Use of “vehicle-companies” in share deals and goodwill tax amortization in Brazil

Share deals involving Brazilian companies benefit from a relevant tax incentive granted by law: the tax amortization (deduction) of goodwill paid in acquisitions of equity interests in Brazilian companies by independent non-related Brazilian companies. This benefit faces uncertainties caused by tax authorities’ restrictive and improper interpretation of the applicable rules.

The concept of goodwill, the rules for its amortization and the tax incentive are discussed in another text of this issue.

One of the several conditions for goodwill tax amortization is that, after the acquisition, the investment in the target company must be extinguished through the absorption of the target company by the purchaser or vice-versa, via merger (incorporação), spin-off (cisão) or amalgamation/consolidation (fusão) between these two entities.

Because of this requirement, investors oftentimes constitute a controlled “vehicle-company” domiciled in Brazil with the specific purpose of making the investment (i.e. be the direct purchaser). The company is then merged by or into the target company, or vice-versa. This practice is common, for example, when the investor is a company based abroad or when neither the investor nor the target company can be extinguished after the deal for business, economic or operational reasons.

Especially in reverse mergers where an investing entity (vehicle-company) is created shortly before the deal only to acquire the shares and is merged into the target company right after the acquisition to allow goodwill tax amortization to begin, tax authorities frequently challenge the amortization based on strict substance-over-form analysis (i.e. prevalence of economic substance of transactions over their legal forms).

Tax authorities claim that there is no reason to incorporate and immediately extinguish the vehicle-company, other than the goodwill tax benefit. In their view, the company that controls the vehicle-company is the real purchaser/investing entity (in substance) and this company would not merge with the invested target entity, as required by the legislation for goodwill tax amortization. For this reason, tax authorities understand that this tax benefit should not be allowed.

There are, however, valid arguments to contest such position and justify the use of vehicle-companies in this context, such as the following:

i) the goodwill tax benefit is expressly granted by the Brazilian tax legislation, as long as goodwill is effectively paid in a share acquisition between non-related independent parties and all other legal requirements are properly complied with; there is no legal restriction regarding the use of vehicle-companies to make the investment enabling the use of the tax benefit, neither are there rules in force authorizing scrutiny based on absolute prevalence of substance over form, especially in cases where there is no fraud, sham, or other type of abuse; the acquiring group is thus entitled to organize itself as deemed more appropriate to make the investment within applicable legal rules;

ii) the goodwill paid and the tax benefit associated with it increases the target company’s purchase price and, consequently, the seller’s taxable capital gain; thus, the goodwill tax amortization enabled by the use of a vehicle-company causes no harm to the public treasury;

iii) while investors resident in Brazil would typically be or have a pre-existing Brazilian company that could make the investment without being encompassed by anti-avoidance arguments, non-Brazilian investors would need to form a new local entity to reach the same benefit; such latter investors would thus be in unequal conditions to compete with Brazilian investors for being unable to use the goodwill tax benefit; and

iv) the use of a vehicle-company does not create additional, duplicated or artificial goodwill.

In certain circumstances the use of a Brazilian vehicle-company as the direct purchaser may also be necessary or convenient for other reasons, such as corporate governance, regulatory requirements or some other business or economic motive. This significantly reduces the risk of goodwill amortization being invalidated.

Based on some of the arguments above, Brazilian administrative courts (second level of administrative jurisdiction - CARF) have rendered decisions allowing the use of vehicle-companies for share acquisitions and their subsequent extinction to enable goodwill tax amortization.

For such purpose, as clarified in some cases judged by CARF’s superior chamber of appeals (third level of administrative jurisdiction - CSRF), the vehicle-company itself must effectively make the acquisition, paying the purchase price and goodwill, and the investment must thereafter be extinguished via merger of the target company by the vehicle-company or vice-versa. In some cases, the benefit was denied because it was not the Brazilian vehicle-company, but rather its non-Brazilian parent company, that originally purchased the shares paying the price and goodwill, subsequently transferring the shares and goodwill to the Brazilian vehicle-company via capital contribution in kind. In other cases, the taxpayer lost the dispute because there had been no effective merger involving the target company.

Nonetheless, there are still some recent decisions rendered by CARF and CSRF upholding tax authorities’ position that the real purchaser (investing entity) is the company that controls the vehicle-company and ultimately bears the economic burden of the acquisition. Since no merger takes place between this “real purchaser” and the invested target entity, as supposedly required by the legislation for goodwill tax amortization, the benefit could not be allowed.

Administrative case law is therefore not settled on this matter.

Brazilian highest judicial courts have still not analyzed the merits of the matter. The Superior Court of Justice (STJ) rendered some decisions dealing only with procedural issues in connection with goodwill tax amortization and vehicle-companies. On a lower level, only the Regional Federal Court with jurisdiction over Brazil’s southern states has properly addressed the matter in a few cases. In a more recent case, the Court accepted goodwill amortization related to an intra-group transaction that used a vehicle-company. In some other cases involving the use of vehicle-companies the court denied the amortization, but only because, in those cases, the vehicle-company had been used to create artificial or abusive intra-group goodwill, rather than to enable amortization of goodwill effectively paid in genuine acquisitions between independent parties (intra-group goodwill is specifically discussed in another text of this issue).

The current status of judicial case law on the subject may however soon change as landmark cases judged by administrative courts in recent years start reaching superior judicial courts.

With respect to tax planning structures in general, the Brazilian Federal Supreme Court is currently judging an important case which discusses the reach and limits of a provision in the Brazilian National Tax Code employed by tax authorities to support tax assessments in cases of lawful tax planning. Such provision reads that “tax authorities may disregard acts and transactions undertaken with the purpose of dissimulating the occurrence of the taxable event or the nature of the elements that constitute the tax obligation, subject to the procedures to be established by ordinary law”.

The five votes rendered so far indicate support to the position that such rule does not authorize taxation of “a totally lawful legal form which enables a lower taxation, taxing the transaction even in the absence of a legal rule characterizing it as a taxable event. Tax authorities are authorized only to apply the tax rate and calculation basis to a taxable event defined by law and which has taken place.” Judgment is currently suspended for closer examination by one of the judges. Should the above position prevail, the chances of success in judicial disputes involving the use of vehicle-companies for goodwill amortization and many other lawful tax planning structures will be considerably reinforced.