Latest Tax Angles For Latin American Projects
Infrastructure projects have the potential to be very costly in terms of taxes. Latin America is no exception, especially with income tax rates generally increasing across the region.
This paper describes the main strategies that project developers are using to reduce the income tax burden on projects in Latin America and reports on recent developments in the region. The following diagram will help put the discussion into context.
The top circle represents the developer or investor in a project. The bottom circle represents the company formed in the project country to own the project.
The project company receives revenue from electricity sales.
The figures are tax rates. There are three places where taxes will be taken out of the revenue stream. There will be taxes in the project country—for example, the 45% shown next to the bottom circle—withholding taxes at the border when the developer or investor tries to repatriate earnings—for example, the 25% shown just above the bottom circle— and income taxes again on the earnings in his home country. It is easy to see the potential for a developer to have very little to show for his efforts at the end of the day. In practice, the combined taxes may range anywhere from 0% to 80% or more depending on the ownership and capital structure for the project.
The key is to focus, when choosing an ownership structure and arranging financing, on what can be done at each level to reduce the tax burden.
Focus first on the potential for taxes in the United States. US participants in Latin American power deals will be subject to US income taxes on their earnings. The United States taxes American companies on worldwide income. In theory, the US gives credit for any foreign taxes paid, but the foreign tax credit rules are so full of fine print that few companies in the utility and telecoms industries are able to use foreign tax credits in practice. Therefore, one starts with taxes of 35% in the United States.
The most common strategy for reducing US taxes is to form an offshore holding company in a tax haven like the Cayman Islands, have the Cayman company, in turn, hold one's interest in the project company, and to make the project company a limitada or comandita—anything other than an SA (sociedad anonime). This will usually enable the developer or investor to defer US taxes until the earnings are physically repatriated to the United States. However, in order for this strategy to work, every entity below the Cayman holding company in the ownership chain must be "trans-parent" for US tax purposes. SA's cannot be trans-parent. Other kinds of entities can be.
The problem in Latin America is that one often starts with an SA for the project company, especially in government privatizations.
There are at least ten strategies in use currently in Latin America when use of an SA is unavoidable.
1. Same-country exception: The most common approach is to put one's offshore holding company for the project in the same country as the project. However, the holding company must own more than 50% of the project company by vote or value in order for this to work. Ownership by vote is measured by the percentage of directors one is entitled to appoint. For example, one might own 50% of the shares but be entitled to appoint 75% of the board. This is 75% ownership by vote.
There are several techniques for getting over 50% by vote if one can at least get to 50%. The simplest is to acquire a few shares in another shareholder. A fraction of the other shareholder's voting rights can then be claimed under "attribution rules."
A frequent issue in deals is what to do when there are two US investors each of whom wants to defer US taxes on his earnings. Logically, both cannot own more than half the company.
However, one solution is to put majority ownership by vote in one investor and majority ownership by value in the other. Another fix is to use stock options. An investor is treated as owning any shares that he has an option to purchase. US equity participants have sometimes resorted to "cross options" where each has an option to acquire enough of the other US participant's shares to put him over 50%. The US courts are split over whether the same shares can be counted more than once. Therefore, it is better to avoid direct cross options. The US participants could be given options to acquire shares from a third party or to acquire shares in entities at different tiers in the ownership chain.
The same-country exception works best in countries like Brazil or Argentina where there are opportunities to do more than one project. Earnings must usually be reinvested in other projects in the same country to preserve US tax deferral. Any dividend of the earnings out of the country will trigger US taxes. US developers sometimes plan to have the holding company in the project country lend its earnings to a sister company in another country for redeployment elsewhere. This works, but it can be inefficient.
2. High-tax exception: If earnings are taxed in the project country at a rate higher than 31.5%, then US taxes can be deferred on earnings even though they leave the country. This is more complicated than it appears at first glance. One must restate the earnings using a US definition of taxable income - for example, by using slower US depreciation allowances - and then calculate what the actual taxes paid are as a percentage of this restated US taxable income. It rarely works, although some developers take the position currently that the high-tax exception can be used for investments in Argentina.
3. Conversion: A simple solution, if the other shareholders are willing, would be to convert the SA into a limitada or comandita. This is usually a problem where employees or the government hold shares in the SA. A conversion has the potential to trigger a US tax on any appreciation in asset value in the company and should be done before US participants formally take shares in the project company.
4. Dropdown: One way to get around a problem that the company cannot be converted is sometimes to have the SA remain in place but to have it either drop its assets or sell them to a limitada that is a subsidiary. US participants would be shareholders in the subsidiary. The employees would remain shareholders in the SA.
5. Sandwich: A problem with the same-country exception is that earnings usually must remain in the project country to maintain US tax deferral. There is a "same-country sandwich" structure that has sometimes been used. The US participant creates a holding company in the country, but then the holding company has a wholly-owned subsidiary in place like the Canary Islands or Madeira. The Canary or Madeira subsidiary owns the shares in the SA, and an election is filed with the US tax authorities to treat the Canary or Madeira subsidiary as a "disregarded entity." The subsidiary disappears for US tax purposes. That way, the earnings can be moved one tier up from the project company - and offshore - without breaking US tax deferral. Proposed IRS regulations would make the sandwich structure harder to use, but not impossible. The proposed regulations would not take effect before mid-2005 at the earliest. A downside is that earnings from any reinvesting done by the Canary or Madeira company must eventually pass through the holding company in the project country to reach the United States. It can be a challenge to avoid attracting tax in the project country when this occurs.
6. Domestication: An SA can be given dual status as both an SA and a Delaware limited liability company by "domesticating" the company in Delaware under section 18-212 of the Delaware LLC statute. This is a simple matter of filing forms in Delaware. Some people take the position that one can then elect to treat the entity as transparent for US tax purposes since a Delaware LLC can be transparent. This strategy has risk.
7. Deemed joint venture: A US participant might enter into an ambiguous contractual relationship with the SA that is viewed by the US tax authorities not as a shareholding in the SA but rather as a joint venture between the US participant and the SA. The US recognizes "deemed" joint ventures. Thus, the US participant will be viewed by the US as deriving his income from a transparent entity - the deemed joint venture - rather than from the SA directly. US tax deferral would then be possible on the earnings.
8. Deconsolidation: An alternative strategy is to give up on US tax deferral but to attack the problem from another angle. The reason US companies are driven to deferral strategies is the foreign tax credit rules don't work. A US participant can get around the foreign tax credit problem by investing in the project through a US subsidiary in which he owns no more than 79% of the stock. An unrelated party would have to own the other 21%. The "deconsolidated" US subsidiary would be subject to 35% US tax on its earnings from the project, but it would get full credit for any income taxes paid in the project country. The main problem with this approach is there is another 7% US income tax to pull earnings out of the “deconsolidated” subsidiary (since share-holders in the subsidiary must pay income taxes on any dividends they receive from it).
9. Stapled stock: A more aggressive form of deconsolidation is to use stapled stock. This has the virtue of letting a company create a deconsolidated subsidiary without having to find an unrelated party to own 21% of the shares. The concept is to “staple” the shares of a US subsidiary to a foreign subsidiary, meaning that shares in one company cannot be transferred without the other. Under Internal Revenue Service Notice 89-94, a US company whose shares are stapled to a foreign company is automatically deconsolidated. This strategy is complicated to implement in practice, and it is not without US tax risk. The same second-tier 7% US tax will be collected on dividends from the stapled subsidiary to the US parent.
10. 861 structures: An aggressive strategy for acquisitions where there will be a lot of debt is to loop the debt through a number of tiers of entities, starting in the US and then working offshore, before the cash ultimately reaches the holding company that will acquire the target. The debt passes down some legs of the structure as debt and down other legs as equity. Interest paid back up the chain counts several times over as “foreign source income” of the US parent — as many times as there are loops in the debt chain. The US parent has no real income from the interest payments in practice because the earnings are offset ultimately by deductions for interest paid to the lender. However, the more foreign source income a US company can claim, the greater its capacity to use foreign tax credits. These structures have been attacked obliquely in the tax trade papers, but the IRS has not yet done anything about them. In the meantime, they can put a US company in a position to use foreign tax credits in just a few months.
The main strategy for reducing taxes in the project country is to have the project company distribute earnings in a form that it can deduct for local country tax purposes. This is called “earnings strip-ping.” For example, the project company might pay out earnings to foreign shareholders in the form of “interest” on shareholder debt. Foreign shareholders might also pull out earnings as payments for services to the project company or as “rent” for leasing the project across the border to the project company.
Tax rates are high in Latin America and getting higher. Therefore, there is a strong incentive to do anything one can to reduce them, especially if one is deferring US taxes. Any reduction in effective tax rate in the project country adds directly to profit from the project.
When earnings cross the border, they usually attract a withholding tax. Earnings stripping is a way to push down the rate. For example, if earnings paid out as interest can be deducted by the project company against a tax rate of 33%, but they attract a 15% withholding tax, earnings stripping has had the effect of reducing the domestic tax rate from 33 to 15%.
Many countries either limit the amount of shareholder debt that one is allowed in the capital structure—these are called “thin capitalization” rules—or deny deductions for certain interest paid to related parties. This is the first of two obstacles to earnings stripping.
Argentina imposed limits on interest deductions in tax reforms that took effect last January 1. Forty percent of interest is deductible provided the debt does not run afoul of limits on borrowing from affiliates. However, the other 60% of interest can be deducted only if the debt-equity ratio of the company does not exceed 2.5 to 1 or the interest does not exceed 50% of adjusted net taxable income. In Brazil, there are no thin capitalization rules and no bar to deducting interest paid to affiliates. Mexico does not have thin capitalization rules per se, but if there is a loan from a related party, the interest payment will be reclassified as a dividend (not deductible) in certain cases on related-party debt.
The second obstacle to earnings stripping has to do with the interplay between strategies for reducing US taxes versus project-country taxes. The goal is usually not only to pay out earnings in a deductible form, but also to defer US taxes. US taxes can only be deferred on active income—not passive income like interest or rents. (Service fees are tricky and are sometimes a problem and sometimes not.)
One way to thread the needle—or pay out earnings in a deductible form but not in a way that creates passive income—is to use a hybrid instrument. A shareholder lends money to the project company so that he can withdraw his earnings as interest. However, the instrument is drafted in such a way that, even though the tax inspector in the project country views it as a loan, the US sees it as just another class of equity investment. Hybrid instruments are tough to draft. However, they are possible in most Latin countries.
Another approach is to inject capital into the project company by means of a straight debt instrument but make the project company into a “disregarded entity” for US tax purposes. That way, earnings will be paid out as interest as far as the project country is concerned, but, from a US standpoint, there is no project company and no loan and, there-fore, no passive income. SA’s cannot be disregarded. Other types of Latin American business entities can be, but require some ingenuity to make work since US rules require that a disregarded entity have only one shareholder while local corporate law usually requires at least five. The key is to make all but one of the shareholders also disregarded.
At the Border
The next place to focus is on the taxes that must be paid at the border to move earnings out of the project country. Earnings are usually subject to a withholding tax at the border.
Look first at the list of withholding rates. Sometimes it makes a difference in what form money crosses the border. For example, the withholding rate in Brazil is 0% on dividends but 15% on interest. Try to pull money out in a form that qualifies for the lowest withholding rate. However, this avenue might be foreclosed by whatever strategy one has already adopted for deferring US taxes and reducing in-country taxes. For example, US taxes cannot be deferred on passive income.
Next, look at the list of tax treaties between the project jurisdiction and other countries. Treaties sometimes reduce withholding rates. This would require investing through a company in the treaty country. However, treaties are of limited value in Latin America. For example, Brazil has treaties with 24 countries, but only one—with Japan—reduces any withholding rate. Unfortunately, the treaty most likely to be of any value is the Caricom treaty among countries in the Caribbean basin. It eliminates withholding taxes on dividends. St. Lucia had been used as a staging post for Caribbean investment, but the government barred any further incorporations by foreign shareholders. Investment is now being run through Belize.
Latin American countries usually allow a reduced rate of withholding on interest paid by the project company to a financial institution. This has led to frequent use of back-to-back loans. For example, in Argentina, the withholding tax on interest paid to foreign lenders is 35%, but this drops to 15.05% if the lender is a financial institution. Back-to-back loans can take a number of forms. One common form is for one’s offshore holding company to make a deposit in the Cayman branch of a bank. The bank then makes a loan to the project company. If one needs hybrid treatment for the debt for US tax reasons, then the documents must be drafted so that the bank’s role can be characterized for US tax purposes as merely an agent collecting payments on the hybrid instrument for someone else.
Brazil waives withholding taxes altogether on interest paid on commercial paper with a term of at least 96 months. Since many projects in Brazil start out with bridge debt that must be replaced after a short period of time, this had led to setting up a Cayman company as the borrower on the bridge loan. The Cayman company then onlends for at least a 96-month term to the project company. When the bridge debt is replaced, the Cayman company simply reborrows and uses the proceeds of the “permanent” debt to repay the bridge lender.
Other Ideas and Issues
Tax sparing: It may possible in some countries to take advantage of tax-sparing credits in treaties as a way of putting more juice into the ownership structure. A tax-sparing credit is the idea that another country—for example, Holland—will allow a Dutch company investing into Brazil to claim foreign tax credits against Dutch taxes at the highest Brazilian withholding rate even though withholding taxes were not in fact paid at this rate. This is a way to introduce more “juice” into the ownership structure. Conceptually, getting a reduction in Dutch taxes that one would otherwise pay is the same thing as reducing the project country taxes. It is also helpful to borrow from banks that can use tax-sparing credits to reduce the borrowing rate.
Cash traps: Most countries in the region bar project companies from paying dividends except out of book earnings. The combination of tax depreciation and the need to pay large amounts of interest initially on project debt usually mean that project companies have almost no book earnings during early years to distribute. Developers usually address this problem by capitalizing the project company with debt. Debt can be repaid without waiting for earnings. In some countries, it may also be possible to pay a “return of capital,” although often not without notice to creditors and government approval.
TJLP: Brazil has a special provision allowing a project company to pay shareholders “interest” on their capital. The interest rate used is the long-term Brazilian rate for bonds (referred to as the TJLP). A company can distribute up to 50% of its profits or retained earnings in this form. The project company deducts the payments as interest, but collects a 15% withholding tax. There is no further tax to the recipient apart from a PIS-CUFINS tax of 3.65%. There-fore, it is usually in a company’s interest to maximize these types of payments since they have the effect of pushing down the domestic tax rate.
Uruguayan holding companies: There is a great deal of interest in Uruguay as a possible place to put a regional holding company, possibly as a way of creating a currency (shares) that can be used for acquisitions, but there has been little real use so far in the power or telecoms sectors. Uruguay has a special type of entity for offshore investment called a sociedad financiera de inversion, or SAFI. Its principal activity must be to invest outside Uruguay in securities or subsidiaries for its own account. At least 51% of total assets must be invested abroad and more than 50% of total income must be from foreign sources. SAFI’s are exempted from taxes in Uruguay, with the exception of a 0.3% annual tax on share capital, outstanding debentures and reserves.
Interest double-dips: Interest paid to lenders is deductible. Ordinarily, the borrowing should be slot-ted into the ownership structure at a level where interest deductions can be claimed against the highest tax rate. Thus, for example, one would ordinarily not put the project debt in the Cayman Islands (unless part of back-to-back lending) because the tax rate is 0%, and the interest deductions produce no value. It is better to put it at the level of the project company where there is a real tax rate.
It is not uncommon to see borrowing structured into Latin America designed to give the equity participants deductions for the same interest expense in both the project country and at home (for example, in the US). There are three basic double-dip structures in use in Latin America. In two of them, the US equity participants get the double dip in the US only by repaying the debt by injecting more equity over time into the deal.