Brazil: Oil & Gas Industry – Main Aspects Related To The Acquisition Of Equipment For Its Activities In Brazil

Several upstream companies in Brazil are in the process of facing the great challenge of drilling the first one or two wells in their awarded areas, which means that the level of investments in equipment (fixed assets) starts to increase.

As a result of that, the need for an efficient way to acquire these assets with the least tax burden becomes extremely important, specially during this phase of uncertainty.

The purpose of this article is to briefly outline some important aspects, from a tax perspective, related to the most common alternatives that companies have to acquire such assets.

This special regime (applicable for equipment that enter the country before December 31^st, 2005) is divided into two subprograms:

1. Importation under the Temporary Admission – ITA, and.
2. Symbolic Exportation – SE.

In summary, under the ITA system, a Brazilian entity leases, rents or borrows the equipment from the non-resident producer without needing to incur in the custom duties and taxes (IPI and ICMS), which would be usually charged (under the regular temporary admission system) based on the ratio between the time the equipment remains in Brazil and its useful life.

The symbolic exportation, on the other hand, was created as a way to extend such benficial tax treatment for the same goods even when purchased from a local producer. In this case, the goods are fictitiously exported to a non-resident company, who pays for them in hard currency and then immediately leases, rents or lends them to a Brazilian Company (related or not), who will use them in its E&P activities.

Besides the fact that the ICMS, under currently regulations, is not due in the ITA system (Convênio 51/99) but it is for purposes of the SE system, which is an issue that both the industry and the States are aware of and are working on it, it is important to point out that the lease and rental charges, which apply for both systems, are currently subject to a withholding income tax of at least 15%, depending on where the beneficiary of the payment is located.

This is certainly a cost factor that needs to be taken into account, and depending on how fast the owner of the equipment needs to recover its costs, it can be incurred by the Brazilian company fairly quickly.

As it is well known for all of those that deal with international tax issues, it is not always easy to use a withholding tax that is imposed on a gross amount (which is the case of Brazil) as a tax credit, especially because most of the companies that operate internationally are, in most cases, in an excess foreign tax credit position. Carefully planning is usually required to maximize such possibility and avoid turning the tax withheld into an extra cost.

As a result of the above, which basically defines that even in the REPETRO system there are tax costs (withholding taxes) applicable to the structure which have not been suspended, several companies have been studying the possibility of applying for other types of incentives available, as an alternative method.

For less expensive equipment (even those that qualify for the REPETRO), it may be possible to reduce the cost of such equipment if it is purchased directly. This is so for several reasons, some of which are listed below:

1. The company would own the equipment and therefore be able to recover the acquisition cost through depreciation expense. Depending on the amount of time the equipment is in use, it may qualify, provided certain specific conditions are met, to an accelerated depreciation rate, which may represent up to 50% of the original useful life of the equipment (this could be more relevant for the development/production blocks than for the exploration blocks);
2. Several States provide for a special deferral mechanism of the ICMS charged on the actual importation of goods (also under specific conditions), which usually represents the largest cost in an importation process. This means that it is possible that the other taxes imposed (i.e. II and IPI) may not be as high as the withholding tax in the REPETRO system.
3. It may also be possible to defer the ICMS that would be charged to the E&P company in a local purchase made in an inter-state transaction (ICMS rate differential), which means that the ICMS and IPI charged in the invoice, may also be lower than the withholding tax charged in the REPETRO. This is so, specially if we take into account the fact the company will be able to eventually use such ICMS as a credit against its sales of Oil (for intra-state sales) and Gas.

There is no "magic formula" for a tax efficient structure.

Each company must carefully evaluate its investment strategies and possibilities, define its priorities, identify all the variables in each process to take advantage of the most efficient way to set up its activities.

It is how accurately and quickly companies can set this up that will leave room for a competitive advantage which, in this industry, could mean millions of US$.