Taxation in Brazil
In this aritcle we have summarized certain issues associated with the Brazilian business environment which affect the nature of the due diligence procedures generally performed in local M&A transactions. As a result of these risk factors, efforts during Brazilian due diligence reviews have a strong emphasis on the identification of tax and labor-related contingencies and potential adjustments required for the historical and projected financial information being considered by the buyer.
Brazilian legislation and judicial decisions in Brazil follow the basic principle that the liabilities associated with a predecessor business generally follow the earnings capacity of such businesses, at least on a secondary level. Accordingly, it is normally difficult to avoid predecessor business contingencies through the use of asset-only purchases or similar strategies.
Successor liability issues must often be considered not only from the perspective of the acquirer/successor, but also as they relate to any predecessor business of the target. In addition, the impact of succession issues must be considered in light of the transaction structure sought by the buyer, including related taxation aspects. The statute of limitations for most taxes and social charges in Brazil is five years (there are some significant exceptions, such as certain social contributions on payroll). In the case of fraud, tax authorities/auditors may access financial, accounting, tax and labor information for periods superior to five years.
Numerous and administratively complex regulations underlie taxes in Brazil. There are frequent changes in tax laws and regulations and pervasive judicial challenges to promulgated requirements. Particularly (but not exclusively) in relation to small and medium-sized companies, aggressive or high risk tax practices are sometimes adopted by companies. There are also a number of other factors which increase the riskin this area, including the nature of the legislation (sometimes with an emphasis on form rather than substance of transactions), the frequency of tax audits performed by federal, state and municipal authorities, the incidence of relatively high penalties and interest charges in the event of non-compliance and an enforcement process which is difficult to predict (and attimes arbitrary).
Many smaller companies follow a simplified tax filing method whereby taxable income is determined as a proportion of gross revenues. Such companies often have very limited or no accounting systems, making it difficult and time consuming to perform a traditional due diligence.
Brazil is commonly referred to as the land of taxes – there are currently 63 different taxes and social contributions that can be assessed against a company. In addition, the tax system is highly regulated and extremely complex and it is difficult, if not impossible, to structure a transaction in order to avoid or eliminate succession liability. As a result, we would strongly recommend that a tax and labor legislation due diligence be performed prior to the finalization of any proposed acquisition of a Brazilian target.
With respect to succession liability in Brazil, the responsibility to pay present and previous tax and labor liabilities, both known and unknown, generally follows the legal entity, based on the concept that the owner of the operating assets or the acquirer of the business unit retains the capacity to generate income and hence,pay the tax or labor liabilities. As a result, whether in structuring the transaction as an asset or a stock acquisition, the buyer steps into the shoes of the previous owner with respect to all present and past tax and labor liabilities and contingencies.
The most common means used by foreign companies to invest in Brazil is through the acquisition of a Brazilian target entity through the purchase of its shares. This acquisition method has several tax and labor implications for the buyer. From a legal standpoint, the business unit retains its identity in all respects including its taxpayer identification number. As a result, the buyer will step into the shoes of the former owner and be subject to, and primarily liable for, any known and unknown tax and labor contingent liabilities. In addition to this, the buyer will also be primarily liable for any fines and penalties imposed by the tax authorities regardless of whether such fines or penalties relate to target activities prior to or after the transaction. When acquiring the stock of a Brazilian Target Corporation, caution must therefore be exercised so that the major tax and labor contingent liabilities can be identified, measured and analysed, so that the buyer can factor the cost of the liabilities into the overall investment decision.
A foreign investor may, for a variety of business reasons, structure the acquisition of a Brazilian Target Corporation as an asset purchase of the business unit (operating assets), and assume part or all of the related liabilities. Unlike a stock acquisition, the acquirer will be secondarily liable for the income tax liabilities but will be primarily liable for VAT taxes and labor liabilities. In addition, it is not common to structure a transaction as an asset acquisition in Brazil because the transfer of assets will typically trigger additional VAT taxes.
A variation of the direct asset purchase method is a transaction commonly used in the market whereby the Brazilian Target Corporation forms a Brazilian ‘Newco’ into which the Brazilian Parent Corporation transfers the targeted assets (and liabilities). Subsequent to the incorporation of Newco and the transfer of assets, the buyer then acquires from the Brazilian Parent Corporation the capital stock of Newco. As is the case of a direct asset purchase, in utilizing this structure, the buyer will be primarily liable for the state and municipal taxes as well as the labor contingencies that are related to the business unit which is transferred to Newco. Also, the buyer will have secondary liability for all other taxes. As previously mentioned, with respect to these other taxes, in the event of default by the party with primary responsibility, the buyer would become liable for the contingent tax liabilities (secondary liability becomes primary liability under the concept of the capacity to pay).
The corporate income tax is determined based on the calendar year, with monthly tax payments, and is generally computed on the basis of annual or quarterly taxable income. IRPJ is charged at the rate of 15 per cent plus a surcharge of 10 per cent on annual taxable income in excess of R$240,000 (approximately US$109,000).
Brazilian tax legislation also provides for a social contribution tax on profits, which also has the nature of a corporate income tax. Its taxable basis is quite similar to the corporate income tax, but with certain distinct adjustments. CSLL is charged at the rate of 9 per cent.
There is no time limit for the carry forward of tax losses. However, the taxable profit of each year can only be reduced by tax losses up to a maximum of 30 per cent. Furthermore, it is neither possible to carry back tax losses nor transfer tax losses to other Brazilian companies. Tax losses of an acquired company cannot be carried forward to be offset against the taxable income of a new activity if the following two conditions are simultaneously met:
Capital gains obtained by local resident companies are taxed at the normal corporate rate (34 per cent), while capital gains of non-residents are taxed at the rate of 15 per cent (unless otherwise specified by international tax treaty). Payments of any type made to tax havens are generally subject to withholding at a rate of 25 per cent.
Entities are allowed to remunerate their shareholders by paying interest on capital, subject to certain limitations (i.e., limited to TJLP -Long Term Interest Rate -and the existence of twice the amount of current or accumulated profits). This payment is deductible for corporate income tax purposes and for social contribution on net income purposes, as well. These payments are subject to a 15 per cent withholding tax (or 25 per cent for tax haven jurisdiction).
Distribution of profits to shareholders are not subject to the withholding tax on profits generated as of 1 January 1996, regardless of being paid to resident or non-resident shareholders.
As from 1 January 2000, the exchange gains or losses deriving from assets and liabilities may be computed for the basis of the corporate income tax and social contribution on net income at the moment the corresponding assets or liabilities is actually liquidated, that is, the expenses and income deriving from exchange gains and losses may be deductible or taxable, respectively, on cash basis, or on accrual basis, at the taxpayers discretion. This is a very dramatic change to our tax system, as so far exchange losses have necessarily been recognized on an accrual basis. Interest expenses and gains are deductible and taxable on an accrual basis.
PIS generally levied at 1.65 per cent is a federal social contribution calculated as a percentage of gross revenue. A new enacted PIS credit system is meant to ensure the tax is applied only once on the final value of each transaction. As from 1 May 2004 the PIS contribution applies also on the imports of goods and on the payment of services to non-residents.
COFINS generally levied at 7.6 per cent is a monthly federal social assistance contribution calculated as a percentage of gross revenue. A new enacted COFINS credit system is meant to ensure the tax is applied only once on the final value of each transaction. As from 1 May 2004 the COFINS contribution applies also on the imports of goods and on the payment of services to non-residents.
CPMF is a contribution charged on every debit (e.g. withdrawal,transfer, etc.) made to a bank account at the rate of 0.38 per cent. The contribution is deducted from bank accounts weekly. The contribution is deductible for income tax and social contribution on net income purposes.
As a general rule, foreign exchange transactions made in order to allow payments to non residents, considering royalties, technical services, technical, administrative and any other assistance or any other revenue, including the reimbursement of any costs, are subject to IOF. Historically, these transactions were subject to an IOF rate of 25 per cent. The current IOF rate for foreign exchange transactions (both inbound and outbound) is of 0 per cent. As a result, IOF may be avoided if the payment requires a foreign exchange transaction from reais to a foreign currency, or from a foreign currency into reais. Payments of interest, for the importation of goods and for the acquisition of an investment in Brazil by a local resident from a foreigner, are not subject to IOF. IOF of 5 per cent is charged on foreign loans with an average maturity of less than 90 days. All other foreign loans are not subject to IOF. The average maturity is determined based on the balance of the loan relative to the number of days of the outstanding balance of the related loan.
Employers’ social security contributions correspond to 20 per cent of the gross payroll. In addition, employers are required to make contributions to other funds, which amount to approximately between 16 per cent and 20 per cent of the gross payroll. These contributions are deductible for the purpose of corporate income tax and social contribution on net income.
The current rates applicable to the following payments to non residents are:
(*) These rates are effective unless otherwise specified by tax treaty. (**) Payments of any type made to tax heavens, defined as jurisdictions that do not tax income or tax income at a rate lower than 20 per cent, will be subject to withholding at a rate of 25 per cent.
It should be noted that the tax authorities respect the exemption from withholding for all dividend payments, including dividend payments subject to withholding tax under the provisions of a tax treaty. In the case of royalties, the royalty contract has to be approved by the National Institute of Industrial Property (INPI) and filed with the Brazilian Central Bank. Deductions for royalties are generally limited up to 5 per cent of net sales of the relevant products or services, the percentage depends on the type of product or activity. Royalties for the use of trade marks and trade names, for whatever type of production or activity, when the use of the mark or name does not result from the utilization of a production patent, process or formula, are limited to 1 per cent of net sales. Repatriation of capital in excess of the cost of the nonresidents investment in Brazil are subject to capital gains tax at 15 per cent (or 25 per cent for tax haven jurisdiction).
A Brazilian company with royalty, licence or service agreements with foreign entities shall pay a 10 per cent intervention contribution at the economical domain, based on the amount paid abroad. Since 1 May 2004 the PIS and COFINS contributions also apply on the payment of services to non-residents. Payments of services to non-residents may also be subject to the service tax (ISS) at rates varying from 2 per cent to 5 per cent.
This federal excise tax is paid by manufacturers on behalf of their customers at the time of sale, either to another manufacturer who will further the manufacturing process or to the retailer who sells to the end user. The tax paid is stated separately on the sales invoice, as is the nature of the goods involved. Certain exemptions are given to goods considered to be of basic necessity to the country’s economy. The rates are defined by the product’s tax code according to the harmonized system. As mentioned above, when manufactured products are sold between producers, the IPI is imposed. However, the subsequent manufacturer is allowed a credit against its IPI liability, equal to the IPI paid to its suppliers (non cumulative tax). IPI is also imposed on import transactions.
The ISS is a municipal tax on gross billings for certain services designated by the Federal Government. The applicable rates to be determined by each municipality can vary between 2 per cent and 5 per cent. In general, the service tax is levied by the municipality in which the company is headquartered. There are some exceptions to this rule for services involving assembly, construction, demolition, among others. New regulation, effective as from January 2004, resulted in important changes to the ISS legislation. The original list of services subject to the tax was expanded and the import of services are now subject to ISS. Additionally, ISS is not levied on exports of services, except when the results of these services will be applied in Brazil.
Import tax is levied on the CIF price. The rate depends on the degree of necessity and is defined by the product’s tax code according to the harmonized system. Taxes on importation are levied on top of one another, as follows:
Import tax (II) is a cost to the company (not recoverable). ICMS, IPI, PIS and COFINS paid on imports are generally creditable.
The constitution of 1988 granted authority to the Brazilian states to collect the tax on the circulation of merchandise and on rendering of interstate and intermunicipal transportation services and on communications, even when the transaction and the rendering of services start in another country. It is not a cumulative tax, that is, the tax is only assessed on the increase in the price of the product in each part of the circulation process. The calculation process involves a system that, in each payment period, the taxpayer must check the amount of debits and credits related to the state value-added tax and, if the taxpayer has more debits than credits, it will have to pay the tax on the difference between them.
In summary, the credits are computed at the moment the raw materials enter the taxpayer’s premises and the debits are computed at the time the final products exit the establishment. Moreover, taxpayers are not allowed to account for credits on materials purchased that will be used on goods that will not be taxable when they exit the company. It is a value-added tax and is collected by most states at the rate usual of 17 per cent, except for the states of Sâo Paulo, Minas Gerais, whose tax rate is 18 per cent and Rio de Janeiro, whose rate is 19 per cent. Some products exceptionally trigger a higher rate (usually 25 per cent) or a lower rate (car industry and other special industries are below 17 per cent or 18 per cent). Special rates apply to interstate sales, as shown in the chart below:
| From | To | Rate |
|---|---|---|
| South and Southeast | South and Southeast | 12 per cent |
| North, Northeast and Midwest | North, Northeast and Midwest | 12 per cent |
| South and Southeast (*) | North, Northeast and Midwest (*) | 7 per cent |
| Any State | Non-taxpayer | Internal rate from the State of the Sender |
(*) Including the State of Espírito Santo