The uncertain future of Brazilian taxation of profits earned abroad

Article by Roberto Codorniz, partner at Maneira Advogados, and Amanda Panissa, published on the website Legal Consultant.

The uncertain future of Brazilian taxation of profits earned abroad

September 24, 2021

Papa-buraco is the name usually given to solutions that seek to cover holes that appear in road networks. This type of repair causes controversy, as, in most cases, the repair is palliative and momentary. The solution is temporary. Shortly after repair, the hole returns to torment drivers' lives, causing accidents and inconvenience.

This same concept, of just filling holes and hiding the root of the problem, is illustrative of the current Brazilian legislation on taxation of profits abroad, governed by Law No. 12,973.

Brazilian taxation of profits earned abroad is perhaps among the topics most criticized by experts, as it has particular characteristics that differ from international practice and that directly impact the competitiveness of national companies when they seek to internationalize their businesses.

The question does not concern the option of taxing the income of individuals and legal entities resident on a universal basis (national and foreign sources) or territorial bases (only national sources), since in Brazil, by express constitutional determination, Income Tax is governed by the criterion of universality [1]. The debate is much more focused on whether or not to admit the deferral of taxation on profits earned by controlled and associated companies residing abroad. In other words: the controversies revolve around the timing of the taxation of profits abroad.

The first rules designed to regulate the timing of taxation of subsidiaries and affiliates abroad were the so-called controlled foreign companies (CFC), designed during the Kennedy administration, in 1962, with the inclusion of subpart F to the North American Internal Revenue Code.

After a broad debate, a consensus was created that the rules, by disregarding the legal personality of non-resident subsidiaries and affiliates, imposing on them an enormous competitive burden, given that the North American corporate income tax exceeded the world average at the time, would only be applied for the purpose of combating abuse involving profits earned by subsidiaries and affiliates in tax havens and, even so, limited to income considerable amounts of easy mobility (so-called “passive income”). In this context, profits arising from productive income in countries with regular taxation were safe from the anti-deferral rule.

This “consensus” persisted throughout the following decades, so that the Organization for Economic Co-operation and Development (OECD) began to defend them and consider them compatible with the treaties signed by countries to avoid double income taxation.

Thus, more than anything, the “consensus” reached is, in fact, a “pact”: on the one hand, of companies, which do not want to be subject to (generally higher) taxation in their State of residence when conquering new markets, and, on the other hand, of the tax administration, which does not give up on combating abusive situations whose damage is seen through the erosion of their untaxable bases and the artificial allocation of assets in low-income jurisdictions. taxation. Consensus is also the expression of the limit that can be accepted without a country breaching its treaties designed to avoid double taxation of income and transforming into a dead letter the rule that imposes respect for legal personalities constituted and existing under the laws of other countries.

Within Europe, the Court of Justice of the European Union has already ruled that applying CFC-type standards without any evidence of artificiality violates the fundamental freedom of free establishment in the European community [2]. The same guideline was followed in the rules of the anti-tax avoidance directives (Anti Tax Avoidance Directive, orATAD), whose orientation is to apply the CFC only to artificial operations or those aimed at evading taxation [3].

Under the OECD, the BEPS (Base Erosion and Profit Shifting) Project tackled the issue in Action 3 [4]. The final report, published in 2015, warned States, when designing their CFC rules, to pay attention to the issue of competitiveness of national companies, since those jurisdictions that apply CFC rules broadly can generate distortions and competitive disadvantages for their transnational companies in relation to jurisdictions that apply CFCs solely for the purpose of avoiding situations of abuse.

Returning to Brazil, Law nº 9,249 changed the tax regime, until then on a territorial basis, starting to automatically tax all profits earned abroad. From the beginning, here, the timing of the taxation of profits earned abroad was immediate for any and all situations involving subsidiaries and affiliates abroad of companies resident in Brazil. Our anti-deferral rule has always pursued the collection purpose and the strengthening of the principle of residence of taxation on a universal basis, without any concern with the idea of “consensus” or “pact” explained above.

Between comings and goings, and the judicialization of the issue, today this taxation regime is governed by Law No. 12,973, which, among other aspects, began to prohibit the deferral of taxation even for indirect subsidiaries. There is also no consideration as to the nature of the investment in question, with the anti-deferral rule applying even in cases of legitimate investments without any trace of abuse (active income coming from a country with regular taxation).

Such incidences, added to the Brazilian rate of 34% (which, even if it will fall with the approval of the reform proposal currently being processed before the National Congress, still shows signs of remaining above the global average of 20%) [5], generates a very high tax cost for profits coming from abroad, which leads to a disincentive to this type of investment, since the largest Some countries adopt criteria based on combating situations of abuse. It loses out in terms of conquering new markets.

Thus, in an attempt to alleviate the rigor of the Brazilian anti-deferral rule, Law No. 12,973 introduced some temporary mechanisms, such as, for example, presumed credit of 9% for production activities and the possibility of consolidating the results of subsidiaries abroad (as long as anti-avoidance rules are observed). These mechanisms will only last until 2022.

The consolidation regime and presumed credit were included in Law No. 12,973 as a result of pressure from national business sectors to alleviate the effects of a very harsh regime for the internationalization of national companies. Using the illustration above, it was a “pothole filler” which, in view of its temporary nature, already begins to highlight the poor quality of the asphalt, in this case, Law No. 12,973 itself (in the part in which it regulates the topic discussed).

The country is urgent for tax reform, however, we must stop looking for ephemeral, sectoral and unequal solutions, to, in fact, rebuild the broken asphalt base and reduce the difficulties and “holes” that Brazilian companies face in navigating the path of internationalization of their businesses.

Tax reforms — such as those proposed under PL nº 2,337/2021 — cannot be aimed at just specific measures, without keeping in mind the tax system as a whole. There is no way to reform the Income Tax and Social Contribution on Net Profit (CSLL) legislation, reducing their rates and taxing dividends, without the rules for taxing profits of affiliates and controlled companies abroad also being changed, especially in a context in which the “fillers” designed in the past are about to lose their effect.

Thus, the time has come to rethink our rules for taxing profits earned by subsidiaries and affiliates abroad, in order to create a true national pact between the protection of our unenforceable bases, necessary for the realization of fundamental rights, and the promotion of legitimate investment abroad, fundamental for the growth of national companies and, ultimately, for national economic development. To this end, it is essential that we rethink the design of our standards, that is, redo the asphalt, instead of creating new pothole covers that will soon create problems for us.

[1] CF/1988: “Article 153 – The Union is responsible for imposing taxes on: (…) III – income and earnings of any nature; (…) §2 The tax provided for in section III: I – will be informed by the criteria of generality, universality and progressiveness, in accordance with the law.”

[2] C-196/04, Cadbury Schweppes Plc and Cadbury Schweppes Overseas Ltd. V. Commissioners of Inland Revenue. Judgment of the Court (Grand Chamber), 12 September 2006.

[3] Council Directive (EU) 2016/1164 of 12 July 2016 laying down rules against tax avoidance practices that directly affect the functioning of the internal market. Available at: https://eur-lex.europa.eu/legal-content/EN/TXT/HTML/?uri=CELEX:32016L1164&from=EN. Accessed on 20.09.2021.

[4] OECD (2015), Designing Effective Controlled Foreign Company Rules, Action 3 – 2015 Final Report, available at: https://read.oecd-ilibrary.org/taxation/designing-effective-controlled-foreign-company-rules-action-3-2015-final-report_9789264241152-en#page1. Accessed on 20.09.2021.

[5] See OECD. Revenue Statistics 2020. Paris: OECD Publishing, 2020. Available at: https://doi.org/10.1787/8625f8e5-en. Accessed on 20.09.2021.

Roberto Codorniz Leite Pereira is a professor of the Professional Master's Degree in International and Comparative Tax Law at IBDT; PhD in Tax Law from the Faculty of Law of USP and partner at Maneira Advogados.

Amanda Garcia Panissa is a lawyer, specialist in Tax Law from USP and in International Tax Law from the University of Barcelona; Master's student in International Tax Law at IBDT.

Legal Consultant Magazine, September 24, 2021