For more than 30 years, nearly all Brazilian airlines have paid lease rent on commercial aircraft without having to withhold Brazilian income tax on rental payments. Even though such tax is technically Brazilian income tax, it is generally referred to as withholding tax.
To a lesser extent, this was also true for non-commercial aircraft such as business aircraft and helicopters, although changes to legislation in 2013 and 2016 limited the circumstances that allowed payments for non-commercial aircraft to remain free of withholding tax.
On 27 November 2019 the Federal Government issued an executive order with the potential to change the tax treatment of commercial aircraft leasing. The changes depend on a further determination from the Ministry of the Economy. Subject to that determination, the executive order sets out the following new rules for commercial aircraft and engine leases:
- leases entered into prior to 31 December 2019: no withholding tax;
- leases entered into between 1 January 2020 and 31 December 2020: 1.5% withholding tax;
- leases entered into between 1 January 2021 and 31 December 2021: 3% withholding tax; and
- leases entered into between 1 January 2022 and 31 December 2022: 4.5% withholding tax.
The precise language of the executive order raises several doubts. For example, it uses the expression 'entered into' (celebrado in Portuguese). In most cases, this expression refers to the date on which an agreement such as a lease is signed; however, some doubts have arisen as to whether the Brazilian tax authority might consider other dates to be the date on which a lease has been 'entered into'. Two such possibilities are an aircraft lease delivery date or the first rental payment date. Normally, 'entered into' indicates the date of execution of a document; but if a tax inspector concludes that parties signed a lease in advance of these dates for the purpose of avoiding withholding tax, the inspector may use a different date. This should not occur with aircraft leases, considering the international industry standard of signing lease agreements well in advance of delivery dates. Aircraft leases are frequently signed weeks or even years before expected delivery dates. Such leases are binding agreements even though delivery may be subject to various conditions precedent. Signing leases well in advance of delivery dates is common in cases involving large numbers of aircraft that are in production. Without the execution of binding leases well in advance of expected delivery dates, the industry would be unable to organise the placement of aircraft that require considerable capital and years to build. Thus, there should be no question that 'entered into' in the context of the executive order refers to the date of an agreement.
Another area of possible misunderstanding concerns the treatment of lease novations and assignment assumption agreements. There is an active market for the trading of aircraft on lease to Brazilian airlines. Many trading transactions involve the transfer of title to a new owner and the transfer of the lessor's position to a new party. Usually, there are no changes to the commercial terms of such leases such as rent, maintenance reserves, lease terms, insurance requirements and redelivery conditions. There are two basic types of agreement used to effect these changes: novation agreements and assignment assumption agreements. In general, novations are used in leases governed by English law and assignment assumption agreements are used with New York law leases. Both agreements tend to achieve the same objective, which is to substitute the lessor without altering the commercial terms. Although both types of agreement achieve that same purpose, they may receive distinct treatment in relation to withholding tax. A true novation, in most legal systems (including the Brazilian one), is technically considered a new agreement. If these principles were to be applied to the new rules for Brazilian withholding tax, lease novations might begin to attract withholding tax, while assignment assumption agreements for leases dated prior to 31 December 2019 would not. This would be an odd and incorrect result considering that for most effects, both types of agreement are essentially the same and share more characteristics of assignments than novations. For example, the Brazilian regulatory approvals that Brazilian lessees must obtain at the start of a lease term are based on the full lease term and are not replaced by lease novation.
In addition, in a novation transaction, an aircraft's registration mark does not change and its file with the Brazilian Aeronautical Registry is continuous. If such novation agreements were true novations, the leased aircraft might have to be exported and reimported, with full replacement of registrations and approvals. Thus, although at this time the treatment of novations and assignments under the new withholding tax rules is unknown, it is logical to expect both to be treated as assignments, with the rules of the original contract governing the withholding tax treatment.
To a lesser degree, there may be some doubt as to whether lease extensions should be treated under the rules in effect when:
- the original lease was signed;
- the extension instrument was signed; or
- the extension period commenced.
The general expectation is that since a lease extension is the continuation of an existing contract and the original contract date should determine the withholding tax treatment.
An area of interest that the new withholding tax rules may affect are leases from lessors located in jurisdictions with which Brazil maintains double taxation treaties. Some treaties allow tax credits against withholding taxes, such as withholding for Brazilian income tax. In some treaties there is a presumption of withholding rates that might be higher than the new rates contained in the executive order.
The executive order has also raised doubts in relation to the applicability of operating and finance leases. The executive order seems to require similar treatment of both types of lease. Presumably, withholding tax would apply to the interest portion of finance lease rentals and the entire amount of operating lease rentals. However, these positions also remain vague and industry participants and advisers speculate that the new rules might apply solely to finance leases or solely to operating leases.
The rules also seem to apply equally to leases from lessors domiciled in jurisdictions that the Brazilian tax authority has deemed to be tax havens. In the past, such leases were structurally discouraged because Brazilian withholding tax would have been applicable at 25%. For this reason, until 2016, lessors to Brazilian operators were never located in tax haven jurisdictions. In 2016 the Brazilian tax authority deemed Ireland a tax haven. That determination would have had a disastrous financial impact on Brazilian aircraft operators, since most leases include gross-up clauses for withholding tax. After a short period of indecision, during the third quarter of 2016, the Brazilian government eventually exempted lease payments from lessors based in tax havens from withholding tax. That exemption was scheduled to end for agreements entered into after 1 January 2020, although payments made pursuant to leases entered into prior to 31 December 2019 were to remain exempt until 31 December 2022. The executive order does not seem to distinguish between leases from tax havens and other jurisdictions.
The executive order has created considerable confusion and doubt in the aviation sector. This uncertainty discourages investment and new transactions. Ironically, this is precisely the opposite of the government's stated goals with the new rules. The official justification that the government issued in support of the executive order states that the new rules aim to assist and support Brazilian airlines. The line of thinking is that the applicable rate for withholding tax was 15% or 25%, so rates between 1.5% and 4.5% should be viewed favourably by airlines. However, this characterisation is misleading. While it is true that rates of 15% or 25% might have applied to aircraft lease payments in the past, those rates were never applied in practice. They were so unrealistic that the government and airlines always found ways to avoid them. Therefore, even if there are technical arguments that the new rules do not create new taxes, in practice, if withholding taxes are assessed they will be new taxes on Brazilian airlines. During the coming weeks, clarifications are expected which will hopefully eliminate any doubt and enable parties to accurately plan for future aircraft transactions.
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