In order to continue the analysis brought by our article from June 3rd with respect to third-party funding (TPF), hereby we discuss the tax aspects involved in this model, which allows for the litigating party to be funded by a specialized investment fund, responsible for the financial support.
As seen, basically TPF may occur by means of three forms: supporting all or part of the expenses, with compensation due only if the funded party succeeds; acquiring future rights on the arbitration award, with assumption of the risks involved in the enforcement of the award; and providing the funded party with the amount upon a compensation determined by setting an interest rate previously established, regardless of the result, in addition to a bonus if the award is favorable to the funded party.
Once there is no legislation specific for funding costs related to the arbitration procedure in Brazil, in these cases the tax involved in the operation will depend, in fact, on the investor’s nationality – whether Brazilian or foreign -, as well as on the definition of its nature – whether the funding is interpreted as an acquisition of receivables or as loan.
With regards to the nature of the funding, the TPF that encompasses expenses which refund is tied to the success of the arbitration and the TPF that encompasses the acquisition of receivables may be understood, in Brazil, as acquisition of receivables by the investor – once the investor acquirers, at its own risk, rights related to the arbitration that may or may not be fulfilled in light of the arbitration award. On the other hand, when there is funding plus bonus, the investor funds the litigation party who shall later reimburse the amount in addition to the interest established between the parties, which is actually a loan. In this context, depending on the nature of the operation, there is capital gain or interest.
As for the nationality, if the investor is foreign: if receiving the amounts involved is subject to the risk of the result of the arbitration award, the capital gain, if any, will be taxed, as of 2017, according to the income tax progressive rate (from 15% to 22.5%) and to the fixed rate of 25% for situations in which the investor is located in a tax friendly country (tax heaven); moreover, there is IOF-exchange in the conversion of currency for the payment to the foreign country at the rate of 0.38%. As for the funding treated as loan, the amount of the principal reimbursed by the Brazilian company to the investor is exempt from income tax, however the interest paid (whichever the calculation form) will be subject to income tax at the rate of 15%, increased to 25% in situations in which the investor is located in a tax friendly country.
Depending on the foreign investor’s country of residence, the existence of agreements entered into with Brazil must be verified, once they may provide lower rates.
In these operations, the IOF-credit will not be due because they are foreign credit operations, while IOF-exchange has a rate reduced to zero in cases of settlement with minimum time limit of more than one hundred and eighty days on average (the rate is increased for 6% if the period is lower).
An investment fund incorporated in Brazil to practice TPF, depending on its form, will be taxed according to the general regime provided in the Normative Instruction 1585/15 of the Federal revenue, considering the average time limit of the portfolio. For short term funds, the quotaholder will be subject to an income tax rate of 22.5% or 20% which will be withheld, if less or more than 180 days. In cases of long term funds, the rate is of 22.5% for redemptions until 180 days, 20% between 181 and 360 days, 17.5% between 361 and 720 days and 15% for redemptions after 720 days.
Lastly, it is important to pay attention to the specific characteristics related to the way the funding has been agreed to between the parties and the way it has been incorporated in Brazil. These characteristics may be interpreted as situations in which the tax is not subject to the general rules discussed in this article. Therefore, each operation and each type of fund must be thoroughly analyzed so to avoid mistakes related to the taxation involved and, consequently, to the assessment of the investment.