Startups and new businesses: tax planning for long term success

Theo Agbi

Weil Gotshal & Manges, Miami

theo.agbi@weil.com

Report on a panel discussion at the 16th IBA/ABA US and Latin America Tax Practice Trends Conference in Miami

Thursday 13 June 2024

Session chairs

Lisa Zarlenga Steptoe, Washington, DC

Thais de Barros Meira Barbosa, Müssnich & Aragão, São Paulo

Brian Harvel Alston & Bird Global Tax Services Group, Atlanta

Panellists

Fabian Birnbaum FBM Advisory, Montevideo

Juan David Cuatrecasas Mexico, Mexico City

Gisele Bossa Demarest, São Paulo

Magdalena Munita Barros Errázuriz, Santiago

Introduction

This panel addressed on a country-by country basis the various tax considerations for startup businesses in Latin America looking to expand both domestically and abroad. Additionally, the panel also discussed the tax considerations for United States businesses looking to expand into Latin America. In each case founders need to consider such things as:

• the entity’s jurisdiction;
• the type of entity;
• how to capitalise the entity;
• the impact of any special tax regimes; and
• exit strategies.

Jurisdiction of investment

Startup businesses in Latin America will often expand by recruiting investors, many of whom may reside outside of the country where the startup is located. Often such investors are sceptical of investing in the country where the startup is located, and prefer to invest through a holding located in the US, United Kingdom or Cayman Islands.

• US HoldCo structure: In this structure investors invest capital in a US holding company which will in turn directly own interest in the Latin American target company. The US HoldCo structure is typically preferred when the Latin American startup is seeking to access both US investors and markets, as upon exits investors can sell shares in the US entity rather than stock of the target. Similarly, US business looking to expand may also prefer a US HoldCo structure.
• Cayman/UK ‘sandwich’: In this structure, investors will invest in a Cayman holding company (‘Cayman TopCo’). Investing in a Cayman TopCo is advantageous for investors who may be more familiar with laws of Cayman, which have been influenced by the UK, and the Cayman TopCo is not subject to corporate tax. Cayman TopCo will control a UK limited liability company (LLC) and the UK LLC will control the Latin American target company. The advantage of the UK LLC is flexibility. During the life of the investment, the LLC can elect to be treated as a flow-through entity. Upon exit there is option to have the LLC converted in to a corporation.

Choice of entity

Corporations and LLCs

• Brazil: Generally, startups in Brazil will be organised as either a S/A (corporation) or Limitada (Brazil’s LLC equivalent). S/A will default to a corporation for US tax purposes, therefore a US holding company may be subject to tax on the earning of an S/A. Further, S/As are required to distribute dividends on annual basis based on the amounts described in the bylaws, which may not be advantageous for early-stage startups. A Limitada has a lot of flexibility on if and when the entity pays dividends, as a Limitada can distribute current year profits before the close of the tax year provided certain conditions are met.
• Chile: Sociedad por Acciones (SpA) a company by share (ie, joint-stock company) is the most common startup form used in Chile. SpAs have more flexible bylaws – having no requirement to distribute dividends, and shares are easily transferable. The SRL is the Chilean LLC equivalent: normally startups do not use LLCs in Chile as they require unanimity of the partners.
• Mexico: Generally, startups in Mexico take the form of Sociedad Anónima de Capital Variable (SA de CV) (corporation) or a stock company for investment promotion (SAPI de CV). A startup can also be organised as a Sociedad de Responsabilidad Limitada de Capital Variable (SRL de CV) (Mexico’s LLC equivalent). An SRL de CV is taxed similarly to a SA de CV and SAPI de CV in Mexico, in that all three are subject to taxation at the entity level as corporate income and shareholder level as dividend income. However, from a US tax perspective an SRL de CV is different, as it is treated as fiscally transparent.
• Uruguay: In Uruguay, SA & SAS (simplified stock company) are the recommended form for startups. The Uruguay LLC equivalent is a Sociedad Anónima Uruguay (SAU), which is taxed like an SA or SAS; however it is for US tax purposes treated as a flow-through entity. Generally smaller companies use SAU.
• US: Generally, flexibility is the main concern for investors looking to expand abroad. Therefore, sometimes investors may use a C-Corp or an LLC (which gives investors the option to make certain elections to treat the LLC as a flow-through entity).

Choice of instrument

Equity

• Brazil: Generally, there is no tax impact when a startup is capitalised by a Brazilian resident with a contribution of cash or assets at book value. However, when a non-Brazilian resident makes a capital contribution to a Brazilian company, the contribution may be subject to the Tax on Financial Operations (IOF). The IOF for foreign exchange transactions (IOF-FX) such as this cross-border contribution is 0.38 per cent.
• Chile: Contribution of assets in exchange for equity may not be tax neutral. Generally, dividends are subject to withholding, unless the beneficiary benefits from a double tax treaty.
• Mexico: In Mexico, contribution to capital is tax free and is normally accounted for in the Contributed to Capital Account (CUCA): an account which for tax purposes tracks all paid-in capital that is registered for future tax-free distributions. Generally, a reduction of an investor’s equity is viewed as a dividend distribution if the company has any retained earnings and profits.
• Uruguay: In Uruguay, contribution to capital is generally viewed as equity. Uruguay tax residents are taxed on dividends if they come from income of the company that is subject to corporate income tax.
• US: For investors obtaining equity in a Latin American startups, generally a dividend from the startup would be subject to tax in the US where they own less than 10 per cent of the vote or value of the startup. If have 10 per cent or more ownership, then there is no US tax on the dividend; however there may be possible exposure to GILTI/Subpart F regimes.

SAFE Notes

The special agreement for future equity (SAFE Note) is a common instrument used by startups to obtain funding by granting investors the right to convert their investment into equity in the startup.

• Brazil: A Brazilian variant on the SAFE Note is AFAC, which can be treated as equity if certain conditions are met.
• Chile: SAFE Notes are used; however there is little guidance from the Chilean taxing authorities. For Chilean tax purposes SAFE Notes are treated as debt, and the exchange for equity equal to the Note’s face value is generally tax free.
• Mexico: Startups commonly employ AFAC; however to avoid the characterisation as debt, very specific requirements must be respected. The subsequent exchange of the AFAC for equity is tax free.
• Uruguay: SAFE Notes are treated as debt.
• US: SAFE Notes tend to be treated as equity; thus the exchange of the Note for shares of the company may be tax-free depending the issuer type and ownership.

Convertible debt

• Brazil: Convertible debt can only be used in private offerings for entities that are not organised as a corporation.

• Chile and Uruguay: Convertible debt is generally respected as debt.
• Mexico: Although convertible debt is generally respected as debt, under certain circumstances the payments of interest therefrom can be viewed as a dividend.
• US: Depending on the terms, it may be respected as debt. The exercise of the right to convert the debt to equity may be tax-free depending on the owner and issuer.

Debt

Generally, all countries will respect a loan as debt: depending on the jurisdiction, such debt may be subject to thin capitalisation rules or other anti-abuse rules.

• Brazil: When non-resident creditors make a loan to a Brazilian company, the payment of interest and principal is subject to IOF-FX; however the current rate is 0 per cent. Generally, payments of interest to the non-resident are typically subject withholding of 15 per cent. Offshore holding companies loaning money to a Brazilian subsidiary should be mindful of Brazil’s thin capitalisation rules, which limit deductions for payments of interest. Generally, the rules impose a 2:1 debt-to-equity ratio, but it may be lower if the holding company lender is in a low-tax jurisdiction.
• Chile: Generally, payments of interest by a Chilean entity to non-resident creditors are subject to 35 per cent withholding (can be reduced if there is an applicable double-taxation treaty). Chile’s thin capitalisation rules take effect when a Chilean company is indebted to related parties at a 3:1 debt-to-equity ratio. Where indebtedness exceeds this ratio, non-resident creditors would be subject to an additional withholding tax of 35 per cent on the portion of interest as it related to the excessive debt.
• Mexico: Payments of interest to non-resident creditors may be subject to withholding tax ranging from 4.9 to 35 per cent. Holding companies located in jurisdictions where there is a preferential tax regime are subject to a rate of 40 per cent withholding on interest payments from a Mexican entity. Mexico’s thin capitalisation rules apply to loans to foreign lenders who are related to the Mexican borrower, where such debt exceeds a 3:1 debt-to-equity ratio. Mexico also has special anti-abuse rules (SAARs), which limit the ability of a Mexican company to deduct interest payments. In some cases, the SAARs can even recharacterise payments of interests as dividends (eg, back-to-back loans)
• Uruguay: Uruguay is unique, because unlike many other jurisdictions it does not have thin capitalisation rules.

• Recharacterisation risk in US and Mexico: Both the US and Mexico will generally respect the character of an obligation as debt, however in some cases depending on the terms the purported debt instrument may be recharacterised as equity.

Special tax regimes

These regimes involve anti-inversion rules such as controlled foreign corporations (CFCs), as well as passive foreign investment companies (PFICs), and finally the Pillar Two rules attempting to impose a worldwide minimum tax on all corporations.

CFCs

• Brazil: Where a Brazilian company has an affiliate located abroad that is a CFC, such Brazilian company must include in the company’s taxable corporate income changes in the investment value corresponding to the profits or losses of the directly and/or indirectly controlled entity. The Brazilian company will only take into income its pro rata share of such changes in investment.
• Chile: Chilean tax residents invested in an affiliate located abroad that is a CFC are subject to current tax on their pro rata share of the CFC’s passive income, if such income is more than 10 per cent of the controlled foreign entity’s gross revenue. Passive income generally includes interests, dividends, royalties, rents and capital gains received by the affiliate. If there is a double-taxation treaty between Chile and the source country of the passive income, a tax credit will be given for any taxes paid in the jurisdiction on such income.
• Mexico: Mexican tax residents who control an affiliate located abroad may be subject to CFC rules where the affiliate is subject to a tax rate of less than 22.5 per cent (ie, less than 75 per cent of Mexican corporate tax rate of 30 per cent) in the jurisdiction where it is located.
• Uruguay: CFC rules only apply to individuals and not companies.
• US: 10 per cent US shareholders of a CFC must take into income their pro rata share of the CFC’s GILTI/Subpart F income. Where the 10 per cent US shareholder is a domestic corporation, the entity may exclude up to 50 per cent of its income, and then apply up to 80 per cent of earned tax credits related to taxes paid in the jurisdiction where the CFC is located.

PFICs

• Brazil: ‘Qualified CFCs’ are foreign controlled entities that either: (1) reside in a low-tax-jurisdiction or benefit from a privileged tax regime (PTR’ in the jurisdiction where they are incorporated; or (2) over 60 per cent of its gross income is passive, then Brazilian tax residents to such entities are subject to an annual IRRF tax of 15 per cent for their pro rata share of the Qualified CFC’s profits regardless of distribution.
• Chile: Chile does not have a PFIC regime.
• Mexico: When more than 20 per cent of the gross income of a CFC is passive income and such CFC is located in a jurisdiction where it is subject to less than 22.5 per cent tax on such income, Mexican tax residents invested in the CFC are subject to tax in Mexico on their pro rata share of such passive income on an accrual basis regardless of distribution.
• Uruguay: Where an Uruguayan entity is invested in a non-qualified entity within a multinational group, a portion of any passive income (ie, dividends, interest, royalties etc) or intangible income (ie, income derived from the exploitation or transfer of trademarks) earned abroad by the non-qualified entity must be included in the Uruguayan entity’s taxable corporate income . However, where there is compliance with certain substance requirements, the Uruguayan entity would be exempt from taxation.
• US: US persons subject to the CFC regime are not also subject to PFIC. Generally, a foreign subsidiary is a PFIC when either 75 per cent of gross income is from passive sources, or 50 per cent or more of the fair market value of its assets are held for investment. Generally, shareholders to who whom PFIC applies can make a QEF election or mark-to-market election.

Pillar Two

So far, Pillar Two has not been adopted in Chile, Mexico, Uruguay or the US.

• Brazil: Brazil has sought to align the accounting practices with the standards of the International Accounting Standards Board, incorporating changes from the International Tax Reform.
• US: Since 2023, the US has adopted a corporate alternative minimum tax (CAMT) of 15 per cent for any corporations with average annual adjusted book income over US$1bn for a period of three consecutive years.

Exit planning

Stock sales

• Brazil: When a Brazilian individual (eg, founder) or a non-resident sells shares in a Brazilian company, capital gains are subject to a progressive tax ranging from 15 to 22.5 per cent. In cases of an IPO, if the seller is a Brazilian company, it will be subject to 34 per cent corporate income tax on the gain.
• Chile: Generally, there is a 35 per cent withholding tax on any capital gains from sale of stock of a Chilean entity. However, the rate may be reduced to 27 per cent where the Chilean entity is a listed local company. Generally, IPOs of a Chilean startups are performed abroad.
• Mexico: Mexican individuals and non-residents are subject to 35 per cent tax on any capital gains from sale of stock of a Mexican company. In case of an IPO, Mexican individuals and non-residents founders can benefit from a 10 per cent tax rate on the capital gain; however this is subject to a number of restrictions.
• Uruguay: If the seller is either an individual or non-resident, the sale is subject to tax at 2.4 per cent of the sale price. Where the seller is a local company, it is taxed at 25 per cent over net profits. IPOs in Uruguay are rare: when done, capital gains are exempt from tax.
• US: For US persons, sale of stock is taxable in the US. It is possible that a portion of the capital gains may be recharacterised as dividends under the GILTI/Subpart F regimes if the foreign entity being sold had undistributed earnings and profits. Further, the US allows sellers to elect to have an asset sale treated as a stock sale by making a 338 election. In case of IPO, a startup that is a flow-through may consider going public through use of an umbrella partnership corporation structure (‘Up-C’).

Asset sales

• Brazil: Net proceeds from an asset sale are subject to corporate income tax of 34 per cent.
• Chile: Generally, proceeds from asset sale are subject to both corporate income tax and VAT.
• Mexico: Proceeds from an asset sale are subject to corporate income tax, and possibly VAT.
• Uruguay: Proceeds of an asset sale are subject to corporate income tax.
• US: Proceeds of an asset sale are subject to corporate income tax.