Brazil: E-commerce Leads To Tax Conflicts Among Brazilian States

It is undeniable that the Internet has altered several social and commercial relationships and created realities that are not satisfactorily regulated by the law.

There is a clear gap between the technological advances and the rules governing the judicial framework for the new forms of interacting and doing business on the web. In tax law, that gap is even larger, because the tax levy rules are strongly linked to rigid concepts which are often inconsistent with the dynamics of the virtual environment.

A case illustrative of that conflicting relationship between taxation and the Internet is the recent debate on the sharing of the Brazilian State VAT tax (ICMS) levied on interstate e-commerce. Many states of the Federation have established tax barriers to goods that consumers residing in those states acquire from virtual stores with distribution centers located in other states. In this context, the ICMS in question is assessed at the time the goods enter the end consumer's state of residence. In most states that have implemented that kind of measure, the tax rate is 10% of the transaction amount. This rate corresponds to the difference between the interstate ICMS rate, which varies from 7% to 12%, and the internal rate in the state of destination, which in most cases is 17%

The main activity conducted by virtual stores is nothing but a form of commercial purchase and sale, wherein the purchaser acquires a certain good offered on the Internet at a site maintained by the seller, that is liable for the delivery. Although the sale has been made on the Internet, the virtual store uses the physical premises of an establishment, as a rule, a distribution center, from which the good is shipped to the purchaser. As a rule, purchasers of goods from virtual stores are individuals, therefore, persons that do not pay ICMS. As a result of the nature of the addressee, most of the interstate transactions with goods negotiated on the Internet are subject to ICMS taxation only in the state where the shipper's establishment is located, that is, the virtual store's distribution center. This is so because under article 155, paragraph 2, item VII, letter 'b' of the Federal Constitution, interstate transactions in which the addressee is an end consumer that does not pay ICMS are subject to the internal tax rate of the state where the distribution center is located, regardless of the location of the headquarters of the virtual store.

Although it is not difficult to classify the transactions made by virtual stores and identify the elements required for determining the ICMS levy, it is undeniable that  e-commerce has exponentially increased the amount of interstate transactions involving non-ICMS taxpayers, which are subject to exclusive ICMS taxation in the state of origin per the Federal Constitution.

The negative consequences for the states that are predominantly destination for goods purchased on the Internet (net "importer" states) are quite clear. To the extent that consumers prefer the Internet to the traditional commerce of their place of residence, the ICMS revenue from their purchases is transferred from the state where they reside to the state where the distribution center of the virtual store is located (net "exporter" states).

This is a new reality generated by the technological advances, which certainly was not contemplated by the drafters of the 1988 Constitution when they subjected intestate sales of goods to non-ICMS taxpayers to the internal ICMS rate, following the state of origin principle.

The claim of the net "importer" states to receive a part of the ICMS generated from interstate e-commerce transactions is justifiable from an economical standpoint. After all, ICMS is conceived as a tax on consumption, and, in the case of interstate e-commerce sales, the states where the consumers are located do not obtain any revenue from that tax.

On the other hand, the current tax rules do not support the net "importer" states's claims. Their practice of charging the difference between the interstate and the internal ICMS rate for e-commerce transactions involving non ICMS taxpayers within their borders is entirely contrary to the constitutional guideline that provides for ICMS taxation at the internal rate of the state of origin; so much so that several preliminary injunctions have already been granted to release the virtual stores from paying ICMS to the net "importer" states in addition to that which they pay to their own state and many of these injunctions have already been upheld by the Brazilian Supreme Court.

In this context, the adoption of unilateral measures by the net "importer" states, which consider themselves harmed by the taxation exclusively by the net "exporter" states has given rise to a tax conflict with net exporter states, that currently hold the full right to tax those transactions at their internal ICMS rates.

Should this situation persist, e-commerce as whole will be affected, inasmuch as interstate transactions will be taxed both in the state of origin, at internal rates from 17% to 19% depending on the state, and in the state of destination, at rates up to 10%. This means that the tax burden on transactions made through virtual stores may reach as much as 29%, which would make those businesses economically unfeasible since the tax burden on traditional commerce is substantially lower. If the states do not take any steps to solve this bottleneck, the virtual stores may either disappear or be compelled to be permanent litigants, which also involves significant costs in bringing and conducting lawsuits in several parts of Brazil.

Although it may seem paradoxical, the current taxation rules may even eventually affect the current net "exporter" states. It is easy to anticipate a race among the states which offer  a variety of ICMS benefits to lure distribution centers conducting interstate transactions which would then generate tax revenue exclusively for themselves. As the constitution does not provide for sharing ICMS on such transactions between states of origin and destination, even an extremely low burden would still give states which previously lacked distribution centers a net revenue gain.

Should that happen, the distortion will be inverted, that is, the taxation exclusively at the state of origin along with the granting of tax benefits would make the tax burden on e-commerce much lower than that on traditional commerce, thereby subjecting the latter to unfair competition. That would also be a fertile field for the sort of tax litigation that is typical of the so-called "tax war", with states questioning the constitutionality of the benefits unilaterally granted by their peers to attract the virtual stores' distribution centers.

Based on those considerations, it is clear that the current constitutional framework for ICMS taxation on interstate transactions is not appropriate to regulate e-commerce in a satisfactory manner.

On the other hand, it is equally correct to affirm that the unilateral measures already adopted or about to be adopted by states allegedly harmed by the current rules on ICMS sharing do not represent a valid solution to this bottleneck, especially because an inequity cannot be remedied by violating the constitution.

The same logic applies to the agreement made between several of the net "importer" states to standardize their measures to collect ICMS tax on interstate transactions. This agreement, Protocol 21/11, provides for sharing that revenue between states of origin and destination, so that the state of origin charges a lower rate ( the interstate rate of 7% or 12% instead of the internal rate ranging from 17% to 19%) and the state of destination charges the difference between the two. The illegality here is that the signing states have been enforcing the rules of the agreement against non-signing, net exporter states. Moreover even compliance amongst signing states is questionable to the extent that it transfers taxing powers from origin to destination states, which goes against the Constitution.

The solution to the tax conflict inherent in e-commerce transactions requires legal changes valid for the whole country, and this may only be achieved by means of the enactment of a Constitutional Amendment changing the ICMS sharing scheme in interstate transactions. In fact, the Brazilian congress is drafting a bill to amend the constitution in order to enable destination states to collect a fraction of the ICMS levied on interstate sales to non ICMS taxpayers.

However, this solution is not simple to implement as it has political and operational obstacles that must be satisfactorily addressed by the national congress.

In this regard, it should be noted that the reason why 1988 Constitution adopted the principle of ICMS taxation exclusively at the state of origin for interstate operations involving non ICMS taxpayers is quite elementary: as a rule, none of the parties involved in this kind of transaction is subject to the tax administration of the state of destination.

Therefore, the adoption of the proposed ICMS sharing system in those transactions would result in imposing the obligation to withhold and pay the tax on behalf of the state of destination on an establishment located outside that state or on an individual residing therein. Considering that the possibility of any state compelling individuals purchasing goods on the Internet to pay the ICMS is practically unfeasible, the remaining alternative is the virtual store becoming liable for calculating, withholding and paying the ICMS in each state where it delivers the purchased goods.

Although that kind of obligation already exists in transactions subject to the Tax Replacement regime, the fact is that the virtual stores would then be subject to 27 different tax jurisdictions, which would certainly demand a great amount of financial effort for the stores to meet countless primary, i.e, payment, and ancillary, e.g. filing returns, tax obligations. In this scenario, smaller virtual stores would either fatally succumb to the costs inherent in such a huge effort or end up restricting their geographic area of operations.

In a nutshell, the creation of new rules with the purpose of addressing state disputes over ICMS in e-commerce would involve a great amount of effort by the involved parties and cooperation among the states so as to give the taxation rules some rationality.

Claudia Liguori Affonso Maluf is attorney-at-law in São Paulo, and a partner of Demarest e Almeida Advogados.

Luiz Carlos Junqueira Franco Filho is attorney-at-law in São Paulo, and a partner of Demarest e Almeida Advogados.

Ricardo Valim de Camargo is attorney-at-law in São Paulo, and a partner of Demarest e Almeida Advogados.

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