Substance Matters

Part of our ongoing focus on Latin American tax and transfer pricing issues.

With Brazil adopting IFRS there are now some serious questions facing Brazilian companies with non-Brazilian subsidiaries, i.e., controlled foreign legal entities. Under the Brazilian accounting rules, results of controlled foreign investees can be recorded two ways: 1) Equity method; or 2) Direct consolidation of foreign legal entities’ results in the Brazilian parents’ results.  In the latter instance, the Brazilian parent will effectively have to consolidate the foreign legal entities’ results into its own results effectively treating the controlled foreign legal entity as if it were a branch of the Brazilian parent.

Which method is used depends on the degree of independence between the Brazilian parent company and the foreign affiliate. i.e., Does the controlled foreign legal entity have sufficient autonomy and functionality to operate independently from its Brazilian parent?

Factors that need to be considered in assessing independence:

1. Organizational structure and autonomy;
2. Power to effectuate transactions in the name of the foreign legal entity, including financial transactions, e.g., borrowings;
3. Engaging in transactions that are distinct from its parent company’s activities;
4. Having relatively few intercompany transactions with the Brazilian parent company, compared to total transactions with other parties; and
5. Ability for the subsidiary to generate sufficient cash flow from its own activities to cover its working capital requirements without need of contributions from the Brazilian parent company.

Now is the time for Brazilian companies to review their cross-border investments to determine whether their controlled foreign legal entities have sufficient economic purpose and an organizational structure compatible with their activities to use the equity method of accounting. Otherwise, the Brazilian parent company will be required to pick-up the controlled foreign legal entities’ assets, liabilities, and profit and loss in its results and pay tax on a current basis in Brazil.