The Controversial Deduction of Expenses with the So-Called “In-House Goodwill"

The concept of goodwill has triggered endless controversy since its introduction in 1977.

Goodwill – also known as surplus value – is used to designate the portion of the equity’s acquisition price which exceeds the net worth and the fair value of the invested Company’s net assets. For more details, please refer to another text of this issue.

Among various controversies that have arisen since its introduction in the Brazilian tax system, one of the most contested matters relate to the possibility of deducting expenses with amortization of goodwill resulting from intercompany reorganizations, the so called “in- house goodwill”.

An “in-house goodwill” arises, for example, when a company (“Parent Company”) increases the capital of a subsidiary (“Sub A”) with shares of another subsidiary (“Sub “B”) whose market value exceeds the net worth and the fair value of its assets, with no cash payment.

In theory, the goodwill so created may be amortized as of the spin-off, merger, or consolidation of Sub A by the Parent Company, or vice-versa.

The Brazilian tax authorities, however, are of the opinion that the deduction of the amortization of such goodwill is not possible, due to the transaction's lack of economic substance. In their view, this lack of purpose is evidenced by the underlying fact that no payment in cash is made, and because the goodwill arises from a transaction undertaken by related parties.

From the tax authorities' point of view, these facts evidence that the real objective of the corporate reorganization is to provide tax savings, and as such, would not be legally acceptable.

Based on these arguments, the tax administration has disallowed the deduction of expenses incurred with the amortization of the in-house goodwill and disregarded the tax effect aimed by the taxpayers. This has led to a long discussion at the administrative and judicial levels.

One of the landmark cases– due to the huge sums involved – was recently decided by the Federal Regional Court of the 4th. Region. The Court held that the deduction of expenses with amortization of goodwill is legal, even when it originates from an intercompany transaction and regardless of the lack of financial flow.

The main argument considered by the Court was that, at the time of the corporate reorganization, there was no rule that prohibited or limited such procedure.

Indeed, the legal impediment to the deduction of expenses with the amortization of goodwill recorded by companies under the same control only arose with the enactment of Law nº12.973/14, which expressly prohibited such practice. Therefore, transactions carried out until this legal provision became applicable (January 1st, 2015) were perfectly legal and legitimate.

The narrow decision – which had 3 votes in favor of the taxpayer and 2 against – is not yet final, as is subject to review by the Superior Court of Justice and possibly the Federal Supreme Court.

In our opinion, transactions structured and carried out before Law 12.973/14 came into effect were legal and feasible. Accordingly, if such structure were not valid before the law came into effect, there would be no reason for the amendment that expressly forbid the tax benefit.

This case will be a great opportunity to test the extent and enforcement of article 116 of the National Tax Code, which permits the Tax authorities to disregard transactions structured with the main purpose of disguising the regular effects of tax provisions, and to have a formal position by the Superior Courts on the best interpretation and application of this rule, which was not regulated by an ordinary law yet, despite the legal requirement.

In brief, this is just one of the many controversies that makes the use of goodwill so challenging, exposing the complexity of the Brazilian tax system.