Brazil’s constitutional taxation overhaul: a comprehensive analysis

Wednesday 21 February 2024

Murillo Estevam Allevato Neto
Bichara Advogados, Rio de Janeiro

Bruno Chechia
Bichara Advogados, Rio de Janeiro

After nearly three decades, Brazil’s Congress has approved the Brazilian tax reform on value added tax (VAT). This aspect of tax law has been discussed since almost the enactment of the Federal Constitution itself in 1988, and follows several attempts to simplify the current tax system. All of these efforts were unsuccessful, until the recent ratification of the proposed Constitutional Amendment No 45 of 2019 in December 2023.

The background

Acknowledged globally for its complexity, Brazil’s tax system is inherently intricate. Much of this is due to the country’s federative division, where the power to tax is distributed between the Federal Union, the states and the municipalities. This decentralised approach has resulted in 27 different state laws on the tax on sales, over 5,000 county laws on the tax on services and additional federal laws governing the taxation on industries and their respective revenue. This complexity, which has been exacerbated by numerous decrees and regulations, has resulted in Brazil having the most extensive tax litigation network in the world.

Despite the fact that some of the current taxes in Brazil were originally designed to be non-cumulative, inadequately drafted laws and disputable interpretation by the tax authorities have hindered taxpayers from fully offsetting their tax credits. This has led to protracted legal disputes before the country’s administrative and judicial courts. Moreover, tax competition between states in order to attract investment has led to more litigation, as benefits granted by one state have been routinely disregarded by other states.

The changes being introduced

Within this tumultuous scenario, the imperative for Brazil's tax system to be reformed in order to attract new businesses and investors became evident. The reform seeks to achieve clear objectives: (1) establish a unified piece of legislation for all consumption taxes; (2) terminate the ongoing tax competition between states; (3) mitigate tax litigation through the implementation of clearer rules; and (4) enhance transparency concerning the amount of tax paid by every commercial operation.

To attain these goals, Congress has opted for the systematic replacement of existing taxes with new ones, adhering to an effective non-cumulative system. The states’ sales tax (ICMS) and municipal service tax (ISS) will be replaced by a unified tax on sales, services and rights (IBS), while federal contributions concerning a company’s revenue (PIS and COFINS) will be replaced by a federal contribution on sales and services and rights (CBS). This model mirrors the dual VAT model, akin to India’s recent tax reform.

Despite introducing two different taxes and separating the federal tax from that shared between the states and municipalities, both the IBS and CBS will be subject to identical rules. These include taxable events; assessment bases; the situation in regard to taxpayers; exemptions; immunities; specific, differentiated, or favoured regimes; and non-cumulative and crediting rules, which are all due to be defined in supplementary law.

Exported goods and services will be exempt from the IBS and CBS, allowing companies to reclaim accumulated tax credits. Furthermore, an innovative feature introduced by the tax reform is the potential for low-income individuals to receive tax cashback. The supplementary law will delineate the scenarios where cashback will be applicable, with a mandatory refund already established for the supply of electric energy and liquefied petroleum gas.

The tax rates will comprise the sum of the CBS rate and the IBS rate defined by the state and the municipality. The rate defined by the federative entity must be equally applied to all sales and services provided in such a location, with some exceptions defined by the Brazilian Constitution.

In this regard, aiming to end the tax competition between the states, the reform establishes that taxes shall be charged based on the commercial operation’s destination – the location where the sale is made or where the service is provided.

This rule is aimed at simplifying the tax system, as well as reducing the numerous litigation cases in Brazil in which the tax classification of a product is conflictual, due to the different tax rates that may apply depending on the classification adopted. This also means that federal entities will not be allowed to create favoured tax regimes and all current laws regarding differentiated tax rules will be revoked. The existing rules on tax deferrals or exemptions in regard to special customs regimes and export processing zones will also undergo a systematic review.

Among the exceptions defined in the tax reform, some products and services will benefit from three possible reduced tax rates: (1) intellectual property services, of a scientific, literary or artistic nature, supervised by a professional council, will qualify for a 30 per cent reduction; (2) health, education and some transport services, medicines, medical devices, basic healthcare products, food intended for human consumption, agricultural, aquacultural, fishing, forestry and plant extractive products in natura, among others, are entitled to a 60 per cent reduction; and (3) some other medicines, medical devices, fruit, eggs and automobiles used by people with disabilities, among others, will have a 100 per cent reduction in the applicable tax rates. Congress will also define the goods that will compose a national basic needs package, which will have a zero IBS/CBS rate.

Beyond the reduced rates, some exceptions have been made for other economic sectors, which will not be subject to the general rules of the IBS and CBS and may even be excluded from the non-cumulative rule, having different rates, a different calculation basis and different crediting rules. Such is the case for fuels and lubricants, cooperative societies, financial services, real estate transactions, healthcare plans, lotteries, tourist services, bars and restaurants, regional aviation, operations governed by international treaties or conventions and some public transport passenger services. The details on the taxation of such economic sectors will be defined in a future law. The exceptions regimes will undergo a periodic five-year assessment encompassing cost–benefit analyses and impact evaluations with a focus on mitigating gender inequalities.

Notwithstanding all of the above, the tax reform preserves some pre-existing special taxation rules. The tax simplification programme in Brazil called SIMPLES, which applies different tax rules to small companies, will continue and companies benefiting from SIMPLES will be able to choose between fully remaining subject to the programme or collecting the IBS/CBS. In the last situation, other companies that acquire goods or services from those small companies will be allowed to keep all the credits from such an acquisition. If not, the credits will only be proportional to what was collected by the small company according to the SIMPLES rate. The same rule will apply to small rural producers.

The special rules are also maintained for transactions within the Manaus Free Trade Zone and other free trade areas, which offer advantages over the Brazilian competitors located outside those regions. Although the specifics will be outlined in a future supplementary law, one advantage is already known. The federal tax on industrial goods (IPI) will have its rates reduced to zero, except for goods produced outside of the Manaus Free Trade Zone and other free trade areas if those products are also produced within the aforementioned regions.

Future supplementary laws will also address the exemption on capital expenditure, allowing for the full and immediate reimbursement of tax credits, tax deferral or full tax rate reduction.

New taxation rules in Brazil have paved the way for the creation of new taxes, outside of the non-cumulative regime. One of them is the federal selective tax. Initially designated as a ‘sin tax’, its scope was amplified during congressional discussions, to encompass every good or service deemed harmful to the environment or health. Nevertheless, the Brazilian Senate also expanded its reach to extraction transactions, such as those relating to mining and oil. Energy and telecommunications related transactions are excluded.

Going forward

The implications of Brazil’s tax reform extend beyond the direct impact on taxpayers. The limitations placed on the prerogatives of the country’s states and municipalities demanded a new structure for redistributing the IBS tax collected among the federative entities. To coordinate the distribution and administration of tax debits and credits, a Tax Committee comprised of 54 representatives from the states and municipalities has been formed.

The transition to the new tax system will span a decade, commencing in 2026. As the necessary supplementary laws regulating the IBS and CBS, as well as the IBS Committee, the selective tax, and other aspects, are yet to be drafted, a one per cent test rate for the IBS/CBS will be charged in 2026, which will be fully deductible from other taxes.

In 2027, the federal transition will transpire, extinguishing current federal contributions in regard to revenue (PIS/COFINS) and introducing the CBS at the full rate. The selective tax will also enter into force and the tax on industrial products will have its rates reduced to zero, with the exception of competitors of companies located in the Manaus Free Trade Zone.

The tax transition of the states and municipalities will unfold gradually from 2029 to 2032. Existing taxes will decrease at a 10 per cent annual rate concurrently with the implementation of the new IBS. All current tax benefits regarding the tax on sales and the tax on services will be reduced yearly, at the same rate.

By 2033, the new VAT system should be fully implemented. The remaining credits deriving from capital expenditure acquisitions may be offset in 48 months and all other credits in 240 monthly instalments.

The Constitutional Amendment has also established two safeguards for taxpayers who might suffer severe negative impacts from the tax reform. The first of these is the Federal Fund to indemnify companies that made investments to settle in a state and used local tax benefits that were deemed legal. Such benefits were already limited to 2033, but since they will be gradually reduced from 2029, the Federal Government will bear the losses represented by these taxpayers during those four years.

A future law will also define possible adjustment instruments to ensure the economic balance of contracts pre-dating the entry into force of the IBS and CBS laws, including in regard to public concessions.

Although a few other adjustments have been made to the taxes applicable to properties, the previous remarks summarise the main changes to the taxes on consumption in Brazil. There is great optimism among accountants, lawyers and economists that such changes will simplify the tax obligations in the country and reduce litigation, but the finer details will unfold when Congress begins its deliberations on the supplementary laws.