Brazil: Tax Treaty Series: The Bilateral Income Tax Treaty Between Brazil And South Korea

This is the third of our series of posts on Brazilian tax treaties. In each post we will provide an overview of a specific tax treaty between Brazil and a particular foreign country, as well as comments on any Brazilian administrative or judicial precedents applying the treaty, and highlights on the impact of the OECD Base Erosion and Profit Shifting ("BEPS") project in its application.

Overview of the treaty

Decree 354, published on December 02, 1991, contains the text of the Bilateral Income Tax Treaty signed by Brazil and South Korea ("Treaty"). This Treaty is aimed at preventing double imposition and double non-imposition of income taxes in cross-border operations between the two countries.

For Brazilian purposes, as of December 09, 2015, the treaty applies not only to the Individual and Corporate Income Taxes ("IRPF" and "IRPJ") and to the Withholding Income Tax ("WHT"), but also to the Social Contribution on Net Profits ("CSLL").

With regard to CSLL, this tax is not expressly mentioned in the Treaty, because it was created after its signature, and as a partial replacement of IRPJ. In addition, recent Law 13,202/2015 contains an article clarifying that double taxation treaties signed by Brazil include CSLL:

Art. 11. For purposes of interpretation, the international agreements and conventions signed by the Government of the Federative Republic of Brazil to avoid double taxation include CSLL.

(...)

Please note that our reference to Withholding Income Tax ("WHT") in the next paragraphs does not describe the entire tax burden imposed on certain income streams, such as royalties, for example. Other taxes may be imposed on cross-border royalty payments (such as the Special Tax on Royalties ("CIDE"), the Municipal Tax on Services ("ISS") and the Tax on Foreign Exchange Transactions ("IOF-FX")), but because these taxes do not qualify as "income taxes", they are outside of the scope of the treaty.

The Treaty was generally based on the OECD Draft Convention available at the time (1977, with amendments), as well as on Brazilian tax treaty practice prior to 2000. Key aspects of this Treaty from a Brazilian perspective are:

Source taxation

Dividends, interest and royalties earned are generally subject to WHT in Brazil and to a WHT credit in South Korea and vice-versa. Specifically:

  • For dividends paid by a resident of South Korea and received by a beneficial owner resident in Brazil, the maximum WHT is 15%.

    If the remittance of dividends is made by a resident of Brazil to a beneficial owner resident in South Korea, the maximum WHT drops to 10% (the Treaty rate is reduced from 15% to 10% by Interpretive Declaratory Act 03, published on March 20, 2006). The same rate is applicable to the payment of dividends (or branch profits) by a permanent establishment of a Korean resident entity.

    A tax sparing credit may be available for the Korean recipient as well as for the Brazilian recipient of dividends (see below). In Brazil, the tax sparing credit may be used to offset applicable IRPJ and CSLL.

    Under current Brazilian Law, dividends paid to Brazilian or foreign recipients are exempt from WHT.1

  • For interest received by a beneficial owner resident in a Contracting State, the maximum WHT is 10%, if the recipient is a bank and if the loan is granted for a minimum term of 07 (seven) years, related with the purchase of industrial equipment, or with the study, acquisition or installation of industrial or scientific units, or with the financing of public works. In all other cases, safe for the two sets of exceptions below, the maximum WHT is 15%.

    A tax sparing credit may be available for the Korean recipient as well as for the Brazilian recipient of interest (see below). In Brazil, the tax sparing credit may be used to offset applicable IRPJ and CSLL.

    For interest received in the following situations, an exemption or non-imposition of WHT may be available:

    Interest arising in a Contracting State and paid to the Government of the other Contracting State, including its political subdivision or local authority, or to the Central Bank of this State, or to any branch (even a financial institution) completely owned, either directly or indirectly, by this Government, by the Central Bank, or by both, is exempt from WHT in the first Contracting State.

    Interest from obligations, bonds or debentures issued by the Government of a Contracting State, including its political subdivision or local authority, or by the Central Bank of this State, or by any branch (even a financial institution) completely owned, either directly or indirectly, by this Government, by the Central Bank, or by both, shall only be taxed in this Contracting State.

    For interest received by a beneficial owner who has a permanent establishment in the source country, if the receipt of the interest is related to the activities of this permanent establishment, the remittance is exempt from WHT.

    Under current Brazilian Law, interest paid to foreign recipients is subject to a WHT of 15%.2

  • For royalties derived from trademark use, the maximum WHT rate is 25%. In all other cases (including payments for technical services and technical assistance), safe for the exception below, the maximum WHT rate is 10% (the Treaty rate is reduced from 15% to 10% by Interpretive Declaratory Act 03, published on March 20, 2006).

    A tax sparing credit may be available for the Korean recipient as well as for the Brazilian recipient of royalties (see below). In Brazil, the tax sparing credit may be used to offset applicable IRPJ and CSLL.

    For royalties received by a beneficial owner who has a permanent establishment in the source country, if the receipt of the interest is related to the activities of this permanent establishment, the remittance is exempt from WHT.

    Under current Brazilian Law, royalties paid to foreign recipients (including payments for technical services and technical assistance) are subject to a WHT of 15%.3

  • Capital gains, differently from the OECD Model Convention, are taxable in both Contracting States, and there is no WHT limitation in the Treaty. The only exception is Article 13, paragraph 2, which determines that gains obtained from alienation of ships and aircrafts are taxable only in the country where the headquarters of the company are located.

    Under current Brazilian Law, capital gains obtained by foreign residents (not located in a tax haven) are subject to a WHT of 15%.4 Source taxation is applicable even in case of non-resident seller and buyer – in this case, the buyer is required to withhold the corresponding amount, nominate an attorney-in-fact in Brazil and cause this attorney-in-fact to collect the WHT due.

    There is intention to increase the WHT from 15% to 22.5% according to the most recent version of the law project proposed by the Government to the Brazilian Congress. This bill, if approved, will be enforceable as of the following calendar year.

Beneficial ownership

Though the expression "beneficial owner" is mentioned in Articles 10, 11 and 12 of the Treaty, the treaty does not define what "beneficial ownership" means (only in recent treaties Brazil has acquiesced to a specific Limitation on Benefits clause, and only in broad terms).

Brazilian tax authorities view the absence of a treaty definition of "beneficial ownership", as is the case with the Treaty between Brazil and South Korea, as a permission for tax authorities of the State applying the treaty to interpret the expression as they see fit. This position is supported by Article 3rd, paragraph 2, of the Treaty, which states:

Article 3rd, Paragraph 2: For the application of this Treaty by a Contracting State, any term not defined herein shall, unless the context otherwise requires, have the meaning that it has at that time under the law of that State for the purposes of the taxes to which the Convention applies.

Tax sparing

The Treaty contains a tax sparing clause, which is a treaty provision that requires South Korea to grant tax credits at a deemed WHT rate for specific payments made by Brazilian residents and vice-versa (many of the Brazilian tax treaties that contain tax sparing clauses benefit residents of the other Contracting State, but the Treaty with South Korea has a clause applicable to payment streams coming from either Contracting State).

Tax sparing credits are usually greater than the WHT rates applicable under the treaty or domestic law. In the Treaty with South Korea, they are:

  • For dividends, a tax sparing credit of 25%. If the dividends are actually profits paid out of permanent establishment profits, a tax sparing credit of 20% shall apply.
  • For interest and royalties not derived from trademark use, the tax sparing credit is of 20%.

Income derived from technical assistance and technical services

In accordance with Item 4 of the Protocol of the Treaty, income derived from technical assistance and technical services is regarded as royalties (Article 12) for Treaty purposes.

This classification is important because Brazilian taxpayers have challenged the imposition of WHT on payments for services to recipients resident in Treaty countries (at the time, Germany and Canada), claiming that the business profits provision of the corresponding agreements (Article 7th) would prohibit taxation at source. The landmark case on this subject, REsp 1161467/RS, was decided in 2012 by the Second Chamber of the Superior Court of Justice ("STJ"), and it was favorable to taxpayers.

Nonetheless, Interpretative Declaratory Act 05, issued on June 16, 2014, by the Federal Revenue Secretariat of Brazil ("RFB"), states that if "income derived from technical assistance and technical services" is regarded as royalties in any particular Treaty, its treatment shall be the one attributed to royalties (Article 12), and not to business profits (Article 7th). Besides, RFB has adopted a very broad concept of "technical services", considering as such any services in which the provider needs "skills, technique and training".

The issue of whether RFB exceeded the limits of its interpretive authority by issuing an Interpretive Declaratory Act that effectively restricted the scope of a court decision by STJ (albeit a non-binding one) is yet to be resolved.

In the meantime, strict compliance with treaty provisions and domestic law would indicate that "income derived from technical assistance and technical services" should be subject to a WHT of 15%, the domestic WHT rate applicable to payments of royalties and technical services.

Interaction with Brazilian CFC rules

In 2013, a binding decision issued by the Federal Supreme Court ("STF") in ADI 2588/DF defined that Brazilian Controlled and Affiliated Foreign Company ("CFC") rules could apply to controlled foreign companies in blacklisted jurisdictions ("tax havens") and could not apply to affiliated foreign companies out of blacklisted jurisdictions.

Among the questions not answered by STF in the 2013 decision is whether controlled foreign companies in Treaty countries would be exempt from CFC rules. Decisions issued by STJ and by the Administrative Court of Tax Appeals ("CARF") have already dealt with this subject, mostly in favor of the taxpayers, but STF is yet to confirm that position from a constitutional perspective.

While STF does not issue a final ruling on this subject, Brazilian tax authorities rely on references in the text of treaties (or on the absence thereof) to impose CFC rules. Though there are treaties that either exempt undistributed profits (such as our Treaty with Denmark) or dividends (such as our Treaty with Spain), our Treaty is not a part of that group. Safe for a systematic interpretation of Article 7th, there is no provision in the text of the Treaty between Brazil and South Korea that would prevent the application of Brazilian CFC rules.

Administrative and judicial case law

There is one administrative precedent applying the Treaty (to date, STJ and STF have not issued any decisions on the terms of the Treaty with South Korea). Please find a detailed description of this precedent below:

In Ruling 2201­-002.074, a Brazilian resident individual spent the year of 2001 working in South Korea, and because this individual earned income in Korea, a Korean Income Tax was imposed. The individual then filed an Individual Income Tax ("IRPF") return in Brazil and required a tax credit for the Korean Income Tax paid, but that credit was denied by tax authorities. CARF ruled in favor of the Brazilian individual, claiming that Article 23, paragraph 1, of the Treaty mandated that the Federal Revenue of Brazil must give a tax credit up to the maximum percentage of applicable IRPF (up to 27.5%).5

BEPS highlights

Both South Korea and Brazil (respectively a member and an associate country of the OECD) have actively participated in the drafting of the final reports for the 15 Actions of the Base Erosion and Profit Shifting ("BEPS") project. The two countries have distinct tax systems and tax treaty networks, but the OECD expects that Brazil, South Korea, and all the other G20 countries are able to implement BEPS proposals in a consistent and seamless manner.

Among the BEPS aspects associated with the application of the Treaty between Brazil and South Korea, we would like to highlight the following:

Hybrid Mismatches (Action 2)

The OECD proposals on treaty issues associated with hybrid mismatches are mainly focused on two separate areas: (i) treaty residence of dual-resident entities; and (ii) a clarification of the entitlement to benefits of transparent entities.

According to the OECD,6 tax authorities should be able to decide, on a case-by-case basis, the State of residence of so-called dual-resident entities (entities that either by virtue of treaty provisions, domestic law, or a combination of both, are regarded as resident in two separate jurisdictions). If tax authorities are not able to reach an agreement, the taxpayer would not be entitled to any treaty benefit (except for the ones agreed upon by competent authorities of both States).

In the Treaty between Brazil and South Korea, the clause that would have to be modified (or overridden) for this proposal to become effective is Article 4th, paragraph 3, which currently (i) favors the default jurisdiction of the place of effective management, and (ii) allows case-by-case decisions, but does not claim that the lack of an agreement would prevent access to treaty benefits (unlike our Treaty with Turkey, for example, that contains this final statement).

Also, according to the OECD,7 "income derived by or through an entity or arrangement that is treated as wholly or partly fiscally transparent under the tax law of either Contracting State" should be regarded as "income of a resident of a Contracting State", but only to the extent that the income is treated, for purposes of taxation by that State, as the income of a resident of that State.

The inclusion of this proposal in Article 1st of the Treaty between Brazil and South Korea (possibly through a Multilateral Instrument) would affect not only WHT reductions (which could be partially denied if the person ultimately receiving the income is not a resident from South Korea), but also the entitlement to tax sparing credits, established in Article 23, paragraph 2, as explained earlier.8

Entitlement to Treaty Benefits (Action 6)

The final report of Action 6 recommends the adoption of an "Entitlement to Benefits" clause, inspired by the Limitation on Benefits clause present in the United States Model Income Tax Convention.9

The purpose of the new "Entitlement to Benefits" clause would be to prevent granting treaty benefits to persons that should not be entitled to them, either because doing so is not in the interest of either Contracting State, or because the relevant taxpayer has employed a structure completely devoid of economic substance for the sole or main purpose of enjoying protection under the treaty. The proposed clause is divided into a set of objective and subjective criteria (the "principal purpose test", or PPT section), and if its text is included in the Multilateral Instrument of Action 15, taxpayers wishing to enjoy treaty benefits must comply with both criteria.10

At this stage, it is difficult to forecast whether Brazil will sign up or not for a Multilateral Instrument containing this proposed clause. Remember that the majority of Brazilian treaties either (i) do not have a Limitation on Benefits clause, but do mention the expression "beneficial owner", or (ii) have a Limitation on Benefits clause that is significantly broader than the already quite broad proposal issued by the OECD. Would Brazil be willing to relinquish its all-encompassing interpretive power of "beneficial ownership" in favor of a streamlined clause that would supersede provisions in all of its existing treaties? As implementation of BEPS proposals goes on, Brazilian policymakers will be compelled to provide a clear answer to this question.

Effectiveness of Dispute Resolution Mechanisms (Action 14)

The OECD has proposed a number of adjustments not only to the text of Article 25 of tax treaties in existence, but to the application of its terms by Contracting States around the world. According to the OECD, a minimum standard for Dispute Resolutions would include (i) a commitment to the timely resolution of treaty disputes,11 (ii) the publication of decisions on treaty issues for the benefit of taxpayers,12 and (iii) a commitment to mandatory arbitration (which, admittedly, is not a consensus among G20 countries).13

Article 25 of the Treaty with South Korea is, in general terms, a feature of the totality of tax treaties signed by Brazil. It does not compel Brazilian tax authorities to reach a decision on the claim presented by the taxpayer, nor does it require that this resolution, if reached, is communicated in a timely fashion. Brazilian tax practice with Dispute Resolution Mechanisms is virtually non-existent: anecdotal evidence points to either a blatant disregard for requests for the application of Article 25 or to formal communications stating that the position of Brazilian Law is not subject to debate before treaty partners. Implementation of BEPS, therefore, will possibly show whether Brazil is willing to modify its historical position of indifference or deficient application of Article 25.

For further comments on the application of the Treaty between Brazil and South Korea, please do not hesitate to contact our firm.

(*) With the collaboration of our associate Lucas de Lima Carvalho (lcarvalho@tozzinifreire.com.br)

Footnotes

1 See Article 10 of Law 9,249/1995.

2 See Article 28 of Law 9,249/1995.

3 See Article 3rd of Provisional Measure 2,159-70/2001.

4 See Article 685, item I, of Decree 3,000/1999 (Income Tax Regulations, or "RIR/99"). See also Article 21 of Normative Instruction RFB 1,455/2014.

5 See CARF. Ruling 2201­002.074. Second Section, Second Chamber, First Ordinary Group. Session of April 16, 2013. Published on May 24, 2013.

6 OECD. Neutralising the Effects of Hybrid Mismatch Arrangements, Action 2 – 2015 Final Report. OECD/G20 Base Erosion and Profit Shifting project. OECD: 2015, pp. 137-138. Available at: (http://dx.doi.org/10.1787/9789264241138-en).

7 See note 6 above. OECD: 2015, pp. 139-143.

8 The final report provides an example that illustrates the interplay between hybrid mismatch rules and a tax sparing clause, such as the one in the Treaty between Brazil and South Korea, in the proposed item 26.7 to the OECD Commentary: "[Brazil] and [South Korea] have concluded a treaty identical to the Model Tax Convention. [Brazil] considers that an entity established in [South Korea] is a company and taxes that entity on interest that it receives from a debtor resident in [Brazil]. Under the domestic law of [South Korea], however, the entity is treated as a partnership and the two members in that entity, who share equally all its income, are each taxed on half of the interest. One of the members is a resident of [South Korea] and the other one is a resident of a country with which [Brazil] and [South Korea] do not have a treaty. The paragraph provides that in such case, half of the interest shall be considered, for the purposes of Article 11, to be income of a resident of [South Korea]." In this example, only half of the interest received would be associated with a tax sparing credit of 20%, in line with Article 23, paragraph 2, of the Treaty.

9 OECD. Preventing the Granting of Treaty Benefits in Inappropriate Circumstances, Action 6 – 2015  Final Report. OECD/G20 Base Erosion and Profit Shifting project. OECD: 2015, p. 11. Available at: (http://dx.doi.org/10.1787/9789264241695-en).

10 See note 9 above. OECD: 2015, pp. 21-69.

11 OECD. Making Dispute Resolution Mechanisms More Effective, Action 14 – 2015 Final Report. OECD/G20 Base Erosion and Profit Shifting project. OECD: 2015, pp. 15-16. Available at: (http://dx.doi.org/10.1787/9789264241633-en).

12 See note 11 above. OECD: 2015, p. 17.

13 See note 11 above. OECD: 2015, p. 41.

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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