Events in Brazil have been moving at such a quick pace that it is difficult to write on any subject without an article becoming outdated immediately. Recent developments include the Chapter 11 filing of Latam Airlines Group of Chile, which subleases a significant portion of its fleet to its Brazilian affiliate TAM Linhas Aereas, as well as draft emergency legislation to deal with the economic fallout arising from COVID-19 (for further details please see "Emergency draft legislation may violate Cape Town Convention"). That emergency legislation is in the process of being evaluated by the Senate.
There is one recent change that has now been finally determined, which is Brazilian income tax withheld on payments of aircraft (and aircraft engines) lease rentals (ie, withholding tax) (for further details please see "Changes in Brazilian withholding tax"). The final legislation became effective on 25 May 2020 and is significantly different from the executive order that was in effect from late November 2019 until 25 May 2020.
The November 2019 Executive Order established a scale of withholding tax that was to commence with payments arising from leases entered into after 31 December 2019. The withholding tax rate was scheduled to increase annually through 2022, commencing at 1.5% and finally ending at 4.5%. This tax is referred to as withholding tax because the commercial banks in Brazil that process wire transfers of aircraft and engine lease rentals on behalf of airlines must withhold the tax from the wire transfer remittances.
Although the executive order had contemplated different treatment depending on the date of the lease agreement, the final version approved by Congress and sanctioned by the president eliminated that criteria. The result is an entirely different rule, which is that all aircraft and engine rentals falling due during the 2020 calendar year are subject to a 1.5% withholding tax. This applies regardless of the date of the lease and whether the lessor is located in a jurisdiction considered a tax haven by the Brazilian tax authority.
Although the executive order had contemplated different treatment depending on the date of the lease agreement, the final version approved by Congress and sanctioned by the president eliminated that criteria. The result is an entirely different rule, which is that all aircraft and engine rentals falling due during the 2020 calendar year are subject to a 1.5% withholding tax. This applies regardless of the date of the lease and whether the lessor is in a jurisdiction deemed to be a tax haven by the Brazilian tax authority. The new law provides no indication of what the withholding tax rate might be for aircraft and engine rent payments due in 2021 and onwards.
Some of the uncertainties of the executive order are now clear. For example, the executive order provided different tax rates depending on the date of the underlying lease agreement. This led to uncertainties as to whether lease assignments, novations or even lease amendments might reset the relevant date. Those uncertainties were eliminated by the final simple text of the new law. A consequence of this is that for most aircraft and engine leases Brazil's airlines will be liable to gross up for the withholding tax since the tax arises from a change in Brazilian law occurring during the lease term. This would depend on the language of the relevant gross-up provision; however, most leases allocate responsibility for this type of change to the lessee.
For airlines, the new law comes at the worst possible time. All of Brazil's airlines are reeling from the effects of the COVID-19 crisis and the dramatic fall in demand for air travel. One possible reason for adding a new tax burden to airlines at this time is that the estimated revenue from the withholding tax may have been included in the government's previously approved budget.
For more than 30 years withholding tax has not been assessed on aircraft and engine rentals. Thus, from an economic perspective, the withholding tax is new. However, withholding tax has been on the books for decades and at much higher rates than 1.5%. In recent years, the government has provided safe harbours for airlines to avoid liability for withholding tax on aircraft engine rentals. However, since the tax was on the books, some government sources have taken the position that the 1.5% withholding tax is not a new tax. It is doubtful that any airline CFO would agree with that analysis, considering that this expense has not been due for so many years. Whether the tax is new has legal relevance. In principle, Brazil does not allow new taxes to be assessed retroactively. This may form the basis for airline challenges to the validity of the law imposing the 1.5% withholding tax.
There are also some lingering doubts about timing for the effects of the withholding tax. From 1 January 2020 until 25 May 2020, the terms of the executive order were in effect and those terms determined that leases entered into prior to 31 December 2019 were subject to withholding tax at the rate of 0%. However, the final law purports to require payment of the withholding tax on all aircraft rents falling due during the 2020 calendar year. Thus, it is arguable that distinct contradictory rules were in effect in respect of the first five months of 2020.
Against all economic logic, Brazil's airlines are now being subjected to a tax that has not been charged on most leases for more than three decades. The revenue that the government will receive is likely to be lower than expected in the short term since close to half of 2020 has passed and the airlines have suspended most lease rental payments due to the economic crisis.
At a time when many governments around the world are supporting airlines viewed as strategic, Brazil seems to be increasing the risk of airline failures. Airlines may be able to successfully challenge the legality of the withholding tax; however, this will require dedication of legal and administrative resources that might have been used elsewhere to fortify airlines. In any event, under the final text of the law, the likelihood of lessors being liable for withholding tax has been reduced significantly.
