This is the first of our series of posts on Brazilian tax treaties. In each post we will provide an overview of a specific tax treaty between Brazil and a particular foreign country, as well as comments on any Brazilian administrative or judicial precedents applying the treaty, and highlights on the impact of the OECD Base Erosion and Profit Shifting ("BEPS") project in its application.
Overview of the treaty
Decree 92,318, published on January 23, 1986, contains the text of the Bilateral Income Tax Treaty signed by Brazil and Canada ("Treaty"). This Treaty is aimed at preventing double imposition and double non-imposition of income taxes in cross-border operations between the two countries.
For Brazilian purposes, as of December 09, 2015, the treaty applies not only to the Individual and Corporate Income Taxes ("IRPF" and "IRPJ") and to the Withholding Income Tax ("WHT"), but also to the Social Contribution on Net Profits ("CSLL").
With regards to CSLL, even though this tax is not expressly mentioned in the Treaty, this tax was created after the signature of the Treaty, and as a partial replacement of IRPJ. In addition, recent Law no. 13,202/2015 included an article clarifying that double taxation treaties signed by Brazil include CSLL:
Art. 11. For purposes of interpretation, the international agreements and conventions signed by the Government of the Federative Republic of Brazil to avoid double taxation include CSLL. (...)
Please note that our reference to withholding income tax ("WHT") in the next paragraphs does not describe the entire tax burden imposed on certain income streams, such as royalties, for example. Other taxes may be imposed on cross-border royalty payments (such as the Special Tax on Royalties ("CIDE"), the Municipal Tax on Services ("ISS") and the Tax on Foreign Exchange Transactions ("IOF-FX")), but because these taxes do not qualify as "income taxes", they are outside of the scope of the treaty.
The Treaty was generally based on the OECD Draft Convention available at the time (1977), as well as on Brazilian tax treaty practice prior to 2000. Key aspects of this Treaty from a Brazilian perspective are:
- Source taxation
Dividends, interest and royalties earned are generally subject to WHT in Brazil and WHT credit in Canada.
Specifically for dividends, interest and royalties, a limit of 15% WHT applies, except in case of loans with maturity of 7 years or more, guaranteed or secured by the Canadian EDC (limit of 10%), and of trademark royalties (limit of 25%). Based on Brazilian domestic law, currently the applicable WHT on those payments is 15%, except in relation to dividends that are currently exempt.
In addition, the Treaty provides for:
- exemption on dividends received by a Canadian company holding 10% or more of the Brazilian company´s shares and the profits arose from operational activities;
- if this exemption does not apply, credit of Brazilian Corporate Income taxes in case of dividends received by Canadian company holding 10% or more of the Brazilian company´s shares, limited to Canadian corporate income tax levied on the same dividends.
Capital gains, differently from the OECD Model Treaty, is taxable in both countries, and there is no WHT limitation in the Treaty. The only exception Article 13, paragraph 1, which determines that gains obtained from alienation of ships and aircrafts are taxable only in the country where the headquarter of the company is located.
Based on domestic law, capital gains obtained by Canadian residents are subject to 15% WHT, which applies even in case of non-resident seller and buyer – in this case, the buyer is responsible to withhold the corresponding amount, nominate an attorney-in-fact in Brazil and cause this attorney-in-fact to collect the WHT due.
There is intention to increase the WHT from 15% to 22.5% according to the most recent version of the law project proposed by the Government to the Brazilian Congress. This bill, if approved, will be enforceable as of the following calendar year.
- Beneficial ownership
Though the expression "beneficial owner" is mentioned in Articles 10, 11 and 12 of the Treaty, the treaty does not define what "beneficial ownership" means (only in recent treaties Brazil has acquiesced to a specific Limitation on Benefits clause, and only in broad terms).
Brazilian tax authorities view the absence of a treaty definition of "beneficial ownership", as is the case with the Treaty between Brazil and Canada, as a permission for tax authorities of the State applying the treaty to interpret the expression as they see fit.
- Tax sparing
The Treaty contains a tax sparing clause, which is a treaty provision that requires Canada to grant tax credits at a deemed WHT rate for specific payments made by Brazilian residents (not by Canadian residents to Brazilian recipients, even though this reciprocal provision does exist in other treaties signed by Brazil, such as the one with Ecuador).
The tax sparing credit is usually greater to the WHT rate applicable under the treaty or domestic law.
In the Treaty, the tax sparing credit for the gross amount of profits to which Article 10, paragraph 5(b) applies is 25%. For the gross amount of interest and royalties not arising from trademarks, the credit is set at 20%.
- Interaction with Brazilian CFC rules
In 2013, a binding decision issued by the Federal Supreme Court ("STF") in ADI 2588/DF defined that Brazilian Controlled and Affiliated Foreign Company ("CFC") rules could apply to controlled foreign companies in blacklisted jurisdictions ("tax havens") and could not apply to affiliated foreign companies out of blacklisted jurisdictions.
Among the questions not answered by STF in the 2013 decision is whether controlled foreign companies in Treaty countries would be exempt from CFC rules. Decisions issued by STJ and by the Administrative Court of Tax Appeals ("CARF") have already dealt with this subject, mostly in favor of the taxpayers, but STF is yet to confirm that position from a constitutional perspective.
While STF does not issue a final ruling on this subject, Brazilian tax authorities rely on references in the text of treaties (or on the absence thereof) to impose CFC rules. Though there are treaties that either exempt undistributed profits (such as our Treaty with Denmark) or dividends (such as our Treaty with Spain), our Treaty is not a part of that group. Safe for a systematic interpretation of Article 7th, there is no provision in the text of the Treaty between Brazil and Canada that would prevent the application of Brazilian CFC rules.
Administrative and judicial case law
There are no recent cases either in CARF or STF that specifically address the provisions of the Treaty between Brazil and Canada.
STJ analyzed one landmark case dealing with the Treaty between Brazil and Canada: REsp 1161467/RS, decided on May 17, 2012, and referred to in the previous section. In that case, the taxpayer made payments to German and Canadian entities in compensation for technical services performed without any transfer of technology. Though STJ confirmed the position of the taxpayer and applied Article 7th to exempt payments from WHT, Interpretive Declaratory Act 05, of June 16, 2014, would indicate that the current tax treatment of these remittances should be the one applicable to royalties (Article 12).
Both Canada and Brazil (respectively a member and an associate country of the OECD) have actively participated in the drafting of the final reports for the 15 Actions of the Base Erosion and Profit Shifting ("BEPS") project. The two countries have distinct tax systems and tax treaty networks, but the OECD expects that Brazil, Canada, and all the other G20 countries are able to implement BEPS proposals in a consistent and seamless manner.
Among the BEPS aspects associated with the application of the Treaty between Brazil and Canada, we would like to highlight the following:
- Hybrid Mismatches (Action 2)
The OECD proposals on treaty issues associated with hybrid mismatches are mainly focused on two separate areas: (i) treaty residence of dual-resident entities; and (ii) a clarification of the entitlement to benefits of transparent entities.
According to the OECD,1 tax authorities should be able to decide, on a case-by-case basis, the State of residence of so-called dual-resident entities (entities that either by virtue of treaty provisions, domestic law, or a combination of both, are regarded as resident in two separate jurisdictions). If tax authorities are not able to reach an agreement, the taxpayer would not be entitled to any treaty benefit (except for the ones agreed upon by competent authorities of both States).
In the Treaty between Brazil and Canada, the clause that would have to be modified (or overridden) for this proposal to become effective is Article 4th, paragraph 3, which currently allows case-by-case decisions, but does not claim that the lack of an agreement would prevent access to treaty benefits (unlike our Treaty with Turkey, for example, that contains this final statement).
Also, according to the OECD,2 "income derived by or through an entity or arrangement that is treated as wholly or partly fiscally transparent under the tax law of either Contracting State" should be regarded as "income of a resident of a Contracting State", but only to the extent that the income is treated, for purposes of taxation by that State, as the income of a resident of that State.
The inclusion of this proposal in Article 1st of the Treaty between Brazil and Canada (possibly through a Multilateral Instrument) would affect not only WHT reductions (which could be partially denied if the person ultimately receiving the income is not a resident from Canada), but also the entitlement to tax sparing credits, established in Article 23, paragraph 3, as explained earlier.3
- Entitlement to Treaty Benefits (Action 6)
The final report of Action 6 recommends the adoption of an "Entitlement to Benefits" clause, inspired by the Limitation on Benefits clause present in the United States Model Income Tax Convention.4
The purpose of the new "Entitlement to Benefits" clause would be to prevent granting treaty benefits to persons that should not be entitled to them, either because doing so is not in the interest of either Contracting State, or because the relevant taxpayer has employed a structure completely devoid of economic substance for the sole or main purpose of enjoying protection under the treaty. The proposed clause is divided into a set of objective and subjective criteria (the "principal purpose test", or PPT section), and if its text is included in the Multilateral Instrument of Action 15, taxpayers wishing to enjoy treaty benefits must comply with both criteria.5
At this stage, it is difficult to forecast whether Brazil will sign up or not for a Multilateral Instrument containing this proposed clause. Remember that the majority of Brazilian treaties either (i) do not have a Limitation on Benefits clause, but do mention the expression "beneficial owner", or (ii) have a Limitation on Benefits clause that is significantly broader than the already quite broad proposal issued by the OECD. Would Brazil be willing to relinquish its all-encompassing interpretive power of "beneficial ownership" in favor of a streamlined clause that would supersede provisions in all of its existing treaties? As implementation of BEPS proposals goes on, Brazilian policymakers will be compelled to provide a clear answer to this question.
For further comments on the application of the Treaty between Brazil and Canada, please do not hesitate to contact our firm.
(*) With the collaboration of our associate Lucas de Lima Carvalho (email@example.com)
1 OECD. Neutralising the Effects of Hybrid Mismatch Arrangements, Action 2 – 2015 Final Report. OECD/G20 Base Erosion and Profit Shifting project. OECD: 2015, pp. 137-138. Available at: http://dx.doi.org/10.1787/9789264241138-en.
2 See note 1 above. OECD: 2015, pp. 139-143.
3 The final report provides an example that illustrates the interplay between hybrid mismatch rules and a tax sparing clause, such as the one in the Treaty between Brazil and Canada, in the proposed item 26.7 to the OECD Commentary: "[Brazil] and [Canada] have concluded a treaty identical to the Model Tax Convention. [Brazil] considers that an entity established in [Canada] is a company and taxes that entity on interest that it receives from a debtor resident in [Brazil]. Under the domestic law of [Canada], however, the entity is treated as a partnership and the two members in that entity, who share equally all its income, are each taxed on half of the interest. One of the members is a resident of [Canada] and the other one is a resident of a country with which [Brazil] and [Canada] do not have a treaty. The paragraph provides that in such case, half of the interest shall be considered, for the purposes of Article 11, to be income of a resident of [Canada]." In this example, only half of the interest received would be associated with a tax sparing credit of 20%, in line with Article 23, paragraph 3, of the Treaty.
4 OECD. Preventing the Granting of Treaty Benefits in Inappropriate Circumstances, Action 6 – 2015. Final Report. OECD/G20 Base Erosion and Profit Shifting project. OECD: 2015, p. 11. Available at: www.dx.doi.org/10.1787/9789264241695-en.
5 See note 4 above. OECD: 2015, pp. 21-69.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.