005) have, historically, hindered tax-efficient recovery plans and created challenges for insolvent companies to pay their tax debts and for creditors to receive the amounts they are owed. Spurred by the current economic crisis resulting from the COVID-19 pandemic, Brazilian legislators are now debating a draft bill which provides a new legal framework to judicial recovery and bankruptcy proceedings and seeks to address some of these obstacles.

Draft Bill No. 4,458/2020, which has already been approved by the Brazilian House of Representatives and is currently under debate in the Brazilian Senate, addresses some of these challenges but fails to tackle more critical issues.

One major problem faced by companies undergoing judicial recovery addressed by the draft bill is the taxation of debt discounts granted by creditors. It is in the nature of judicial recoveries that debts be negotiated with creditors in order to obtain discounts and/or special payment conditions, thus enabling the debtor to recover from its state of financial distress. However, under the current rules, any benefits obtained from these negotiations are treated as revenues subject to taxes levied on gross revenues (PIS and Cofins) and to corporate income taxes (IRPJ and CSLL). The Draft Bill partially addressed this by providing that debt reductions obtained under judicial recovery should not be subject to the PIS and Cofins taxes.

The Draft Bill does not address taxation of income and revenues of bankrupt estates. Although uncommon, revenues and income are sometimes earned by bankrupt estates, especially those involving financial institutions, whose assets have greater liquidity. Such revenues and income do not derive from true economic activities and the resulting increase in net worth is precarious, for it is destined to paying creditors. They are nonetheless taxed. A legal provision exempting them from taxation would be most welcome, because it would allow greater availability of funds for the payment of creditors and for the company to recover from insolvency. It would also bring legal certainty with respect to the matter, eliminating the need for judicial discussions and their related costs.

Under the current law, companies undergoing judicial recovery face restrictions to use and sell accumulated Net Operational Losses (NOLs). As a general rule, Brazilian tax law allows companies to offset only 30% of the taxable profit of a given year with NOLs from previous years, even if losses were much greater. Furthermore, companies are currently not allowed to sell or transfer NOLs, neither are they allowed to use their own NOLs in case there is change to the company’s corporate control and field of activity.

Considering that NOLs can be seen as valuable assets, these restrictions, coupled with the fact that companies facing judicial recovery usually accumulate a great amount of NOLs due to reiterated losses, make it even harder for such companies to recover. The Draft Bill partially addresses this problem by authorizing these companies to offset 100% of gains stemming from debt renegotiations and sales of assets against accrued NOLs. Although this is a step in the right direction, it would be more coherent to allow companies to offset 100% of net profits against NOLs during the judicial recovery, and/or allow NOLs to be sold/transferred to other companies and used without the limitations concerning change of corporate control and field of activity.

An additional unreasonable tax obligation imposed by the current Brazilian Business Insolvency Act is the requirement that companies present their Tax Debt Clearance Certificates (CND) together with the request for judicial recovery. The requirement that companies petitioning for judicial recovery first prove that they do not have outstanding taxes in practice requires that they pay or guarantee tax debts before the judicial recovery is even started, thus making tax debts preferred over labor credits and credits with in rem guarantees. This preferential treatment of tax debts violates the credit preference order defined by this very law (which places labor credits and credits with in rem guarantees before tax credits) and ignores the fact that most, if not all, companies that seek judicial recovery have outstanding tax debts.

The need to present a CND also jeopardizes the very purpose of the judicial recovery, as stated in Article 47 of Act 11,101/2005, which is to preserve the company and maintain its economic activities.

Due to these inconsistencies, the requirement that companies petitioning for judicial recovery submit the CND has, historically, been waived by judicial courts, and tax authorities have consistently appealed these decisions without success. Recently, however, the Supreme Court (STF) granted a preliminary order to enforce this requirement. The Draft Bill has unfortunately not addressed this problem.

The Draft Bill does, however, provide for more beneficial conditions for payment of outstanding tax debts by bankrupt estates and companies undergoing judicial recovery. If approved, the Bill would allow extended payment agreements (increasing the maximum number of installments to 120), the possibility of using part of NOLs to offset tax liabilities, as well as the possibility of negotiating tax debts with tax authorities.

Under current rules, renegotiation of debts under judicial recovery proceedings can also be subject to the tax on “credit transactions” (IOF) which applies a second time to the unliquidated debt balances of the original loans. In cases where the original loan has no defined principal amount (e.g., a revolving credit), the basis for the calculation of this new IOF tax is the renegotiated amount minus any portion amortized on the renegotiation date. This has also not been addressed by the Draft Bill, which could have provided for a useful IOF exemption in cases where outstanding debts are renegotiated under a judicial recovery process.

Financial institutions that do not meet certain levels of solvability are subject to a special extrajudicial liquidation process led by the Central Bank of Brazil (BACEN), which precedes bankruptcy and aims to avoid it. In order to preserve the stability of the Brazilian Financial System and avoid bankruptcy of financial institutions, a potential solution is to transfer the operations of the liquidating entity to another financial institution. However, this alternative may transfer tax liabilities to the acquiring entity because rules that limit tax succession apply only to acquisitions under judicial recovery and bankruptcy proceedings. The lack of express legal provisions limiting tax succession in acquisitions within extrajudicial liquidation jeopardizes the conclusion of these processes, which usually end up being converted into bankruptcies. The Draft Bill could have expressly extended the tax succession limitation to such extrajudicial liquidations, thus facilitating their successful conclusion and avoiding their conversion into bankruptcies, but the present wording of the Draft Bill does not address this.

Finally, the judicial recovery does not suspend tax foreclosure proceedings against the recovering entity – differently from other foreclosure proceedings, which as a rule are stayed during the recovery. Although the Draft Bill does not change this, it enables the judge in charge of the judicial recovery to request the judge in charge of the tax foreclosure to suspend lien/attachment acts over assets deemed essential to the maintenance of the company’s operations, for a period of 180 to 360 days, and to replace such assets by others during the course of the judicial recovery proceeding.

In summary, Draft Bill No. 4,458/2020 warrants relevant adjustments aimed at achieving a more efficient legal framework for judicial recovery and bankruptcy processes. Hopefully at least some of these additional changes can still be included in the bill before its final approval, which remains uncertain.