Keywords: Brazil, taxation, charter agreements,

Brazil's oil & gas industry and the Brazilian Revenue Service are embroiled in a significant tax dispute regarding the contractual model adopted by the industry and the taxation over outbound payments related to charter agreements.

The first component of this dispute refers to the zero percent tax rate of the withholding income tax (IRRF) on outbound payments related to the chartering of vessels. This benefit was introduced in the Brazilian tax system by Law no. 4,862/1965, enacted 50 years ago, and later renewed in 1997 by Law no. 9,481.

It is important to bear in mind that this rule was not created specifically to benefit vessels used in oil & gas operations. Rather, it was meant to encourage the general charter of foreign vessels for transportation, considering the lack of sufficient Brazilian vessels at the time.

Another element that should be taken into consideration in the analysis of this dispute is the split of E&P ser¬vices into charter and services agreements in Brazil. The split is a contractual model created by Petrobras that has been in place at least since the '90s. It has been adopted by the oil & gas industry in Brazil and virtually imposed in every tender process by Petrobras or on invitations to bid by International Oil Companies doing business in Brazil.

This contractual model determines how to split the global price of service activities that have an intensive asset use into charter and services agree¬ments, with the charter usually holding most of the contractual price (80 to 90 percent). Thus, the material part of the global price is not taxed in Brazil because it consists of outbound payments related to the charter, which are benefited by the zero tax rate of IRRF established in Brazilian legislation.

It should be emphasized that the contractual model adopted by the oil & gas industry was solely created for tax planning purposes. The existence of an agreement with a Brazilian entity, as opposed to a charter-only arrangement, was needed due to the local crew and local content require¬ments established by labor and regulatory legislation, as well as for the convenience of paying local costs in Brazilian Reais (avoiding currency exchange rate variation on foreign currency).

Nevertheless, considering the significant tax savings the model has delivered, it is easy to imag-ine the current mindset of the Brazilian Revenue Service vis-à-vis the oil & gas industry. The tax authorities already perceive the industry as over-benefited due to the existence of tax exemptions applied not only to exploration but also to the development and production phases.

Besides the zero tax rate of IRRF on outbound payments related to the chartering of vessels, the oil & gas industry in Brazil also counts on the special customs regime called REPETRO, which estab¬lishes tax suspension of federal taxes levied on the temporary importation of certain goods and equip¬ment destined for exploration, development and production. In brief, REPETRO consists of a tax relief mechanism applied to capital expenditures.

In addition to REPETRO, there is also a state tax benefit on ICMS (a VAT-type tax on sales of goods that also levies on imports) that represents an exemption, or a material reduction, to the ICMS on imports of tangible assets or goods for oil & gas exploration and production.

In fact, the total government taxation on the oil & gas industry was designed during the '90s, when the sector opened to private investments. At that time, exploration offered high risks to investors, estimated production was between 300 and 500 million barrels of heavy crude oil and oil prices ranged from US$15/bbl to US$17/bbl.

The Brazilian Revenue Service contends that the reduced tax burden should not be applied in the current scenario because pre-salt reserves offer lower risk to investors and oil prices have crossed US$100/bbl multiple times.

There have been at least three "rounds" in the "fight" between the Brazilian Revenue Service and the oil & gas industry over the years, with the tax authorities challenging the oil & gas industry by issuing tax assessments based on several different arguments.

At least since 2002, in the so-called "first round" of the dispute, tax authorities filed assessments against Petrobras and International Oil Companies charging IRRF on outbound charter payments. The tax authorities argued that the concept of "vessel" did not encompass production platforms, FPSOs, drilling rigs, semi-submersibles and jackups because "true" vessels would be exclusively designed for the transportation of people and goods. Currently, those assessments are still being challenged at the administrative and judicial levels and, although decisions have been issued favoring each side, it appears that they are now mainly favoring E&P companies.

In 2004, in the "second round" of the dispute, tax authorities started to file assessments against Brazilian service providers of rig operations (the local party in the charter/services split), arguing that any intercompany amount received from abroad should be considered as revenue and also as part of the services fees paid by Petrobras or International Oil Companies to the service provider.

Because of the split between charter and services, and the fact that there is usually a shortage of funds from the Brazilian servicing entity, tax authorities understood that any foreign amount received by the Brazilian entity was actually repatriation of part of an amount that was paid to the charter party without any taxation, but should have been paid to the local Brazilian entity.

Most recently, the "third round" of the dispute started in 2013 when tax authorities considered that the charter contract is actually a service contract—understanding that the split of contracts is artificial mainly, but not solely, because the contracts are not independent of each other. Because there is only one service agreement, the Brazilian Revenue Service assessed E&P companies for the taxes that levy on the import of services—IRRF, CIDE (Contribution for Intervention in the Economic Domain), PIS and COFINS (both social contributions on revenues)— adding almost 50 percent of taxation over the remittance of funds to the charterer.

Considering that the reclassification of the charter as a service is a threat to the whole industry model, lengthy litigation is expected if some kind of legisla¬tive settlement cannot be developed.

The first step in that direction came recently through Law no. 13,043, published on November 14, 2014. The law clearly foresees the split into charter and services agreements as a valid legal option while establishing maximum percentages for charter revenues in the split, according to the type of vessel, to benefit from the zero percent IRRF rate from January 2015 on.

Although, due to poor wording, there is some uncertainty regarding its actual effects going forward, it is clear that Law no. 13,043/2014 can be used as a logical argument against all three types of assessments thrown so far at the Brazilian oil & gas industry, especially because the law validates the split between charter and services as a concept and specifically identifies some oil & gas equipment as vessels.

However, Law no. 13,043 is far from a cure-all. Since it does not have retroactive effect, fiscal years 2009 to 2014 still can be assessed, and are open to interpretation. Moreover, the law does not expressly list as "vessels" some oil equipment that is currently treated as such by the industry (e.g., production platforms, semi-submersibles or jack¬ups). Finally, the maximum percentages for charter revenues established in the new law are unlikely to prevent the shortage of funds from the servicing Brazilian entities.

It is difficult to predict, in the light of the new law, how tax authorities will treat the various mechanisms that will continue to be used to cover this shortage—such as intercompany services and reimbursement agreements, loans and capital contributions. Time will tell!

Originally published Winter 2014

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This article provides information and comments on legal issues and developments of interest. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed herein.