Brazil: Deduction Of Royalties In Intragroup Transactions

Last Updated: 1 March 2016
Article by Marcelo Gustavo Silva Siqueira

We refer to the wrongful decision of the highest level of Brazil's tax administrative court1 (CSRF, Decision 9101-001.908 of May 13, 2014) against the deductibility for income tax purposes (IRPJ)2 of any royalties3 whatsoever (e.g. copyright royalties regarding software, books, songs, movie, magazine and cartoon characters) paid by a Brazilian company to its partners (individuals or legal entities, foreigners or not, with any shares), with the exception of royalties for patents and trademarks (forgetting that know-how is also included) regarding agreements signed from 1992 on with its foreign parent company. The case refers to software royalties.

Nowadays intellectual property licensing agreements (e.g. patent, trademark, know-how) – import of technology – are still subject to strict regulations regarding necessary clauses of the agreements and, specially, the amount to be paid/remitted/deducted for tax purposes (limited to royalties of 5% instead of other transfer pricing rules methods), involving the Brazilian Patent and Trademark Office (INPI), the Central Bank of Brazil (Bacen) and the Brazilian IRS (RFB).

Copyright royalties on the other hand are not subject to such restrictions and shall comply with Brazilian transfer pricing rules, although we are not aware of tax assessments in this regard.

In order to understand and proceed with the adequate interpretation of Brazilian regulatory tax legislation regarding royalties for intellectual property rights it is necessary to understand the historic perspective of its enactment since royalties for intellectual property rights were one of the first instruments of abusive international tax planning in Brazil.

In the 1950's Brazil taxed heavily a company's profit and its dividends with a joint taxation (income tax, compulsory loan, additional income tax and withholding income tax) that could reach 50% or more of such amounts. Royalties on the other hand were deductible without limitation and taxed by withholding income tax of 25%. There was also a shortage of dollars due to dividends remittances restrictions in several countries. Thus it was better to pay royalties than dividends.

Corporate groups always look to the whole taxation of its transactions and since royalties had a lower taxation, abusive royalty rates of 10%, 15% or more were established in intragroup transactions regarding patents, trademarks and know-how (technical assistance). The problematic was limited to the transactions regarding such intellectual property rights, with copyright not being an issue. Such royalties were above the highest rates between non-related parties transactions, which were of 3% or 4% tops (according to Brazilian IRS tax assessments back then).

Since royalties were fully deductible as a necessary expense without any quantitative limitation, such abusive royalties were deducted and remitted abroad resulting in loss of tax revenues to Brazil since only the withholding income tax over royalties was being paid.

In this scenario Brazilian legislation limiting royalty deduction for income tax purposes was first enacted in 1958 (art. 74 of law 3.470/58) regarding only the licensing of patents, trademarks and know-how (technical assistance). Copyright was not included. Back then - and now - a major problem was how to establish reasonable royalty rates.

With the lack of a clear method or fixed regime in this regard, Brazil chose to establish a royalty rate cap of 5% for deduction for income tax purposes (since between non-related parties transactions, the royalty rates were of 3% or 4% tops). Such rate was subject to regulation according to its necessity to the country (and not to the company), a clear non-fiscal purpose. Another requirement was the prior registration of the agreements in the Brazilian Patent and Trademark Office4.

Ministry of Finance's Rule 436/58 ("MF Rule 436/58") was enacted in this regard according to President Juscelino Kubitschek economic plan (Plano de Metas) and the goal of import substitution. Technologies necessary to develop Brazilian heavy industries were higher than others and trademarks were at the minimum rate of 1% since they do not add any technology to the country. MF Rule 436/58 has a non-fiscal (regulatory taxation) purpose and it has never been changed since then (only the inclusion of few new activities/technologies, such as information technology and, by IRS rulings, franchising and cultivars).

Such tax problem soon has become a balance of payments between the early 1960's and 1991 (Law 4.131/62), since royalties from group companies could not be deducted or remitted with the transfer of technology being a kind of performance requirement (technologies for free) for foreign companies investing in Brazil.

In the 1960's new tax provisions were enacted establishing the non-deductibility of royalties between companies and its partners (art. 71, sole paragraph, d of Law 4.506/64). While scholars and taxpayers always considered such provision limited to individuals, the Brazilian IRS wrongly insists (by reading the provision alone) that legal entities are also included.

In our view the non-deductibility of necessary expenses for fiscal purposes (even in transactions between related parties) is unconstitutional. Only in case of non-fiscal purposes and if observed the substantive due process of law requirement, it could be considered constitutional.

Also, the non-deductibility of royalties between companies and its partners shall not be interpreted alone, but jointly with other provisions and according to our historic analysis where patent, trademark and know-how royalties between Brazilian affiliate companies and its foreign parent companies were the ones resulting in abusive tax planning. An interpretation claiming that only these royalties are now deductible (while licensing from minority shareholders are not) is absurd and contrary to several other tax administrative court decisions against such limitation regarding e.g. copyright royalties, being also clearly against Brazil's goal to foster R&D&I of its companies (regarding transactions between Brazilian companies).


1 Câmara Superior de Recursos Fiscais – CSRF.

2 There is a discussion if such restriction also applies to CSLL, but this was not part of the trial.

3 Royalties are amounts due for the licensing of intellectual property rights. They are established as a percentage of the revenue of the products manufactured and sold by the licensee.

4 Back then, except the know-how one.

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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