BRASILIA - Following the latest in a series of blows to their claims of tax immunity, Brazilian closed pension funds are closer to conceding defeat, contemplating how they will preserve their financial health and also the minimum guaranteed returns they promised to their affiliates.
A Nov. 8 Supreme Court decision against the US$270 million pension fund Ceres, rejecting the fund's claim of exemption from municipal property taxes, shook the industry and cast a shadow over 580 other tax suits - all from pension funds - now before the court.
Closed pension funds are ones sponsored by private and public companies that restrict affiliation to outside firms. They co-exist in the market with open pension funds, which are those formed by insurance companies and offered to companies and individuals.
The court's historic ruling follows the government's imposition in September of Provisional Measure 2.222, which decreed that pension funds pay income tax of 20% beginning in 2002. The measure excused back interest on the estimated $4.4 billion in unpaid taxes and established an alternative to the income tax for all pension funds that agreed to drop claims of tax immunity. The industry hadn't shown any signs of budging from its claims, however, while awaiting the Supreme Court's ruling.
The pension funds, which managed US$51 billion at the end of September, have been holding the tax funds in escrow accounts in the event their immunity claims would be rejected.
Making a generalization
While the Ceres case was related to property taxes, the decision reinforced the provisional measure, implying the court eventually would rule similarly on all pending tax-immunity cases. "We judged an individual case ... but evidently, with six votes in favor and four against, the Supreme Court laid out an understanding by which pension funds do not have (tax) immunity," Supreme Court President Marco Aurelio Mello said in published reports immediately following the decision.
(The Supreme Court further ruled Nov. 28 that the only pension funds that can claim tax immunity are those that are 100% funded by sources other than worker contributions. In a unanimous decision, the judges ruled funds that do not deduct contributions from worker salaries are similar to social welfare agencies, and therefore could consider themselves tax-exempt. The court mentioned that fewer than 10 pension funds fit this description now. It is believed many funds would consider adjusting their statutes in order to claim tax exemption).
But members of the closed-fund association, known as ABRAPP, still saw a silver lining to the Nov. 8 ruling. The optimism stems from the court not ruling categorically that it will not respect a pension fund's claims to immunity from income taxes.
Nevertheless, the association realizes its best hopes lie in pushing for a change in the provisional measure, said Carlos Duarte Caldas, president of ABRAPP. Mr. Duarte, who is critical of the government's lack of interest in encouraging a savings culture, said the supplemental pension plans help compensate for the low sums workers can expect to receive from social security entitlement programs.
"The government needs to make perfectly clear what it is looking for: a strong supplementary retirement system that provides the country with internal sources of financing, or to keep asking the International Monetary Fund every time there's an economic crisis that affects one of our neighbors," said Mr. Duarte.
Meanwhile, others in the industry are quietly considering how quickly and efficiently they could adapt to the provisional measure.
"The new reality is going to lead pension funds to take cost-cutting measures in order to respect their commitments with their affiliates," said Adacir Reis, a lawyer representing closed pension funds in Brazil. "But it is likely that costs will go up and benefits will go down."
Aiming for targets
Pension funds are bound to actuarial targets, requiring they yield 6% over inflation annually. With the application of the 20% income tax on nominal returns, funds with a portfolio of bonds with nominal returns of 30% (10% plus 20% inflation) will pay 6% in income taxes and be left with a real return of just 4% - less than the 6% target. And this is before considering other taxes in the market, such as the 0.38% financial transactions tax on all buying and selling activity. This could cause the funds to lower their actuarial targets, according to Marcelo Rabbat, a noted pension fund consultant in Brazil.
Experts said the funds could limit their tax exposure by using the alternative proposed by the government. Instead of charging the pension funds 20% on total returns, the alternative measure would apply the tax on 12% of annual plan sponsor contributions. According to Felinto Sernache, a consultant with the local branch office of Towers Perrin, many pension funds are likely to find the alternative tax more economical, especially those that are growing moderately but have large portfolios accumulated over many years, as the tax would only apply to new contributions.
Although no funds have acknowledged it publicly, there exists the possibility that some closed pension funds will convert to open pension funds. According to the provisional measure, beginning in 2002 open pension funds will have to pay taxes only on the profits (or contributions) of those affiliates added to the funds on or after Jan. 1, 2002. Meanwhile, profits (or contributions) corresponding to all existing affiliates prior to that date will be exempt from taxes for the life of the affiliate.
There is no such differential for the closed pension funds. Therefore, it is expected that some closed pension funds would try to convert to open funds before the end of the year, for their existing members to be exempt from taxes.