NI 1658: overview and implications
NI 1662 and NI 1664
In September 2016 the Brazilian Revenue Service (SRF) unexpectedly promulgated a change in its treatment of Ireland, which had the potential to wreak havoc on the aircraft leasing sector for the entire country. After four weeks of considerable uncertainty, the changes – as they apply to commercial aircraft leases – were suspended. While the clarifications temporarily resolve the initial concerns regarding commercial aircraft leases, they provide no relief for other important sectors such as the air taxi sector (encompassing the country's helicopter operators, used to support the oil and gas sector). Equally, the clarifications have not benefited the business aviation sector.
NI 1658: overview and implications
The controversy relates to the definition, classification and treatment of jurisdictions that the SRF has deemed to be 'tax havens' under Brazilian law. The applicable Brazilian tax law defines a 'tax haven' as a jurisdiction with an annual tax rate of less than 20% per year. Under this definition, Ireland could have qualified as a tax haven years ago due to its incentive tax rates; however, under the SRF's system, only those countries included on the list periodically published by the SRF are treated as tax havens. Ireland was not included on the SRF's tax haven list until September 2016. However, on September 14 2016 the SRF issued Normative Instruction (NI) 1658, unexpectedly adding Ireland, Curacao and Saint Martin to the tax haven list. NI 1658 purported to be effective retroactively, from August 2016.
The consequences of this change to aircraft leases were potentially disastrous for Brazil's airlines. Paying rent to a lessor domiciled or otherwise located in a tax haven attracts a high rate of withholding tax if the lease is an operating lease. Although the term 'withholding tax' is commonly used, the tax is actually Brazilian federal income tax withheld at source, usually by the bank in Brazil processing the payment. These commercial banks can be held liable for improper processing of payments if they do not withhold applicable taxes, essentially giving the commercial banks an auditing role in the collection of withholding tax. If and when this tax is assessed, either the lessor receives a lower amount of rent or, in the case of leases with gross-up provisions, the lessee must gross up the rent. Virtually all leases contain gross-up provisions, so the onus usually falls on the Brazilian lessee.
For many years, the basic withholding tax rules applicable to cross-border aircraft leases were as follows:
- Operating leases with lessors not domiciled in tax havens were not subject to withholding tax.
- Operating leases with lessors domiciled in tax havens were subject to a 25% withholding tax.
- Finance leases with lessors not domiciled in tax havens were subject to a 15% withholding tax on the interest portion of all rent payments; however, there was an exemption from that tax for several years.
- Finance leases with lessors domiciled in tax havens were subject to a 25% withholding tax on the interest portion of all rent payments.
One consequence of these rules was that for decades nearly all of Brazil's commercial aircraft fleet was structured through operating leases.
The change introduced by NI 1658 affected the treatment of operating leases from Irish leasing entities. Although the precise number is subject to speculation, it is estimated that approximately 65% of the existing Brazilian commercial fleet is leased from Irish-based lessors, most or all of which suddenly became subject to an unexpected, significant withholding tax burden.
As soon as NI 1658 was published, the Brazilian Association of Airlines (ABEAR) began lobbying the government to reconsider the decision. The change came as a complete surprise to the industry and had a far-reaching effect. Brazil's airlines were already experiencing an unprecedented economic recession and decline in demand, and none could afford the additional expense of such a high tax. The reasons for the SRF's unexpected change are unclear, but it is unlikely that the SRF was targeting the aviation sector. There is some speculation that the SRF's sudden change was provoked by the recent publicity over a tax case involving Apple's operations in Ireland. Another possible reason is that a major Brazilian meat-processing conglomerate recently announced that it would be relocating its headquarters to Ireland.
NI 1658 contained certain questionable terms from the onset. One such term was that it applied retroactively to payments falling due from August 1 2016. Retroactive application is prohibited in Brazil. Since the regulation was not altering a law, there was a chance that the SRF would argue that it was not changing the rules, but merely 'correcting' an error with prior regulations. However, instead of embarking on such a questionable course of action, on September 19 2016 the SRF promulgated a new regulation that changed the effective date of the new treatment to October 1 2016, thereby resolving the potential problem of retroactivity.
However, airlines and other operators were still left with a new 25% withholding tax, a financial burden that none could afford. ABEAR's lobbying efforts against the measure continued. Meanwhile, one Brazilian airline sought and obtained a judicial injunction authorising it to pay rent to Irish lessors without any withholding through the end of 2016. The injunction was issued on the basis that the affected lessees were entitled to advance notice before such a drastic tax increase could be implemented.
During this period, lawyers and tax advisers considered different ways to structure leases. Ironically, for the past few decades, the tax laws have encouraged operators to structure most of their leases as operating leases. The sudden change that occurred in September 2016 reversed this trend and finance leases suddenly became more tax efficient. Brazil has several laws and regulations that refer to certain types of lease as 'mercantile leases'. In the past, 'mercantile lease' was understood to refer to a finance lease. Local banks in Brazil that finance the acquisition of vehicles and equipment under finance leases are called 'mercantile leasing companies'. That said, there are a few references in the Central Bank's regulations and other regulations to mercantile leases without purchase options or to 'operating-type mercantile leases'. In late September 2016 several tax advisers considered whether there was scope to restructure or re-characterise existing operating leases as mercantile leases. Some of the arguments to support this structure are supported by laws and regulations; however, no precedents allow lessees to adapt such a structure with confidence that the withholding tax would not apply.
Finally, on October 3 2016, after heavy lobbying from ABEAR and several press reports describing the havoc that the new law would bring to Brazil's airlines, the SRF published NI 1662, which seemed to exclude airline operating leases from any obligation to pay the withholding tax on rent payments made to lessors based in tax havens. However, the regulation contained several drafting problems and was insufficiently clear in its intent and effect. Thus, on October 13 2016 the SRF issued NI 1664 in order to clarify NI 1658. NI 1664 expressly exempts commercial aircraft lease payments to lessors located in tax haven jurisdictions from withholding tax. With some irony, the SRF created a safe harbour for Brazilian airlines to lease aircraft from jurisdictions such as the Cayman Islands, the British Virgin Islands and Cyprus, all of which have been on the tax haven list for years. Despite this, it is doubtful that the airlines will change their practices and begin to lease from those jurisdictions. NI 1664 is effective for leases dated until December 31 2019 and for payments due until the end of the 2022 calendar year.
NI 1664 has not resolved all of the issues raised by the characterisation of Ireland as a tax haven. Ireland is still on Brazil's tax haven list. Air taxi companies and business jet operators do not benefit from NI 1664. This affects countless helicopter leases for aircraft used to support Brazil's oil and gas industry. Relatively few corporate aircraft have been leased by Irish entities and consequently that sector was less affected. Other non-aviation business activities that Irish entities conduct with Brazilian entities will also remain subject to tax haven treatment.
Some tax advisers and lawyers view the technical terms of the October 13 regulation as potentially faulty and subject to challenge. In other words, they are concerned that the withholding tax may still be imposed on airlines, despite the October 13 regulation. However, the fact that airlines and commercial banks are currently processing payments without withholding 25% demonstrates a certain confidence that the issue has been resolved for commercial aircraft lease payments.
In terms of aircraft finance, the impact of Brazil's designation of Ireland as a tax haven is most significant for operators of helicopters used to support Brazil's oil and gas industry, mainly air taxi operators. The airline industry will need to be vigilant to ensure that the sunset provisions of NI 1664 are extended beyond the 2019 and 2022 expiry dates. In the meantime, Ireland will likely try to engage the Brazilian government in a dialogue to remove Ireland from the tax haven list. A few years ago, Switzerland successfully sought to have its name removed from the list. However, that effort took approximately four years, so no quick change is expected.
Another tax law that is receiving some attention from Brazil's airlines relates to the deductibility of payments made to tax haven entities. If these payments are made for the purpose of overall tax reductions, they may be deemed non-deductible for tax purposes. Considering that Ireland is one of the world's primary jurisdictions for aircraft leasing, there are strong arguments against aircraft leases to Irish lessors being subject to determinations of non-deductibility of payments.
For further information on this topic please contact Kenneth D Basch at Basch & Rameh by telephone (+55 11 3064 8599) or email ([email protected]). The Basch & Rameh website can be accessed at www.baschrameh.com.br.