Brazil

Nelio Weiss and Philippe Jeffrey
PwC
Brazil

While the Brazilian president has decided to split the issue of much-needed tax reform into different parts, the courts added to the wealth of tax case law and the legislature passed more new measures, explain Nelio Weiss and Philippe Jeffrey of PwC

The Brazilian gross domestic product (GDP) showed remarkable growth of 7.5% at the end of 2010 (the highest in 24 years), due to heavy investment inflow and macroeconomic adjustments, which triggered an expansion of various sectors of the Brazilian economy, along with a strong increase in domestic demand based on growing employment rates, leveraged purchasing power, and ease of financing.

Since 2003, Brazil has steadily improved macroeconomic stability, building up foreign reserves, reducing its debt profile by shifting its debt burden, adhering to an inflation target, and committing to fiscal responsibility. In 2008, Brazil became a net external creditor, and two ratings agencies awarded investment grade status to its debt. Brazil was one of the first emerging markets to begin a recovery from the last economic downturn.

The Brazilian Central Bank expects a reduction of GDP growth in 2011, fixed at 4%, due to recent inflationary pressures that forced the government to adopt credit restriction measures. Also, the appreciation of the Brazilian currency against the US dollar is reducing the surplus accrued in the country's trade balance in the year. Nonetheless, the Brazilian government already released optimistic forecasts for 2012, when the economy should resume its growth pattern.

Apart from these positive economic indicators, Brazil still struggles with serious infrastructure problems that represent the main obstacle to the country's economic growth. Key areas such as power supply, industrial capacity, transportation and technical expertise demand much more development than the country is able to bear. Along with the required investment in infrastructure, the Brazilian government faces the challenge of reducing public costs and the country's dependence on foreign investment.

Another serious hindrance for economic growth and further investment is the Brazilian tax burden, one of the highest in the world – around 35% of GDP in 2010. Moreover, an issue that has been under debate for quite a long time is the need for comprehensive tax reform which would redistribute the tax burden and contribute to the development of the country. The new Brazilian president intends to splinter the subject of tax reform and send a number of separate projects to the National Congress, in an attempt to facilitate their approval.

In spite of all this, Brazil is still considered a strategic market and will be one of the most important players in the world economy for the years to come, notably by hosting two important international events: the next football World Cup in 2014 and the Summer Olympics in 2016.

Jurisprudence

Brazilian court determines WHT exemption on remittance of service fees

The Federal Court of Appeals (Tribunal Regional Federal, or TRF) recently confirmed a decision previously issued by the same court which exempted from the levy of the withholding income tax (WHT) the service fees remitted by a Brazilian source to foreign service providers located in countries with which Brazil has signed a double tax treaty (DTT).

According to article 7 of the DTTs, profits derived by a foreign company (which would generally include service fees) may only be taxed in its residency state, unless the company performs activities in the other contracting state through a permanent establishment. However, certain countries such as Brazil have adopted a unilateral solution, in that they subject income derived from the supply of services by foreign companies to withholding taxation regardless of the provisions contained in article 7 of the DTTs.

With the issuance of Declaratory Act 1/2000, the Brazilian tax authorities expressly stated their position that income derived from technical services (not involving transfer of technology) should be subject to taxation in Brazil based on the provisions stated under domestic legislation, even though the foreign company does not have a permanent establishment in the country. This is still a controversial matter in Brazil, as discussions ensued regarding the limitation of the scope of articles 7 (business profits), 12 (royalties) and 21 or 22 (other income), in relation to income derived from services (technical or not).

The decision in question, which unanimously withdrew the levy of WHT on the total service fees remitted to the foreign entity, refers to a company located in the state of Rio de Janeiro, engaged in the paper and pulp segment, belonging to a Finnish group. In spite of the position adopted by the Brazilian tax authorities, the court ruled out that article 7 of the DTT signed between Brazil and Finland should prevent the double taxation of the same income (the service fee) considering that the Finnish service provider does not have a permanent establishment in Brazil and that the DTT prevails over the declaratory act.

Tax ruling – PIS and COFINS levied on the payment of royalties

On April 28 2011, divergence ruling n. 11 was issued by the Brazilian Revenue Service to align the understanding of its regional oversight boards with respect to the levy of the employees' profit participation program (PIS) and the contribution for social security financing (COFINS) on the remittance of royalties. This ruling basically states that such contributions may not apply to royalty payments to foreign beneficiaries in case the corresponding agreement clearly segregates such remittances from those relating to technical service fees. PIS and COFINS are normally due at the combined rate of 9.25% for imports of goods and services.

This subject has always been controversial in connection with license to use fees, which are normally characterised by the Brazilian tax authorities as payment of royalties that are not, in principle, subject to PIS and COFINS taxation. The main point of contention is that, once the license to use (technology, trademarks or software) is included in the service list for the purposes of municipal service taxation, it may also be subject to PIS and COFINS levied on the import of services, which resulted in the tax authorities issuing divergent rulings on this regard, both for and against the levy of the contributions on the corresponding payments.

The divergence ruling, which is binding on all regional federal tax offices when requested to issue private rulings on the matter, is an important precedent to sustain that a pure payment of royalties, duly separated from other payments of service fees shall not be subject to these contributions.

Gains deriving from the equity pickup method are not subject to taxation in Brazil

On June 16 2011, a decision issued by the Brazilian Superior Court of Justice (STJ) confirmed its previous understanding that gains from currency variations determined on investments held in controlled foreign companies (CFCs), valued based on the equity pickup method, should not be taxed in Brazil. This represents an important landmark in a long controversy existing between the Federal Revenue Service and Brazilian taxpayers.

As per existing legislation (article 74 of provisional measure (PM) 2,158-35/2001), profits earned by CFCs are considered available to the Brazilian controlling company at the time the CFC closes its financial statements and as such, is subject to Brazilian corporate income tax at the rate of 34%. However, normative instruction (NI) 213/2002, issued by the tax authorities, broadened this concept by stating that the positive results determined based on the equity pickup method should also be added to the taxable basis for the purpose of calculating the corporate income tax.

In its decision, the Superior Court considered that the rule stated under NI 213/2002 is not supported by the ordinary legislation, including PM 2158-35/2001. The Court concluded that only the profits generated by the foreign CFCs should be taxed in Brazil, in the proportion of the participation held by the Brazilian investor in their capital. Accordingly, a positive equity pickup adjustment deriving exclusively from gain on currency variations shall not be taxed locally, as it is not part of the profit generated by foreign CFCs.

Divergence solution issued by the tax authorities with regards to the calculation basis of the CIDE contribution

The general tax coordination agency of the Brazilian Revenue Service, COSIT, issued on July 5 2011 divergence solution ruling n. 17 which clarifies the calculation basis of the contribution for the intervention in the economic domain (CIDE) when the Brazilian payor bears the cost of the withholding income tax (WHT) levied on remittances made to foreign beneficiaries.

In Brazil, the remittance abroad of royalties or payment of service fees is generally subject to WHT at the rate of 15% (increased to 25% in the case of tax havens), which is due by the recipient of the payment abroad. Additionally, among other taxes, such remittances are subject to the CIDE at a 10% rate, levied by the Brazilian payor.

The divergence ruling, which is binding on all regional federal tax offices when requested to issue private rulings on the matter, stated that in cases where the WHT burden is borne by the Brazilian payor, as agreed between the parties, the corresponding amount should be part of the calculation basis of the CIDE.

Spanish ETVEs temporarily excluded from the privileged tax regimes list

On December 2 2010, declaratory act 22/2010 (ADE RFB 22/2010) issued by the Brazilian Revenue Service, based on a request submitted by the Spanish government, suspended the effects of the inclusion of the Spanish Entidad de Tenencia de Valores Extranjeros (ETVEs) in the privileged tax regimes list.

In June 2010, the Brazilian tax authorities issued a normative instruction (NI 1,037/2010), with an updated tax havens list. The regulation is divided into two separate articles. Article 1 enumerates jurisdictions which are considered not to tax income or to tax it at a rate lower than 20% , or that deny access to information regarding shareholding and ownership of assets and rights. The main change made to the new tax haven list was the inclusion of Switzerland.

Article 2 of the NI, by its turn, enumerates jurisdictions which are considered to have privileged tax regimes, as set forth in Brazilian legislation. The following types of entities were at that time included in the updated list: holding companies incorporated under the laws of Luxembourg (which were later removed); financial investment corporations incorporated under the laws of Uruguay up to December 31 2010; holding companies incorporated under the laws of Denmark, which do not carry out substantial economic activity; holding companies incorporated under the laws of the Netherlands, which do not carry out substantial economic activity; international trading companies incorporated under the law of Iceland; offshore companies incorporated under the laws of Hungary; limited liability companies incorporated under the state law of the US, owned by non-residents and not subject to US federal income tax; holding companies incorporated under the laws of Spain; and international trading companies and international holding companies incorporated under the laws of Malta.

It is generally understood that the concept of a privileged tax regime (article 2) renders these entities subject to stricter transfer pricing, thin capitalisation and tax deduction rules. As for the jurisdictions included in article 1 (tax haven jurisdiction), besides the tax consequences applicable for those under article 2, the withholding income tax rate due on capital gains and cross-border payments such as services fees, royalties and interests is increased from 15% to 25%.

On June 24 2010, the authorities issued NI 1,045 which set forth that countries and jurisdictions listed as tax havens or privileged tax regimes may apply for a review of their characterisation as such. In addition to the Spanish authorities, both the Dutch and Swiss authorities have lodged similar requests which had the effect to temporarily suspending the adverse tax consequences derived from the inclusion of Switzerland in the tax haven list and Dutch holding companies as a privileged tax regime.

Luxembourg holding companies removed from privileged tax regimes list

On March 25 2011, declaratory act 3/2011 (ADE RFB 3/2011) issued by the Brazilian Revenue Service, based on a request lodged by the Luxemburg government, permanently excluded Luxemburg holding companies from the privileged tax regimes list beginning on March 28 2011

Authorities amend transfer pricing legislation

To minimise the effect for Brazilian exporting companies of the appreciation of the local currency in relation to foreign currencies (more specifically the US dollar), the Brazilian authorities issued on January 17 and 24 2011, ordinance 4 and NI 1,124 which amended the Brazilian transfer pricing legislation to allow Brazilian exporting to increase their export revenues for calendar year 2010 (for transfer pricing calculation purposes) using the ratio of 1.09. This measure applies for the fiscal year 2010.

For export transactions, Brazilian companies may opt to use a purchase or production cost plus taxes and profit method, which sets forth that the minimum export price is to be equal or higher to the cost of acquisition or production of exported property, services, or rights increased for taxes and contributions imposed by Brazil plus a profit margin of 15%.

Yet, Brazilian exporting companies may also use one of the three safe harbor rules to document their transfer prices. Two of these rules, for which the adjustment to export revenues is allowed, are referred to as the 90% safe harbour rule and the relief of proof rule:

The 90% safe harbour rule set forth that a taxpayer is deemed to have an appropriate transfer price when the average export sales price is at least 90% of the average domestic sales in the Brazilian market during the same period and under similar payment terms.
One of the relief of proof rules, which is subject to adjustment, set forth that a taxpayer may be relieved from the obligation to document the adequacy of the export sales price if its net income before tax derived from export sales to related entities is equal to or higher than 5% of the corresponding revenue, considering the annual average of the fiscal year and of the previous two years. For the purposes of calculating the referred average, export sales revenues relating to calendar years 2008 and 2009, in operations with related parties, may be multiplied by the factors of 1.2 and 1, respectively.

As an alternative to the three year average calculation, the exporter may assess the annual minimum net profit of 5% only for calendar year 2010 by multiplying the factor of 1.09 for the export sales revenues with related parties.

New changes to IOF rules

The Brazilian government changed on March 28 2011 the tax on financial operations (IOF) rate that is levied on foreign loan transactions (intercompany loans between a foreign entity and a Brazilian entity), with the aim of stemming speculative short-term investments in Brazil and the depreciation of the US dollar against the Brazilian real.

As per the initial rules published on March 29 the applicable IOF tax rate on foreign currency exchange transactions (inflow of funds into the country only) related to loans with an average payment term of up to 360 days and subject to registration at the Brazilian Central Bank was increased from 0% to 6%.

On April 6 2011 the rules were subsequently amended setting forth that as of April 7 2011, the applicable IOF tax rate on foreign currency exchange transactions related to loans with an average payment term of up to 720 days (as opposed to 360 days) and subject to registration at the Brazilian Central Bank is increased to 6%.

New regulation on Brazilian thin capitalisation rules

On May 13 2011, the Brazilian Revenue Service issued NI 1,154, to regulate the deductibility of interest and other general expenses paid or credited by a Brazilian source to individuals or legal entities considered related or resident or domiciled in a tax haven or in a jurisdiction under a privileged tax regime. In line with provisional measure 472 that introduced the thin capitalisation rules back in December 2009, later on converted into law 12,249 in June 2010, the NI provides more detailed guidelines with respect to the calculation of the limits for deductibility of interest expenses based on statutory debt to equity ratios.

Other provisions set forth by the new NI include:

Description of the concept of a related party, reproduced from the Brazilian transfer pricing legislation;
Applicability of the rules when a financial institution is the mere intermediary between the foreign lender and the Brazilian borrower, when such companies are related;
Applicability of the rules for companies beginning their operations in the course of the calendar year and going through a merger, spin-off or consolidation events;
Debt limits generally not applied to loan operations with Brazilian lenders, even if the guarantor, representative or intervening entity is a foreign related party; and
Restrictions on the deductibility of general amounts paid to entities in a tax haven or under a privileged tax regime not applied to financial operations carried out by foreign investors according to the rules and requirements stated by the National Monetary Council.

Nélio Weiss (nelio.weiss@br.pwc.com) is an international tax senior partner with PwC in São Paulo, Brazil and is responsible for the international tax services practice in South and Central America.

Philippe Jeffrey (philippe.jeffrey@br.pwc.com) is an international tax director with PwC based in São Paulo, Brazil.