Brazil: STF – Levy Of Income Tax On Profits Earned By Affiliated And Controlled Companies Abroad

The Full Bench of the Brazilian Supreme Court (STF) analyzed, last Wednesday, the constitutionality of the levy of income tax on profits earned by affiliates or subsidiaries established abroad.

In this opportunity, the Court analyzed the constitutionality of Article 74 of the Provisional Measure ("MP") n. 2,158/20011 especially taking into consideration the availability of legal concepts and economic availability of income.

To address the issue, the Justices judged the Direct Action of Unconstitutionality n. 2588 ("ADI 2588"), filed by the National Confederation of Industry, and the Extraordinary Appeals n. 611,586 (brought by the cooperative Coamo Agroindustriral) and 541,090 (filed by the Federal Government).

The Justices started continuing the trial of ADI 2588, considering that such a process was already in judgment by the Supreme Court since 2001, with 9 votes cast by Justices (many of which are no longer in the Court).

The last missing vote, of the Justice Joaquim Barbosa, acknowledged that the rule would be constitutional only in cases in which it taxes the income derived by countries with favorable taxation2 ("tax havens"), where controlled companies are located, precisely because only in this case the lawmaker could abstractly assume that the profits would belong to the Brazilian company and that this company seeks to escape the tax internally.

He said that, in cases other than this, Tax Authorities would be required to prove that the corporate restructuring would not have business purpose or is intended to evade domestic taxation, with the deferral of payment of income tax, which can not be abstractly provided by law.

Considering that, as mentioned above, many justices that had judged ADI 2588 have already retired, the judgment result was limited to the decisions that represented the majority of the justices. Thus, the Court ruled for:

  1. The constitutionality of article 74 of MP 2158 with respect to income derived from controlled foreign entities located in tax havens. Such decision has a erga omnes (i.e, it applies against every individual) and binding effect;
  2. The unconstitutionality of article 74 of MP 2158 with respect to income derived from related legal entities located in non-tax havens. Such decision also has a erga omnes and binding effect; and
  3. The unconstitutionality of article 74 of MP 2158 with respect to income derived from controlled and related foreign entities until December 31, 2001.

In this sense, the session continued with the judgments of the appeals to the extent that other relevant matters remained undefined.

With respect to appeal n. 611.586, the majority of the justices but Justice Marco Aurélio rejected it because the controlled foreign entity was located in a tax haven (Aruba).

In Appeal n. 541.090, however, there was a different situation because the controlled foreign entities were located in China, Italy and Uruguay, which are not considered tax havens under the Brazilian tax Law. Considering this, reporting Justice Joaquim Barbosa rejected the arguments of the appeal in order to consider the income derived from such foreign entities as non-taxable for Brazilian purposes, to the extent that the Tax Authorities neither proved the lack of business purpose nor the tax avoidance purpose in this case.

After that, Justice Teori Zavascki presented a diverging vote, in order to partially accept the arguments of the appeal and to declare the constitutionality of the taxation of controlled foreign entities, even when located in non-tax havens, because he understands that the accounting accrual method for the recognition of income derived from branches and subsidiaries of Brazilian entities located abroad, which anticipates the income tax taxable event, already exists in Brazil for a long time. In this sense, it is his understanding that article 74 only extended such treatment for controlled and related entities located abroad. Finally, justice Zavascki declared the unconstitutionality of the sole paragraph of article 74, which provided for the taxation of income derived from controlled foreign companies and related legal entities until December 31, 2001, based on the non-retroactivity principle.

Justices Rosa Weber, Dias Toffoli, Carmen Lúcia and Gilmar Mendes followed Justice Teori. Justices Lewandowski, Marco Aurélio and Celso de Mello seconded the Reporting Justice.

As such, with 5 votes for and 4 against, the Supreme Court declared the constitutionality of MP 2158, article 74, in respect to the taxation of income earned by foreign controlled corporations, whether they are domiciled in a tax haven jurisdiction or not, and it declared the unconstitutionality of the article 74's sole paragraph, based on the argument that it offends the tax norm's non retroaction principle.

The Justices briefly discussed whether the Tax Treaties entered into by Brazil and several nations would override MP 2158, article 74, considering that the Tax Treaties, article 7, sets forth that the income shall be taxed only in the country in which it was generated.

Although some Justices stated their ideas concerning this matter3, they decided that the theme shall be discussed previously by the Local Court (in the case, the Regional Federal Court, 4th Region), which had not analyzed the issue in detail, as it had preliminary declared the unconstitutionality of MP 2158, article 74.

It is important to mention that the issue involving taxation of income arising from affiliated companies domiciled in tax haven was not examined in any of the three processes.

In addition, it is important to note that with respect to the taxation of income derived from controlled entities located in non-tax havens, which was the subject of appeal n. 541.090, the judgment was not under article 543-B of the Brazilian Civil Procedure Code that provides for the general repercussion of the judgments, which means that it is not immediately binding other agencies from the judicial and executive powers.

Footnotes

1 Article 74 - In order to determine the basis for calculation of income tax and social contribution on net profit, pursuant to art. 25 of Law No. 9249 of December 26, 1995, and art. 21 of this Provisional Measure, the profits earned by controlled or affiliated companies located abroad shall be deemed available to the parent or affiliate in Brazil at the date such profits were registered in the balance sheet, as established in the regulations.

2 As features articles 24 and 24-A of Law n. 9.430/1996 and IRS Normative Instruction n.1.037/2010.

3 In brief, is respect to the application of the Tax Treaties, Justice Teori stated that there is no double taxation, as the income is taxed in the Brazilian company, and not in the foreign company. Plus, the Tax Treaties have their own rules for avoiding any double taxation, particularly when they authorize tax credits to be offset.

Justice Dias Toffoli – although agreed with Justice Teori –, stated that Tax Treaties' violation could only be possible on a case-by-case basis, and that the existence of the double taxation shall be demonstrated in light of the rules concerning the tax credits offsetting.

Justice Rosa Weber followed Justice Teori in respect to the inexistence of double taxation, but she stated that she would rather follow Justice Toffoli's reasoning.

Justice Gilmar Mendes mentioned that he had decided a similar case (Extraordinary Appeal 460,320, Volvo do Brasil Veículo Ltda.'s case), and that his opinion is for the prevalence of Tax Treaties. He was seconded by Justice Lewandowski.

In light of the deadlock concerning the question, they decided to send the process to the Local Court to exam the subject and delimit the breadth of the issue in view of the case details (for instance, to analyze what does the Tax Treaties set forth, and if there is any provision concerning tax credits etc.).

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.

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