Analysis: Some intended (and unintended) effects of Brazil’s proposal to tax dividends

Rio de Janeiro, Brazil – Brazil’s Ministry of the Economy has proposed initiating a 20% tax on dividends and other profit distributions received by the owners of companies. The tax would burden all distributions over R$240,000 (US$48,000) per year or R$20,000 (US$4,000) per month.

Before 1995, Brazil taxed dividends at 15-25%. Creating an exemption made Brazil one of very few countries in the world (Estonia, Hong Kong, Singapore) that does not tax dividends.

Reinstituting taxes on profit distributions will have important consequences for Brazil and Brazilians – some intended, but some unintended.

TWO INTENDED CONSEQUENCES

A pressing geopolitical reason for the proposal is Brazil’s desire to become a member of OECD, the so-called “rich countries club”; it would like to join Chile, Colombia and Costa Rica as members from Latin America. Taxing dividends is universal among OECD nations and will be a prerequisite for club membership.

A pressing domestic reason is the government’s desire to increase its tax revenues, as pandemic spending has stretched the limits of the federal budget. Estimates of dividend tax revenue range from R$18 billion to R$53 billion, as no one is sure whether companies will reinvest their profits (which is tax-free) rather than distribute them (which is taxable).

TWO UNINTENDED CONSEQUENCES

A positive (if probably unintended) benefit of dividend taxation is that it will make Brazil’s tax system slightly more progressive. Brazil now has one of the most regressive systems in the world, where the poor (who can least afford them) pay almost all taxes and the wealthy (who can easily afford them) pay almost none.

An indirect (and surely unintended) consequence of taxing dividends is the probable effect on employment law – it should significantly reduce the number of limited liability companies created by service professionals.

Brazil’s constitution and statutes impose costly labor and social benefits, which employers must pay all registered employees. A rule of thumb is that the actual cost of registered employees is at least double their monthly salaries.

When individuals form a company, however, and have the company bill their services, there is no employment relationship. For employers there are no labor or social benefits to be paid; for workers, there are no withholdings or payroll taxes: a win/win situation.

Similarly, almost all professional firms – lawyers, accountants, doctors, engineers, and architects – make their new hires “partners” (0.01% owners) of the firm, rather than employees, paying them “dividends” rather than salaries.

Depending on the professional’s personal income tax bracket, earning dividends rather than salaries can mean a 10-20% increase in take-home pay. However, that advantage will disappear if the dividends paid the professional by his company are subject to a 20% tax.

This state of affairs – where individuals become corporations solely for tax reasons – has long been anathema to labor unions, the ministry of labor and the labor courts, which often treat single-owner legal entity service providers as shams, used to defraud the labor and social security system.

Any tax on dividends will upset this applecart. Professional service providers will be loath to create their own companies, which will bring them no financial advantage, and will prefer to become registered employees, entitling them to constitutional and statutory benefits.

The only unaffected employment group is that of micro- and small-business entrepreneurs, whose size exempts them from the dividend tax, so it still makes financial sense for them to incorporate themselves.

CONCLUSION – WILL IT HAPPEN?

A large majority of Congress members are wealthy business owners and professionals. As described above, a tax on dividends could adversely affect their business organizations. It remains to be seen if Congress will, in the end, agree to a tax that is good for the country but not good for them personally.