Brazil: Recent Changes to VAT ("ICMS") Legislation in The State of Rio De Janeiro, Brazil, May Adversely Affect Oil And Gas Industry

Last Updated: 6 July 2004
Article by Ivan Tauil and John Cohn

The state of Rio de Janeiro ("RJ") has recently approved two harmful, and possibly unconstitutional, laws that may hinder exploration and production activities in and off the coast of RJ.

1. Federal E&P Incentives.

In 1999, the Brazilian federal government implemented tax benefits, called REPETRO, to stimulate investment in upstream activities and improve the domestic energy industry. These provisions reduced the operating costs of oil and gas E&P during the initial exploration phase by suspending federal taxes, such as Import Duty ("IF") and Excise Tax ("IPI"), on the importation of goods and equipment for the term of the concession contract so long as the equipment returned to its country of origin at the end of the concession period. REPETRO is currently set to expire in December 2007.

Following the federal policy as set forth in REPETRO regulations, the National Council of Fiscal Policy ("CONFAZ"), through Agreement #58/99, authorized the states to exempt the equipment imported through REPETRO from the state value added tax ("VAT" or "ICMS").

2. Contrary RJ VAT Legislation.

RJ has taken a contrary course of action, passing two laws that increase the cost of upstream activities in the state.

  • VAT on Equipment. RJ State Law No. 3.851/2002 provides that, from June 30, 2003, the RJ state tax authorities will impose VAT (currently at the rate of 19%) on all operations of direct importation and interstate transfers carried through ports outside RJ, of goods and equipments destined for the oil and gas industry imported under REPETRO rule. The new law suspended a previous special temporary admission rule.

This new law is contrary to the CONFAZ Agreement and Brazilian Complementary Law No. 24/75, which regulates states’ agreements about fiscal incentives. The federal Supreme Court ("S.T.F.") has already stated that all CONFAZ Agreements have binding character for all signatory states (including RJ), prohibiting any one of those states from unilaterally revoking such an Agreement.

Further, both the S.T.F. and the Superior Court of Justice ("S.T.J.") have ruled that a state’s VAT should not be incurred over the temporary importation of a good or equipment because there is no transfer of property, which constitutes the taxable event. Although the Constitution states that the state VAT may be imposed over the circulation of goods, the circulation can only be considered if it implies a transfer of property.

  • VAT on Oil at Wellhead. Likewise, on June 27, 2003, RJ enacted bill #407/03, amending existing law to make the exploration of oil a taxable event for VAT purposes. According to this law, the taxable event will occur when the oil reaches the measuring point and the tax basis will be the oil’s reference price. The law will go into effect not before January 1, 2004. (A provision to put the law into effect on July 1, 2003, was vetoed.)

3. T&K Analysis.

These new laws will likely bring little or no benefit to the exploration and production of oil and gas in and off the coast of RJ. They will increase the tax burden of the activities – in particular, oil would be subjected to VAT twice: once at the wellhead and again at the refinery gates.

Further, we believe that the state’s view is mistaken on several counts:

  • The oil, before its extraction, cannot be considered a good, in the specific sense of the word, which is a good of someone’s property and destined for commercialization – not even the Brazilian federal government, which concedes the right of exploration to private companies, owns it.
  • The Brazilian federal government does not own the oil reserves such that VAT could be imposed. The federal government is entitled to the right to explore any oil that might exist as reserves and, after its extraction, to appropriate it. Even if it were true that the federal government owned the oil and was transferring its ownership to the concessionaire (as the revised law now seems to imply), the state should not be able to impose VAT, because it would violate the constitutionally granted reciprocal tax immunity that forbids the federal government, the states, and the municipalities from instituting taxes on the property, income or services of one another.
  • All operations related to the circulation of goods must include the legal transfer of its property (and not only its physical transfer). Such a legal transfer is not possible to occur with oil before extraction, since the oil, while still on reserve, is not considered property. Only once the oil passes through the measuring point does the oil exist as a good. Thus, no legal transfer has occurred.

These new laws have and will continue to be challenged in Brazilian courts. Several international oil companies recently challenged the nullification of the VAT exemption for equipment; however, a RJ court dismissed this challenge. Petrobras, the national E&P company, has announced that it believes that the tax on oil at the wellhead is unconstitutional, and that it will take legal actions to challenge the tax. Further recognizing the problem with the legislation, the Governor of RJ has created a task force including representatives of the government and Petrobras to evaluate the economic impact of the taxation.

We also hope that the bill will be re-evaluated and that new alternatives will be found to meet the government's objectives, due to the negative impact the bill would have on the oil industry. The Brazilian federal government still maintains its commitment to opening the oil and gas sector and aims to build a safe environment for foreign investment. Further, Brazil’s market (both consumer and supplier) and its political and economic stability still constitute a great advantage before its competitors for foreign investment.

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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