Weekly Updates – Tax Reform in Brazil: Quota-eaters and Closed Funds

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Bruno Drummond comments on the impact of annual quota-eaters

Check out the complete audio of the interview on our Podcast:

On the second episode of the “Updates of the Week” series, Bruno Drummond, partner and founder of Drummond Advisors, comments on the inclusion of annual quota-eaters and the taxation of private funds present in Brazil’s Income Tax Reform bill.

Drummond explains that a quota-eater is a fiscal period which effectively acts as a payment settlement of an appreciation of variable or fixed income assets for withholding income tax purposes. Some investment funds carry out this process twice a year, in February and November.

“The changes proposed by the government’s bill take into account several aspects. One of them is the reduction of this quota-eater to once a year, instead of twice, which would take place only in November. Another aspect presented in the reform is the collection of the quota-easters for private funds”, he says.

The entrepreneur says that the application of quota-eaters implies a generating factor without it having actually occurred. “The whole objective of passive investment in shares is the control to carry out the sale at the time that is best for the investor. And the principle of quota-eaters is always to restart the income tax calculation base in February or November. This has several very bad aspects. Often the person does not want to settle at that moment, often the fund manager does not want to carry out the settlement procedure. It may be that, depending on the moment of the year, the settlement of certain assets for the fund’s appreciation is not so positive”.

The executive pointed out three not so positive aspects of the annual quota-eater:

There exists a tax payment without the presence of a liquidity factor

When this occurs, the implications are innumerable for investors, both local and foreign.

To make the quota-eater not too prohibitive for the fund, the manager himself will have to increase the number of transactions to enable the offset of gains with losses.  This type of action is not positive for the markets, as the transactions are often of low quality for the segment as a whole.

“If you have an investment fund and there is a very high devaluation in that quarter, some stocks that are not performing will have to be discarded. With this, the position of those shares suffers a fall, as you, as an institutional fund, will have to sell them at a time of loss, which makes the story told about that share go from worse to worse, with the motivation only from the inside of the fund so that it can stabilize its performance since some actions were not working correctly”, explains Drummond.

The entrepreneur explains that in many of these funds, if there is a loss of 10% or 15% of a share, there is a tendency for the manager not to make the sale at that moment. The funds themselves have a very large share in company stocks. And when such a situation happens, the tendency is to bring the market down even further. This brings very high volatility just to reduce the impact of quota-eaters simply because there was no liquidity factor for the investor as a whole.

Bruno Drummond concludes by saying that it would be interesting to have other mechanisms to reduce this type of exposure to the market and investors. “There are alternatives. For example, a distribution trigger, which works as follows: from the moment the fund has remuneration, it must be distributed. This causes the distribution factor to be taxed at the time of settlement. This is a good mechanism for the asset to be transferred to the investor and for paying taxes at the time of transfer. The capital market in Brazil is already over-regulated and quota-eaters add an extra layer of regulation that is not necessary.”

Written by Aline Ribeiro, Content Consultant at Drummond Advisors