Paulo Cezar Aragão^[1]
BMA Advogados, Rio de Janeiro
pca@bmalaw.com.br

Taxes in Brazil have never been easy, and they are likely to become even more complicated in the years to come, even if, in the long term, they are for a potentially positive outcome.

Brazil is expected to achieve its largest and most ambitious tax reform in more than 50 years, primarily focussing on the taxation of trades of goods, services and rights. By the end of December 2023, a bill that had initially been regarded with a certain skepticism, was finally approved by the National Congress. It was a major constitutional reform setting the framework for the changes to come and aiming to rebuild the whole intricate system of Brazilian value-added taxes. It is now subject to implementation by a series of new laws. In April 2024, a bill for the first of these new laws was submitted to the House of Representatives. Even if the actual benefits of the new system may be in doubt for many, it now appears that its implementation is a matter of time, with impacts to virtually every single sector of the Brazilian economy, not to mention foreign investors, business lawyers and, of course, thousands of Brazilian tax practitioners. This article offers a summary of what is going on with such tax reform and the expected next steps that foreign lawyers and investors in Brazil should be aware of.

The current Brazilian regime of consumption taxes

The Brazilian tax system is complex for many reasons. This continental sized country is politically organised as a three-level federation formed by a federal union, 27 states and over 5,500 municipalities. Each of them has its own taxing powers attributed by a lengthy and detailed Federal Constitution. For example, income is only taxed by the Federal Union, gifts and inheritances are only taxed by the states, while property of urban real estate is only taxed by Municipalities.

However, complexity escalates to extreme levels when it comes to consumption taxes. Federal union taxes the trade of industrialised products (imposto sobre produtos industrializados – IPI), while states tax sales of merchandise and rendering of communication services and intermunicipal transport services (imposto sobre circulação de mercadorias – ICMS), within boundaries set out by federal laws and agreements entered into among the States themselves. For their turn, municipalities tax the rendering of services in general (imposto sobre serviços – ISS) and are also subject to limits that are set by a federal law.

IPI and ICMS are VAT-like taxes in the sense that the taxpayer can offset credits resulting from the acquisition of inputs. In practice, relevant constraints may be applicable to the use of such credits, which, in some cases, may lead to their accumulation. ICMS is generally levied in the state of origin of the goods or services with standard rates of 18 per cent but that may vary depending on the nature of the goods and the local legislation. ISS is ‘cumulative’, which means that the taxpayer cannot offset any credit arising from the acquisition of inputs that are used for the rendering of the services, even if there are other services that are also subject to ISS. This municipal tax is generally levied at rates ranging from two to five per cent.

Thus, there is complexity as there are many different local laws (state or municipal) that need to be coordinated when dealing with any transaction that reaches more than one state or municipality. Also, there is complexity as the same transaction can be subject to two of these taxes (namely IPI and ICMS, which are VAT-like), while for others, there may be doubts and disputes on whether they characterise a trading of merchandise (IPI/ICMS) or service (ISS). In addition, harmful tax competition is common among states and municipalities, which have different economic profiles and need to fight with their neighbours for new investments by offering tax reductions and incentives.

Even at the federal level, tax complexity is extremely high. Two different taxes (PIS and Cofins) are levied on the same triggering event, the revenues or invoicing of legal entities, but under sets of rules that may differ significantly from one taxpayer to another depending on its size and type of business. Even if they have been created 20 years ago, the rules related to the general PIS/Cofins regime, in which the taxpayer is allowed to use credits resulting from the acquisition of inputs, is still object to uncertainty and extensive litigation as tax authorities are frequently trying to restrict the use of such credits.

Other struggles derive from the development of the economy and new technologies. ICMS and IPI were designed many decades ago in the context of a world in which transactions were exclusively physical. Likewise, the triggering event of ISS usually do not encompass activities that did not exist when this tax was originally created. The current tax system was also shaped decades ago for a world of physical trades, but economy finally shifted to digital and immaterial goods. Of course, this problem is not limited to Brazil, but it also needed to be addressed by the country’s legislators.

The new Brazilian regime of consumption taxes

All challenges that were mentioned above are clear to anyone dealing with the Brazilian tax system. Countless studies point out the high cost of tax compliance and complexity and their impact as restraints to the development of the country’s economy. Simplification of such rules is not a convenience but an actual need for the country. Thus, it is agreed that deep changes to the system are required, notably by tax reform. However, up to now, these ideas have not progressed very far, when the political entities involved had to negotiate mutual concessions, defining who should give away a portion of its tax income and how big it would be. Considering the number of states and municipalities and their profoundly different interest and economics, political consensus over such reforms seemed to be utopian and almost impossible.

However, times seem to have changed. The federal government elected a major tax reform as one of the pillars for strengthening the country’s public accounts, up to the point of creating a special and very active office within the Finance Ministry focused on different proposals of tax reforms.

During 2023, the two main projects on this matter, which had already been submitted to the Brazilian Congress, were consolidated into a single bill that was finally approved in mid-December – Constitutional Amendment 132. It sets a large and complex framework to be considered by federal and local legislators in the creation of the new laws that would enact a new tax system. Even if such constitutional rules are still broad and leave important questions unanswered, they define the core aspects of the new VAT regime. In sum:

• The new system, described as a ‘dual VAT’, considers the replacement of five current taxes by three new taxes. They would be (1) IBS, a new non-cumulative state and municipal goods and services tax replacing ICMS and ISS; (2) CBS, a new non-cumulative federal goods and services tax replacing IPI, PIS and Cofins; and (3) a ‘selective tax’ (IS), combining aspects of a sin tax and of an excise tax. IBS and CBS are VAT-like, designed to enable a broad use of tax credits from inputs and acquisitions, and would be generally levied in any transaction involving the trade of material and immaterial goods. While CBS would have a flat rate, IBS rates would vary based on the type of product, service and right, although being uniform among the different states. A national law is expected to rule on special regimes and use of tax credits.
• A managing committee (Comitê Gestor) with super political powers would be created to manage key aspects of IBS operation, including the distribution of tax revenue among states and municipalities, issuing guidance on interpretation of the rules of IBS, and regulating tax inspections and litigation.
• The new system envisages IBS reductions of 30, 60 or even 100 per cent for certain goods and services, as well as special regimes for industry sectors such as fuel and lubricants, financial services, real estate, health plans, lotteries, cooperatives, hotels and theme parks, travel agencies, bars and restaurants, soccer corporations, regional aviation companies, transport services, independent professionals, among others.
• Accumulated tax credits are expected to be reimbursed, unlike ICMS credits in the current regime. The new rules also allow limited use of credits deriving from fixed assets, use of stocks of ICMS credits after 2032, as well as IPI and PIS/Cofins credits. Tax cash back is considered for low-income families.
• Existing tax incentives are planned to be revoked, with the ones already in place being preserved until 2032. A National Fund for Compensation of ICMS Incentives is expected to indemnify taxpayers that may be affected by the limitation of existing tax benefits.
• Transition to the new system would be progressive during a ten-year term, during which the new taxes would be implemented progressively as the current ones are suppressed. Therefore, for years, taxpayers would need to handle two different tax regimes, with all challenges that may reasonably expected, such as separate control of credits, different inspections, impacts of the double regime to existing and new case law.

Even if the new system is sound and good, the reasonable question is how would the country, tax authorities and taxpayers, shift to it from the current one? The solution considered is a transition period of ten years, during which the new system would be progressively implemented as the other system would be phased-out. Even if sudden changes are welcome, for years, taxpayers would need to handle two different tax regimes, with all challenges that may reasonably be expected. As noted above, these would include separate control of credits, different inspections, impacts of the double regime to existing and new case law.

In late April 2024, the Brazilian Finance Minister presented to the National Congress a bill for the first of many laws that would rule and implement the new VAT system as set forth by the recent tax reform. It is massive document comprising 360 pages introducing 500 sections that are organised in three different parts. It aims to address (1) general rules for IBS and CBS; (2) special custom regimes; (3) tax cashback for low income families; (4) special tax regimes with reduced IBS and CBS rates; (5) special regimes for selected industry sectors; (6) a set of rules on regulation, interpretation, ancillary obligations and crediting of IBS and CBS; (7) transitional rules to the new tax regime, including phase out of tax rates; (8) triggering rules for the IS; and (9) Manaus (capital city of Amazonas state) and other free trade zones. Nonetheless, the new bill is still silent about key aspects for understanding the new taxes, such as applicable rates and answers to a large number of controversial ICMS issues. A second bill is expected to be presented soon addressing management, control and inspections of IBS and many others should follow.

Other possible trends on Brazilian tax reforms

Although VAT would be the largest and most ambitious tax reform in Brazil, a number of relevant changes have also been put in place recently, while others are expected to be presented soon.

These include:

• During the last two years, a new legislation on transfer pricing has been enacted and regulated, effective as of 1 January 2024. It discarded the former transfer pricing rules that were particular to Brazil and adopted the guidance of the Organisation for Economic Cooperation and Development (OECD). Approval of such new legislation was an openly declared move by the Brazilian Government in its attempt to become a member of the OECD.
• For that same reason, a bill for a new law implementing OECD’s Pillar Two is expected to be presented soon by the Brazilian Government to the National Congress. Pillar Two is a key part of the OECD/G20 BEPS Project to address tax challenges arising from the digitalisation of the economy. It is an international plan to update key elements of domestic tax laws to ensure that large multinational companies pay a minimum level of tax on the income arising in each of the jurisdictions where they operate. It would be made by means of a coordinated system of taxation that imposes a top-up tax on profits arising in a jurisdiction whenever the effective tax rate is deemed to be below a minimum rate.
• In December 2023, the Brazilian National Congress approved new legislation on the taxation of offshore investment and income deriving from local investment funds. Essentially, it revoked possibilities of tax planning via tax deferrals and consolidated the rules on these matters, which were traditionally scattered, into a single law and regulations.
• Specific changes have been proposed in the taxation of Brazilian local infrastructure bonds and a new set of rules is expected to be presented for the taxation of investments in the Brazilian capital market and financial market.

Notwithstanding the above, the most expected and potentially revolutionary change to Brazilian income tax that has been publicly promised by the current federal government is the revocation of the long-time tax exemption of dividends distributed by Brazilian legal entities, which dates back to 1995. It is expected that as an offset to such a tax increase, the same bill would reduce the corporate income tax rates. This may be beneficial to large corporations deploying industrial and commercial activities but potentially burdensome to small or mid-sized taxpayers and service providers that elect to be assessed by income tax under special presumed profit regimes. It may also impact non-resident investors that currently benefit from presumed withholding income tax credits when receiving exempt dividends from a Brazilian company, based on tax treaties to avoid double taxation.

Reasonable concerns

Putting aside punctual changes and updates to Brazilian income tax rules, the country is jumping into its most extensive VAT reform in more than 50 years. The causes for a tax reform are clear. The current system of consumption taxes is complex, unfair and outdated. However, it does not imply that any change or replacement to it will necessarily be good. The new system that is being approved is clearly more modern and reasonable in many aspects, but many questions remain answered and, worse, many challenges are already envisaged.

Brazilian companies, lawyers and tax advisors will need to prepare for a completely new system of rules, with their own complexities, which will not reduce substantially the number of existing taxes when it is finally implemented. In the meanwhile, it will require the co-existence of two different VAT regimes, each of them sufficiently puzzling in itself, during a substantial transition period of progressive phase-in and phase-out. Preparation is key for the changes to come and Brazilians must hope that the medicine envisaged to heal the old Brazilian VAT system is not strong enough to kill its patient.