Controversial topics related to the application of tax treaties in Brazil

A. Brazilian CFC rules

One of the most important controversies related to the interpretation of tax treaties in Brazil refers to the application of article 7 to prevent the taxation, in the country, of profits derived from controlled foreign corporations (CFC).

?Accordingly, article 77 of Law n. 12,973/14 determines the automatic taxation of profits derived from direct and indirect subsidiaries located abroad, independently of whether these subsidiaries are in low or high tax jurisdiction, or whether these companies receive passive or active income.

The tax authorities argue that article 7 of the tax treaties does not prevent the taxation of said profits, as the tax basis provided in article 77 refers to the positive result of the investment (company abroad) evaluated through the equity method, which might result, at most, in the economic double taxation of the income, that is not protected by article 7.

On the other hand, the taxpayers argue that the tax basis provided in article 77 is the profits — and not the positive result of the investment evaluated through the equity method — of the company located abroad, which means that, according to article 7 of the tax treaties, this income is only taxable in the State of the subsidiary.

Also, the taxpayers point out that the Brazilian rules are not strictly a CFC rule, as it determines the taxation of active or passive income derived from companies in high or low jurisdictions. Therefore, article 7 of the tax treaties would be applicable even if the OECD has a position in the sense that this article does not prevent the application of domestic CFC rules.

The Brazilian Superior Court of Justice (Ruling 1.325.709) — the Court that has constitutional competence to give the final interpretation on tax treaty rules[1] — has once decided in favor of the taxpayers, providing that article 7 of the tax treaties prevents the automatic taxation of income derived from subsidiaries located abroad.

Note that the interpretation of the tax authorities in this regard — in the sense that article 7 of the tax treaties does not prevent the application of Brazilian CFC rules — has never been disputed by other treaty partners, as it preserves the competence of these countries to tax the income derived from subsidiaries owned by Brazilian resident companies.

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B. WHT on technical services

Another relevant case refers to the application of article 7 to prevent the taxation (WHT) of income remitted abroad for the payment of non-residents that provide technical and technical assistance services in Brazil.

The discussion arises because most of the Brazilian tax treaties qualify the income paid for the provisions of technical and technical assistance services — in protocols — as royalties. Contrary to article 7, article 12 of the Brazilian tax treaties provides that both the source and residence states have the competence to tax the income (as the country follows the UN MC recommendations in this regard[2]).

Today, only 5 (five) treaties do not provide for that qualification in protocols (income for technical and technical assistance services qualify as royalties). This is the case of the tax treaties signed with Austria, Japan, Sweden, France, and Finland.

Brazilian tax authorities maintain the position to withhold the tax whenever the protocol qualifies it as royalties (see Ato Declaratório Interpretativo RFB n. 5/2014), but the taxpayers usually argue that only income paid for the provision of technical and technical assistance services with the transfer of know-how qualifies as such.

This reasoning has been accepted by the Brazilian Superior Court of Justice in Rulings 1.161.467 (Canada and Germany), 1.618.897 (France), and 1.556.574/1.272.897 (Spain), but in the last years some decisions ruled by that Court indicate that these precedents will be overruled (Rulings. 1.808.614, 1.743.319 and 1.759.081).

The tax authorities’ interpretation in this regard — in the sense that WHT applies on the remittance of payment abroad for the provision of pure technical services, i.e., without the transfer of know-how — has been disputed by other Brazilian treaty partners, such as Spain, that entered in a MAP with Brazil. In the end, the countries concluded that the concept of royalties includes technical and technical assistance services provided with or without any transfer of know-how (ADI SRF n.?4/2016[3]).

Despite this, other tax treaty partners, such as Portugal[4], challenge the position given by the Brazilian tax authorities and do not concede the tax credit for its residents on the income tax that they pay in Brazil for the provision of technical and technical assistance services, an approach that might result in double taxation.

Recently, Brazil has signed tax treaties with Switzerland, Singapore, and the United Arab Emirates that provide for article 12-A of the UN Model Convention, which says that fees for technical services arising in a Contracting State and paid to a resident of the other Contracting State may be taxed in that other State. According to these treaties, Brazil may tax the income up to a limit of 10% (Switzerland and Singapore) and 15% (UAE).

Note that this article (12-A) is only applicable to fees for technical services. Payments of technical assistance services still qualify as royalties, according to the protocols of each of those tax treaties.

We expect that the discussions related to the qualification of the income paid for the provision of technical services in Brazil may end up in cases that the treaty provides for article 12-A.

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C. Social Security Tax and tax treaties

Another interesting case refers to the application of tax treaties to a Brazilian Social Security Tax enacted in 1988, called CSL.

The tax basis of the Brazilian income tax (IRPJ) and CSL is the same (or almost the same, as article 57 of Law n. 8,981/95 establishes that each of these taxes has its own tax basis), but during a period, the Brazilian authorities have interpreted that, whenever the tax treaties have not provided otherwise in article 2 (3)[5], the tax treaty should not be extended to CSL.

The dispute at hand was resolved with the enactment of article 11 of Law n. 13,202/15[6], which clarified, with retroactive effects, that the Brazilian tax treaties cover CSL, even in cases the treaty is not clear in this regard (in article 2).

This dispute and other controversies involving CIDE (Contribution of Intervention in the Economic Domain), according to which Brazil has been alleged to engage in treaty dodging (as Brazil reduced its WHT from 25% to 15%, for the payment of technical and technical assistance services, and introduced a 10% rate CIDE, that is not covered by the tax treaties as it is considered a consumption tax), resulted in the termination of the tax treaty signed between Brazil and Germany, in January, 1st, 2006.

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D. Interest on net equity (JCP)

Juros sobre capital próprio (or interests on net equity, hereinafter JCP) is the Brazilian version of the allowance for corporate equity (otherwise referred to as ACE). JCP is a remuneration paid to the shareholders of the company, based on the amount of its equity.

The main idea is that since companies are allowed to deduct from their tax base the amount of interests it pays to third parties (usually banks) for the cost of the capital employed in their activities, the same allowance should be granted to those companies who do not need third parties’ resources since their shareholders grant them such resources.

Although Law n. 9,249/95 states that JCP is “interest paid or credited individually to the holder, partners or shareholders”, a discussion has flourished in the doctrine and the courts about whether JCP is in fact interest or dividends.

Those who defend the nature of a dividend for the JCP point out that: (i) JCP is paid only to partners or shareholders in proportion to their participation in the capital stock and only in case there is a profit to be distributed; and (ii) the amount paid as remuneration of equity capital may be imputed to the amount of the minimum mandatory dividend provided for in article 202 of Law n. 6,404/76.

On the other hand, those who defend the nature of interest on the JCP point out that the fact that its payment is conditional on the existence of profits does not mean it is dividends. For them, JCP, unlike dividends, is paid based on “the cost of money”.

For tax treaty purposes, the wording of Article 11(3) states that the core element of the concept of interest resides in that it constitutes a credit income of any nature, that is to say, an income from borrowed amounts, related to a debt-claim that provides the creditor to a right to participate in the debtor’s profits, which is not the case of JCP.

The Brazilian tax authorities have a position in the sense that JCP has characteristics of “interests”, and not “dividends”. The authorities issued rulings saying that JCP shall be qualified as “interest” for tax treaty purposes, even in cases where there is nothing in the protocol providing that article 11(3) comprises JCP.

In our opinion, the qualification of JCP as “interest” for tax treaty purposes may be admitted in case the contracting states have negotiated in this regard. This is the case for the Brazilian treaties with Chile, Israel, Mexico, Peru, Portugal, Russia, South Africa, Switzerland, Trinidad and Tobago, Turkey, Ukraine, the United Arab Emirates, and Venezuela, which have stipulated in protocols that JCP is considered “interests” for the purpose of article 11(3) of the relevant tax treaty.

Also, the qualification of JCP as “interest”, for tax treaty purposes is possible only if the treaty provides for a renvoi clause, as is the case with Brazil’s treaties with Argentina, Austria, Belgium, the Czech Republic, Denmark, Ecuador, France, Hungary, Japan, Korea (Rep.), Luxembourg, the Netherlands, Norway, the Philippines, Slovakia, Spain, and Sweden. Brazil’s tax treaties with China (People’s Rep.) and Finland do not provide for a renvoi clause and there is no proviso in protocols stating that JCP is considered “interests” for the purpose of article 11(3).

Other countries have already had the opportunity to analyze whether JCP fits better in article 10 or article 11 of the relevant tax treaty. The Dutch authorities, through Decree No. 2020-14853 (published on 27 August 2020), defined that for purposes of the Brazil-Netherlands Income Tax Treaty (1990), the qualification of JCP payments to Dutch companies must follow the treatment of the country of origin, i.e., interests.

Recently, by way of MAP, Dutch and Brazilian authorities have reached a consensus on the qualification of JCP as interest.

On the other hand, the Second Section of the Sala de lo Contencioso-Administrativo de la Administración de Justicia of Spain (Litigation-Administrative Room of the Administration of Justice of Spain), on 20 February 2014, in the judgment of appeal no. 232/2011 concluded that “the earnings from equity interest qualify as dividends for the purposes of the treaty between Brazil and Spain”.

[1] Brazilian Constitution, article 105, paragraph III, subparagraph “a”. Also, the Brazilian Supreme Court has decided that the Superior Court of Justice is the Court that has constitutional competence to give the final interpretation on tax treaty rules (RE no 460.320).

[2] Article 12 (1) of UN MC: “Royalties arising in a Contracting State and paid to a resident of the other Contracting State may be taxed in that other State”.

[3] This Declaratory Act revoked ADI SRF n. 27/2004, which also provided that the concept of royalties includes technical and technical assistance services provided with or without any transfer of know-how.

[4] CAAD: Arbitragem Tributária Processo n.o 232/2013-T. Available at: https://caad.org.pt/tributario/decisoes/decisao.php?listPage=36&id=324. Accessed in November, 2th, 2022.

[5] The existing taxes to which the Convention shall apply are in particular: (in State A…) (in State B…).

[6] Art. 11. For purposes of interpretation, the international agreements and conventions entered into by the Government of the Federative Republic of Brazil to avoid double taxation of income cover the CSLL.