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By Kimberly S. Blanchard, Esq.
Weil, Gotshal & Manges LLP, New York, NY
It's official. The taxing authority of Brazil has promulgated a new regulation treating the state of Delaware as a tax haven, such that henceforth any payments of Brazilian-source income to a Delaware limited liability company (LLC) owned by nonresidents will be subject to a higher-than-normal Brazilian withholding tax, and subject to formulaic transfer pricing rules.1 Actually, that's just my attention-grabbing headline. Notwithstanding breathless reports to the contrary, including by Delaware's chief deputy secretary of state,2 nothing in the new rule seems limited to Delaware, and in fact the new rule would appear to apply to any nonresident-owned LLC set up in any of the 50 U.S. states.
Where have we seen something like this before? Oh yeah—Russia made the same mistake in 2007, but subsequently saw the error of its ways and said "never mind."3 Only last year, Luxembourg Prime Minister Jean-Claude Juncker made the same claim against Delaware quite loudly in protest of a threat to blacklist his country as a tax haven.4 The first thing we do is congratulate Brazil for not making the mistake that Russia and Juncker did, and thinking this had something to do with U.S. state law corporations. No nonresident in his or her right mind would try this stunt with a corporation. This ain't Bermuda, or even Luxembourg. A corporation formed in any state of the United States is subject to federal income tax on its worldwide income, without benefit of anything like a participation exemption. So even if all the corporation's income was earned from sources outside the United States, it would be taxable on that income at the federal rate of 35% (and could be subject to much higher tax rates once state taxes and any foreign taxes are factored in). And if the corporation decided to distribute some if its after-tax income to its nonresident shareholder(s), they would be subject to a 30% federal withholding tax on those dividends, which tax can be reduced under treaties but only very rarely to zero. Anyway, the United States doesn't have a treaty with Brazil, so if the shareholder is a resident of Brazil, this combined rate of tax of about 54.5% is a complete non-starter.
What Brazil has done is to list, as a "privileged tax regime," an LLC formed under U.S. law where the LLC is itself not subject to tax (which would be the default case) and where the members of the LLC are nonresidents of the United States not subject to U.S. federal income tax. It is unclear whether an LLC would meet this test if only some of its members are nonresidents. It is also unclear what is meant by "not subject to tax" in this context. The new rule might pick up any LLC with nonresident owners, on the ground that the United States taxes the worldwide income only of its residents. Or it might be more limited, exempting LLCs the nonresident owners of which pay U.S. tax on items of U.S.-source income or effectively-connected income passing through from the LLC. Presumably, it would not apply to LLCs that are owned by nonresident citizens of the United States, who are taxable in the same manner as resident citizens on their worldwide income.
Several reports on this new regulation cite to claims made by local Brazilian lawyers that it was aimed at states "like Delaware" that have LLC legislation that does not permit public access to information concerning "corporate structure" (whatever that means) and beneficial ownership.5 There is nothing special about Delaware insofar as this aspect of its LLC legislation is concerned. Probably the reason tax practitioners in Brazil believe this was aimed at Delaware is that most LLCs are formed in Delaware. But it looks like the Brazilian tax agency was smart enough not to limit the scope of its new rule to any particular state.
To Americans, used to practicing federal tax law in a system in which entities are primarily formed at the state level, the obvious question when reading about what Brazil has done is "How can a state have a privileged tax regime when the state is not the taxing jurisdiction in question?" It's a fair question, and probably one that Brazil didn't truly understand; certainly Mr. Juncker did not. While several other countries have federal systems, none is as strictly separated as the United States, with its Tenth Amendment. States have the power to authorize the formation of legal entities, but it is the federal government that imposes the main income tax on those entities and their owners.6 States don't require beneficial owner information to be submitted, reviewed, or made public, because they don't need to: The federal government makes sure that the correct amount of tax gets paid by the correct owners of the income.7 Most other countries do not have this division of labor; the government that is doing the taxing is the same government that is in charge of regulating what types of entities can be formed, and how.
However, it is fairly obvious what Brazil is going after here, even if they've phrased it somewhat awkwardly. Brazil believes, probably correctly, that there is something about the way entities are formed in the United States that permits some tax benefits to be reaped outside of the United States. The rules were not developed for this purpose, obviously. But they can, in certain cases, be used by nonresidents in a manner that might seem inappropriate to the taxing authorities of other countries.
LLCs, unlike corporations, are not taxable at the entity level. They are instead taxed like partnerships or sole proprietorships, so that only their owners are taxed on their income. If the owners are nonresidents of the United States and earn no U.S.-source or effectively connected income through the LLC, the U.S. taxing authorities will have no interest in the entity or its members. So it seems likely that at least one concern to which the new regulation is addressed involves the use of a U.S. LLC by a resident of Brazil to hide income from Brazil by tricking Brazil into thinking it is dealing with a U.S. company.8
However, if this were the main problem to which the new regulation is addressed, it seems likely that little will be accomplished by it. That is because the LLC could be used to invest in income-producing assets having a situs in a third country, say Bermuda. The new regulation only imposes withholding tax or transfer pricing penalties on Brazilian-source payments. If Brazil really wanted to solve this particular problem, it would enact strong "PFIC"-like rules backed up by considerable penalties for noncompliance. Brazil could also try to prevail upon the 50 states, or perhaps the U.S. federal government, to share information with Brazil. In fact, Brazil signed an exchange of information agreement with the U.S. federal government on March 20, 2007, but so far the agreement has not been ratified by Brazil.
It may also be the case that Brazil was worried about residents of third countries (including residents of blacklisted jurisdictions) tricking it in the same way. And Brazil might be further concerned that a resident of a "normal," high-tax country could use a U.S. LLC to trick Brazil into giving it benefits while not paying tax at home, in those cases where the nonresident's own country treats an LLC as opaque.9
As applied to residents of third countries, the new regulation is overbroad. Suppose, for example, that two German individuals set up a Delaware LLC to invest in a business that has operations throughout North and South America, including Brazil. Assume that the LLC is taxable as a partnership under both U.S. and German law, such that all of its income flows through automatically to its members for both German and U.S. tax purposes. Because Germany operates a territorial system, as long as the income is truly business income earned outside of Germany, no German tax will actually be imposed. And if we assume that the sole assets of the LLC consist of shares of stock of foreign corporations, there will not be any U.S. tax imposed, because the German members will not realize any U.S.-source or effectively connected income. (If the LLC did earn items of U.S.-source or effectively connected income, they would, of course, be taxable, and in the latter case subject to §1446 withholding.) If the new regulation is applied literally, any payments from Brazil would be subject to the draconian rules applicable to tax shelters.
You may ask, how can any of this be an issue, given that the states have been enabling the formation of limited partnerships (and other flow-through entities) for decades, and Brazil does not seem to be complaining about that. The short answer is that U.S. LLCs pose a problem for Brazil because Brazil insists upon characterizing an LLC as a "company" or corporation, applying its own entity classification rules. (Many countries make this mistake.) Because Brazil had convinced itself (with absolutely no prodding from Delaware, who could not care less) that an LLC is a corporation, until this new regulation was issued, Brazil granted benefits to the LLC as if it were in fact taxable as a U.S. state-law corporation.
So it seems pretty clear that Brazil could more easily solve the problem here simply by recognizing the entity classification of the LLC in the United States. There is no good reason not to do so, and indeed the United States has accorded that treatment, in appropriate circumstances, to foreign entities for years. The OECD has made clear that this is the correct approach in applying tax treaties to entities taxable in at least one Contracting State as a partnership. There is no reason why the same approach should not be applied unilaterally, even absent a tax treaty. If Brazil were to adopt this sensible position, it would grant benefits or not depending upon whether the members of the LLC came forward to claim them. If the members did not come forward, then Brazil could apply the tax haven rules.
This commentary also will appear in the October 2010 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Streng, 700 T.M., Choice of Entity, Isenbergh, 900 T.M., Foundations of U.S. International Taxation, and Tozzini, Freire and Berger, 954 T.M., Doing Business in Brazil, and in Tax Practice Series, see ¶7110, U.S. International Taxation — General Principles, and ¶7160, U.S. Income Tax Treaties.
2 See Bell, "Delaware Asks Brazil Agency Not to List State as Tax Haven," 95 BNA Daily Tax Rpt. I-3 (5/19/10); see also "Brazil's Tax Department Releases New List of Tax Havens and Privileged Tax Regimes," 115 BNA Daily Tax Rpt. I-2 (6/17/10).
5 There have been some other, fairly ridiculous, suggestions of what this new regulation was intended to accomplish. Some have suggested that the regulation was targeted at funds, including private equity funds. If so, it completely missed its target, since funds almost never make use of LLCs (or any domestic entities, for that matter) when they invest outside of the United States. Others have suggested that "American" companies that invest in Brazil through LLCs will have to review their structures. But given that the new regulation is limited to nonresident-owned LLCs, this can't be right either.
7 Among other things, if the entity does so much as open up a small bank account in the United States, it will need a federal tax ID number. To get that number, an authorized individual will have to sign a form that gets filed with the U.S. Internal Revenue Service, which will indicate whether the entity is an LLC or a corporation. (Delaware has nothing to do with this.)
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