Law 14754 received presidential sanction this week – and with that, it will transform the taxation of Brazilian resident individuals investing abroad from 2024 onward. TL;DR: the new law now anticipates the collection of taxes to the moment the profit is generated, instead of when it’s distributed.
Being prepared is always a good call, be it when talking about taxes or when talking about Latin America. So here's everything you need to know about Law 14754:
Before the law, Brazilian resident individuals would invest abroad and only pay income taxes on profits when the earnings were actually distributed or the asset was sold. When Brazilians effectively saw money in their hands, they'd face tax brackets that went all the way to 27.5%. When the cash stayed offshore, there was no tax levy.
So in most cases, investments were 1) held through offshore entities in low-tax jurisdictions (such as the Cayman Islands); 2) no earnings were distributed; 3) and so, there was no income tax to be paid in Brazil.
With the approval of Law 14754, this eternal deferral will no longer be available from January 1st, 2024.
The law promotes an anti-deferral tax regime, like what we see in countries such as Chile, Colombia, Mexico, and the US. That means you pay taxes upfront, not when you move the money to Brazil.
Brazilian resident individuals investing abroad through controlled offshore entities will now be required to state the earnings and yields from their entities in their income tax returns.
These earnings and yields, e.g. profits and dividends, should be verified every December 31st and then be reported on each individual's income tax declaration (Declaração do Imposto sobre a Renda das Pessoas Físicas/DIRPF). Then, the Brazilian resident individuals will pay an income tax on these earnings and yields. Yes, even if they were not distributed.
But it's not all bad news: the income tax rate on these profits has now been reduced from up to 27.5% to always 15%.
This new piece of legislation targets primarily the profit seen by high-net-worth Brazilian individuals and institutions (e.g. family offices) that control international investment entities.
Offshore structures are also commonly used in the venture capital market, and so, startups and VC investors are also affected by the legislation. Still, as we'll see, the changes aren’t as impactful.
Angels, venture capital investors, employees with stock options, co-founders without ownership or decision rights – they won't probably be affected as they're probably not controllers of the offshore entities.
As we've mentioned, Brazilian tax residents will now have to report and pay taxes on earnings from their controlled offshores in their personal tax returns.
"Control" can mean either having more than 50% ownership (straightforward) or having decision rights (not straightforward) – so check first if you do have control or not.
In the case of controlling founders, it's important to mention this tax payment is also pro-rated to their percentage of ownership in the company. Let's see the example of a fictional startup called XYZ:
Offshores created by startup founders are usually non-operational, pure holding companies. So the taxable profits are usually generated from passive sources, such as a round raised with VCs generating yield by staying invested in international accounts.
Founders who set up personal offshore holdings and own their shares intending to postpone the tax effect after their startup's liquidation will be impacted.
This has become more popular recently – and we foresee that changing starting next year, as the benefits of having a personal holding aren’t as clear-cut anymore, and should now be assessed on a case-by-case basis.
What happens when a startup raises a new round and sees an uptick in the valuation of its shares?
In most cases, these changes should not be accounted as operational results generating a profit. Therefore, depending on the accounting treatment adopted, it will not be necessary to pay the annual income tax established by the new law in this case.
It's important to note, however, your ownership position after each round. If you've gained or lost control, that could make you susceptible or not susceptible to the new law.
There's a partial way out when it comes to illiquid assets.
Brazilian resident individuals investing abroad through offshore entities controlled by them are eligible for a check-the-box solution, treating these offshore entities as transparent for income tax purposes and owned by each founder as individuals.
This election must be made until the deadline for filing the income tax return and is irrevocable and irreversible for as long as the investors hold the controlled offshore entity. It will likely be made by the majority of Brazilian resident individuals holding illiquid assets abroad through controlled offshore entities, especially venture capital and private equity investments.
Treating the offshore entities as transparent for income tax purposes allows for a partial deferral – a.k.a. no income tax will be paid until the illiquid assets are sold.
Nevertheless, when the corresponding assets are indeed sold, the Brazilian resident individuals will be required to pay income tax on their earnings. Sorry, no way out of this one.
While the rolling over of assets into a personal holding might not be as advantageous anymore, from a liquidation standpoint, the tax rates remain identical (might be reduced to 15%, depending on whether the assets sold are considered to be financial assets abroad).
Yes, the Cayman Sandwich remains an efficient option for startup founders looking to set up an international corporate structure. Here's why:
Still, it's important to remember: founders and investors will be affected, even if not as much as offshore individual investors and family offices, and should discuss the strategy to be implemented with tax advisors.