Brazil: Tax Treaty Series: The Bilateral Income Tax Treaty Between Brazil And Mexico

This is the fifth of our series of posts on Brazilian tax treaties. In each post we 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 6,000, published on December 27, 2006, contains the text of the Bilateral Income Tax Treaty signed by Brazil and Mexico ("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 generally 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"). In particular, though, the Treaty with Mexico establishes in Article 24 that the principle of non-discrimination between the tax treatment of Brazilian and Mexican nationals/residents applies to all federal taxes labeled as "impostos", not only the ones applicable to income. We discuss the application of this Article in further detail below.

With regard to CSLL, this tax is not expressly mentioned in the Treaty. However, recent Law 13,202/2015 clarifies that Bilateral Income Tax 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 the 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 is generally based on the OECD Model Convention available at the time (2003), as well as on Brazilian tax treaty practice after 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 Mexico and vice-versa. Specifically:

  • For dividends received by a beneficial owner resident in a Contracting State, the maximum WHT is (a) 10% if the beneficial owner is a legal entity that owns at least 20% of the voting stock of the payor, or (b) 15% in all other cases.

    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 generally set at 15%. However:

    (1) Interest arising in a Contracting State and paid to the Government of the other Contracting State, including any of its political subdivisions, or to its Central Bank, or to any financial institution exclusively owned by this Government, or owned by a political subdivision thereof, is exempt from WHT in the first Contracting State – except if the interest is classified under item (2) below.

    (2) Interest from obligations, bonds or debentures issued by the Government of a Contracting State, or by a political subdivision thereof, or by its Central Bank, or by any financial institution exclusively owned by this Government, shall only be taxed in this Contracting State.

    (3) Interest received by a pension or retirement fund certified by a Contracting State may only be taxed in this State if the recipient is the beneficial owner of the interest and if its income is generally exempt from income taxes in this State.

    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 15%. In all other cases (including payments for technical services and technical assistance), the maximum WHT rate is 10%.3

    Under current Brazilian Law, royalties paid to foreign recipients (including payments for technical services and technical assistance) are subject to a WHT of 15%.4
  • 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%.5 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 an 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

The Treaty with Mexico is similar to the majority of Brazilian tax treaties in the sense that it uses the expression "beneficial owner" in Articles 10, 11 and 12, but it is different from other treaties because it contains (sparse) references to the meaning of "beneficial ownership". These references are:

(1) Paragraphs 7, 9 and 7 (respectively) of Articles 10, 11 and 12: these provisions state that if the main purpose of the receipt of dividends, interest and royalties is obtaining a benefit under the Treaty, no treaty benefit shall be granted – domestic legislation becomes applicable.

(2) Paragraph 1 of Article 28: provided that competent authorities from both Contracting States agree to do so, they shall deny treaty benefits to a particular person or operation, if, in the opinion of these authorities, granting treaty benefits would be an abuse of the object and the purpose of the Treaty. Unlike the provisions in item (1) above, this denial would seem to require a prior formal agreement between Contracting States.

(3) Paragraph 5 of Article 28: if a taxpayer is denied treaty benefits under item (2) above, or if a taxpayer is subject to the application of thin capitalization or controlled foreign company ("CFC") rules because its relevant operation is devoid of sufficient business purpose, the taxpayer may still be able to claim treaty benefits if it presents to the tax authorities evidence that none of the main purposes of the operation was obtaining a benefit under the Treaty.

Although unfavorable to taxpayers in light of their degree of discretion, these provisions are in line with the recommendations of the OECD in Action 6 of its BEPS Action Plan.6

Finally, it is important to highlight that the Treaty with Mexico contains other provisions that limit the granting of treaty benefits. These are associated with the level of taxation imposed on the income of the person claiming them, as provided by Article 28, paragraph 2:

(1) If the income is exempt from tax in a Contracting State in which the beneficial owner is a resident, or if the income earned by this resident is subject, in this Contracting State, to a tax rate lower than the tax rate applicable to the same line of income earned by other residents of this Contracting State that do not benefit from this exemption or tax rate, then treaty benefits shall not be applicable.

(2) If the income earned by a beneficial owner resident in a Contracting State is subject to a deduction, refund, or other grant or benefit, which is related directly or indirectly to this line of income, which is not a foreign tax credit and is not applicable to other residents of this Contracting State, then treaty benefits shall not be applicable.

In a sample case, if a Mexican company receiving royalties from a Brazilian payor is subject to a domestic "tax sparing" credit for these royalties, or to any other kind of tax benefit other than the foreign tax credit granted under the Treaty, the WHT rate of the Treaty, of 10%, will no longer apply. The applicable rate will be the domestic WHT rate on royalties, which is 15%.

Tax sparing

Like the majority of Brazilian tax treaties signed after 2000, the Treaty with Mexico does not contain any tax sparing clause. The credit system in Brazil and Mexico is therefore based on the actual WHT imposed on each transaction.7

Income derived from technical assistance and technical services

In accordance with Item 6 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.

Application of Article 24 to all federal taxes labeled as "impostos"

Unlike its counterpart in the majority of Brazilian tax treaties, Article 24, paragraph 5 of the Treaty with Mexico states that the principle of non-discrimination shall apply to all federal taxes labeled as "impostos" (and therefore not only to income taxes per se). In other words, Brazil may not discriminate Mexican nationals/residents – nor Brazilian entities controlled by them or Brazilian permanent establishments of Mexican entities – strictly on the basis of nationality/residence for purposes of the following taxes (in addition to IRPJ, IRPF, WHT and CSLL):

  • Federal Excise Tax on Manufactured Products ("IPI");
  • Federal Import and Export Taxes ("II" and "IE");
  • Federal Taxes on Credit, Foreign Exchange, Insurance, Bonds/Titles, and Gold as a Financial Asset or Foreign Exchange Instrument ("IOF/Credit", "IOF/FX", "IOF/Insurance", "IOF/Bonds/Titles", and "IOF/Gold");
  • Federal Tax on Rural Properties ("ITR"); and
  • Federal Wealth Tax ("IGF"), if ever enacted.

In general, Brazilian tax treaties only require the application of the non-discrimination principle to income taxes. This modified clause is a feature of the Treaty with Mexico and only ten other treaties (Austria, Belgium, Denmark, Finland, France, Japan, Luxembourg, Portugal, Spain and Sweden).

Interaction with Brazilian CFC rules

In 2013, a binding decision issued by the Federal Supreme Court ("STF") in ADI 2588/DF defined that Brazilian 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 the absence thereof) to impose CFC rules.

Article 28, paragraph 3, of the Treaty with Mexico specifically allows both countries to impose CFC rules. This means that tax authorities may resort to the text of the Treaty to justify their assessment of IRPJ and CSLL on undistributed profits of Mexican subsidiaries, although taxpayers may challenge this assessment if the profits are earned by affiliated companies, in accordance with the binding precedent of STF.

Administrative and judicial case law

To date, CARF, STF and STJ have not issued any decisions on the terms of the Treaty with Mexico.

There is one decision of CARF, however, that references the Treaty with Mexico to support the argument that CFC rules do not apply to the undistributed profits of Dutch subsidiaries. The relevant part of this decision is commented below.

In Ruling 1103-001.122, the majority vote referenced Article 28, paragraph 3, of the Treaty with Mexico (which allows the application of CFC rules) to cancel the tax assessment of IRPJ on undistributed profits of Dutch subsidiaries. In accordance with the position of CARF in this case, if Brazil wished to apply CFC rules to Dutch subsidiaries, it could have stated this application in the treaty with the Netherlands, as it did with Mexico.8

BEPS highlights

Both Mexico 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 both of them, as well as the entire G20 community, 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 Mexico, we would like to highlight the following:

Hybrid Mismatches (Action 2)

The OECD has condensed two sets of recommendations into a final report on the subject of hybrid mismatches. These address (i) adjustments to domestic law and (ii) adjustments to existing tax treaties.9

Hybrid Mismatches (Action 2): Adjustments to Domestic Law

Though adjustments to domestic law are not within the scope of our comments in this Series, it is important to highlight that with regard to one type of "hybrid payment" for equity ownership, the Treaty already favors compliance of Mexico with OECD proposals.

Item 4 of the Protocol to the Treaty defines that interest on net equity ("JCP"), a "hybrid payment" deductible at source and generally regarded as dividends by the residence country prior to the BEPS Action Plan, should be regarded as interest for Treaty purposes. Therefore:

  • At source, JCP is calculated on the shareholder net equity accounts and limited to the pro rata die variation of the Long Term Interest Rate ("TJLP"). Deductibility of JCP is limited to the higher of the following amounts: (i) 50% of the net profits of the period before the deduction of JCP;10 or (ii) 50% of the sum of accumulated profits and profit reserves, without taking into account the results of the current period.

    The current WHT applicable to JCP is 15% (except for recipients resident in tax haven or "blacklisted" jurisdictions, who are subject to a WHT of 25% – this is currently not the case of Mexico).11

    If converted into Law in 2016, starting on January 1st, 2017, Provisional Measure 694/2015 will require payors to limit JCP to the pro rata die variation of TJLP or to 5%, whichever is lower. It will also increase the domestic WHT on JCP to 18% (the Treaty rate of 15% should remain generally applicable to transactions before Mexican residents, however).
  • At residence, pursuant to Article 23, paragraph 1, item (a), of the Treaty, the Mexican recipient should be entitled to a foreign tax credit equivalent to the WHT imposed in Brazil (generally 15%, as described earlier). Please note that the actual foreign tax credit granted by Mexican tax authorities should be validated with Mexican counsel on a case-by-case basis.

    The literal application of the Treaty terms is in line with the recommendation of the OECD in this case, which would be for Mexico to include "hybrid payments" that have been deducted at source. Since Mexico already regards JCP as interest, provided that its tax treatment of this payment under domestic law is not more beneficial than the treatment under the Treaty, the country (and therefore the Treaty) is already in compliance with this proposal of the OECD in Action 2 of the BEPS Action Plan.

Hybrid Mismatches (Action 2): Adjustments to Existing Tax Treaties

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,12 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).

Unlike the majority of Brazilian tax treaties (which resolve residence challenges in favor of the "place of effective management"), Article 4th, paragraph 3, of the Treaty between Brazil and Mexico, already contains a provision in line with the recommendation of the OECD.

Also, according to the OECD,13 "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 Mexico (possibly through a Multilateral Instrument) may affect WHT reductions, which may be partially denied if the person ultimately receiving the income is not a resident from Mexico, or vice-versa.

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.

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.14

At this stage, it is difficult to forecast whether Brazil will sign up or not for a Multilateral Instrument containing this proposed clause. The Treaty with Mexico, however, is already in line with the recommendations of the OECD in Action 6 of the BEPS Action Plan (as we described above, it already contains elements of the PPT proposed by the organization).

  • 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,15 (ii) the publication of decisions on treaty issues for the benefit of taxpayers,16 and (iii) a commitment to mandatory arbitration (which, admittedly, is not a consensus among G20 countries).17

Article 25 of the Treaty with Mexico 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 Mexico, 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 1st of Interpretive Declaratory Act SRF 01/2007.

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

5 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.

6 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.

7 Foreign tax credits are allowed in Mexico if the source country has with Mexico a bilateral treaty for the exchange of information with a "broad scope". Both countries view the Treaty with Mexico as a treaty establishing an exchange of information with a "broad scope". See Article 26 of the Treaty.

8 See CARF. Ruling 1103-001.122. First Section, First Chamber, Third Ordinary Group. Session of October 21, 2014. Published on March 31, 2015.

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

10 The net profits for purposes of item (i) are calculated after the deduction of CSLL and prior to the deduction of the IRPJ provision.

11 See Article 9th, paragraph 2nd, of Law 9,249/1995.

12 See note 8 above. OECD: 2015, pp. 137-138.

13 See note 8 above. OECD: 2015, pp. 139-143.

14 See note 6 above. OECD: 2015, pp. 21-69.

15 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.

16 See note 14 above. OECD: 2015, p. 17.

17 See note 14 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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