Since November 2019 issues relating to income tax withheld at source (known as 'withholding tax') have plagued the Brazilian airline sector (for further details please see "Changes in Brazilian withholding tax" and "Withholding tax on aircraft lease rentals – new rules finalised"). The latest developments have resulted in confusion, widespread lease defaults and erratic payments from Brazil's airlines.
In late 2020 the general expectation was that the withholding tax for 2021 would be definitively set by the end of the year. When that did not occur in early January 2021, the consensus view was that the withholding tax rate would be set definitively by the end of that month. Failing any definition from the government in January 2021, the expectation shifted to late February 2021. It now seems unlikely that the issue will be resolved before the Federal Government's annual budgeting process is completed in April 2021.
Since early January 2021 lease payments have been erratic. During 2020 most international lessors, in recognition of the COVID-19 pandemic, agreed to lease amendments that included combinations of rent reductions and rescheduled payments. These amendments, while understandable, left lessors with lower-than-expected revenue flows. Lessors were certainly not expecting widespread payment cessation caused by the introduction of new taxes.
For more than 30 years, Brazilian airlines have not had to pay withholding tax on aircraft that operate lease rent payments. In late 2019 the government initiated changes that resulted in withholding tax becoming applicable. The new rule initially stipulated that the withholding tax rates would be as follows:
- leases entered into before 1 January 2020 – 0%;
- leases entered into during 2020 – 1.5%;
- leases entered into during 2021 – 3%; and
- leases entered into from 2022 – 4.5%.
These rates, which were established through an executive order, were to apply to leases entered into from January 2020.
Six months later, when considering the executive order, Congress changed the rules. The president then vetoed part of the Congressional changes. The result was that a withholding tax rate of 1.5% would apply to all aircraft rental payments that were due in 2020. This law was passed in May 2020 but purported to apply to payments that were due from January 2020, thus raising questions of retroactivity. The May 2020 law was completely silent on the rules that would apply from January 2021.
Although the May 2020 law purported to apply the 1.5% withholding tax to all leases, the tax authority opined in an unpublished document that the 1.5% withholding tax applied to leases entered into between 1 January 2020 and 31 December 2020. This view was not widely known in the industry and resulted in doubt throughout 2020. One airline, possibly unaware of the tax authority's view, sought and received a preliminary injunction that enabled it to pay rent during 2020 on all of its leases without incurring any withholding tax on the grounds that taxes cannot be enacted retroactively in Brazil.
Contrary to expectations, 2020 ended with no solution. When the special rates of 0% and 1.5% for aircraft rents ceased to be effective, the rate soared to 15%, which is the general rate applicable to cross-border leases of any equipment, not a special rate that applies to aircraft or engines thereof. In the aforementioned unpublished document, the tax authority stated that payments made to lessors in jurisdictions that the government considers tax havens are subject to a 25% withholding tax, although that statement is inconsistent with a standing regulation.
Airlines, which were already low on cash and operating on reduced schedules due to the pandemic, immediately began suspending payments. A sudden 15% gross-up obligation would have stretched their finances even further.
Air taxi companies appear to be unaffected by these new changes, based on a 2019 tax authority decision. Air taxi companies are not liable to pay withholding tax for rent payments made to lessors that are not based in tax havens.
Most, if not all, cross-border lease agreements include gross-up provisions that allocate the risk of Brazilian withholding tax to the lessee. Gross-up clauses are valid in Brazil, so contractually this problem should not affect cash flow to lessors. However, due to the severity of the tax, nearly all payments have ceased. Although lessors may be entitled to repossess leased aircraft, the wholesale repossession of entire airline fleets is neither desirable nor practical.
Withholding tax rates are likely to be defined in the next few weeks. A 0% or 1.5% rate is likely to be set for 2020, followed by annually increasing rates for the next few years, likely stopping at 5%.
The confusion and widespread payment defaults have benefited no one. Lessors have become more sceptical of Brazil's stability. While most lessees have the resources to pay the rent that they expected to pay, they have been financially prevented from doing so due to the 15% tax rate. The government is receiving no additional revenue from these measures and has contributed to the projection of a negative image of the country. A quick solution would go far to improve Brazil's position as a safe jurisdiction for leasing aircraft.
