Overview on state tax controversies for the oil industry
Gustavo Brigagão and Bruno Lyra of Ulhôa Canto provide an assessment of state tax controversies related to Brazil’s oil industry.
This article was submitted in September, before the Supreme Court had rendered a decision which alters slightly some of the elements discussed here.
As per the Brazilian rules currently in effect, importations of goods into the country are subject to a wide variety of taxes: federal importation tax (II), federal tax on manufactured goods (IPI), federal social contributions on imports (generally referred to as PIS and COFINS), and the state tax on circulation of goods (ICMS). To attract investments for the Brazilian oil industry, during the late 1990s a special temporary admission regime named REPETRO was created covering both the federal and state taxes mentioned above. REPETRO is a more comprehensive customs regime, which includes other benefits in addition to the temporary admission regime. However, for objectivity purposes, we will simply refer to the temporary admission regime as REPETRO.
Regarding federal taxes, the aforementioned regime is fairly straightforward and, regarding its core elements, has not been the subject matter of much controversy over the years. That is not to say there have not been discussions between taxpayers and the authorities on a wide rane of issues including the time required to obtain the licence, the types of goods which may be entered into the regime and so on, but the general scope of the rules has remained unchanged and there is a certain level of comfort within the market regarding the application of the regime. Through such regime the taxpayer enjoys a full suspension of the relevant taxes as long as certain formal conditions are met.
Regarding the state REPETRO rules, the matter is substantially more complicated.
Indeed, a first element to be considered is that the current prevailing understanding of the Brazilian Supreme Court is that ICMS can only be charged on importations that imply a transfer of ownership.
On the other hand, any temporary admission regime necessarily implies that the owner of the imported item is located abroad and therefore that the ownership of the good was not transferred to the Brazilian importer. These circumstances would lead any reasonable reader to the conclusion that such regime would be irrelevant for ICMS purposes, since said tax could not be demanded under such circumstances regardless of any additional benefits.
Notwithstanding the logic of the conclusions above, the tax authorities continue to demand ICMS on importations regardless of whether transfer of ownership is verified or not, based on the argument that the Supreme Court is re-analysing its former position issued less than a decade ago (which is, in fact, true, although the new vote currently stands favourably for the taxpayer).
Having surpassed the preliminary matter above, the current state REPETRO rules (which, unlike the federal REPETRO rules, have had several substantial changes in scope over the years, but have remained relatively stable since 2007) are set forth in Agreement (Convênio) 130/07 and, in summary, establish the following benefits:
Exemption (the general rate for ICMS is 18%) or taxation at a 1.5% rate (the state entitled to the tax may unilaterally choose which of the two it prefers) for goods destined to be used in the exploration phase;
Taxation at a 3.5% rate, without the right to any input credits, or at a 7% rate, with the right to input credits (the state entitled to the tax may unilaterally choose which of the two it prefers) for goods destined to be used in the production phase; and
Exemption or taxation at a 1.5% rate (the state entitled to the tax may unilaterally choose which of the two it prefers) for goods destined to be used in the "interconnected use between the exploration and production phases", as long as they only remain in national territory for a period not exceeding 24 months.
The first major problem related to the current state REPETRO rules refers to the scope of application of item iii) above. Indeed, there is absolutely no definition in the Brazilian legislation of "interconnected use between the exploration and production phases".
Despite the lack of clarity of the expression, it is the understanding of the authors that the only reasonable conclusion would be that it refers to what is defined in the Brazilian regulatory legislation as the "development stage".
Indeed, as per the Brazilian Oil Law (Law n. 9,478/97) the development stage is defined as the "different activities and investments destined to make the production of oil viable". Still according to the regulatory rules in effect in the country, the development stage is considered the initial mark of the production phase.
If, for legal purposes, there are only two phases in the oil extracting activities (exploration and production) and the development stage is the absolute first step in the second phase, it is a natural conclusion that a "development stage" is what connects (or interconnects) both phases.
The conclusion above is equally reached based on the values that the REPETRO was created to uphold. Indeed, the basic idea behind the REPETRO rules is to reduce the tax burden on investments in the oil industry, doing so in such a way that a larger tax cut is given to activities regarding which the investor is acting under a great deal of risk (which would be the case of the exploration phase, during which there is no certainty whether oil will be found at all).
In the development stage, although there is certainty of the existence of oil in the relevant area, the investor is still verifying whether extraction of such oil is viable (both from a practical and financial perspective). Hence, since the investor is still acting fully at its own risk (without any extraction of oil being performed), it is reasonable that the same level of benefits granted to the exploration phase would be applied.
Notwithstanding the arguments above (which are seen as indisputable by the authors of this article as well as by the absolute majority of Brazilian scholars), the tax authorities of several Brazilian states have adopted a different interpretation, in the sense that, to enjoy the relevant benefits, the imported goods would have to be used in both the exploration and the production phases (in a cumulative manner).
In addition to this not being in line with a literal interpretation of the REPETRO rules ("interconnected" cannot be seen as the same as "cumulative"), it would imply that the taxpayer knows, at the moment of importation, whether or not the exploration activities it is performing will result in actually finding oil, which is obviously impossible. Also, considering the time limit of 24 months, representatives of the oil sector have clearly demonstrated that the benefits would be virtually inapplicable to any practical situation.
Regardless of the wide variety of counter-arguments, the tax authorities continue to stand by their position and the matter will have to be settled by the Brazilian judicial courts, which have not yet issued relevant precedents on the matter.
Another issue related to the state REPETRO rules refers to the state entitled to collect the ICMS due on importation.
Regardless of the REPETRO rules, this is an extremely controversial matter in Brazilian law, which has been dealt with in a previous article published in the International Tax Review ("What taxpayers need to know about ICMS compliance in Brazil", published on February 21 2011).
In summary, for general purposes, the prevailing understanding is that ICMS on importations is due to the state in which the establishment that is ultimately responsible for the importation of the goods is located, that is to say, where the true acquirer of the imported object is located, therefore deeming the place of customs clearance or the physical receiver of the goods to be absolutely irrelevant.
This conclusion is reached based on constitutional provisions and, therefore, cannot be changed as a result of rules of a lower hierarchy.
However, the aforementioned Agreement 130/07 (which is undeniably of a lower stature than the Brazilian Constitution) created specific rules regarding the state entitled to charge ICMS under the REPETRO rules. In summary, according to the relevant agreement:
i) ICMS is due to the state in which "economic use" of the imported good occurs; and
ii) if the first state in which "economic use" of the imported good occurs does not charge the tax (which is to say, if it chose to provide exemption for goods destined to the exploration phase or "interconnected use"), said tax may be charged by the second state in which "economic use" occurs.
Regarding item i) above, although "economic use" is one of the elements set forth by the Supreme Court to establish where the "true importer" of the goods is located, other issues are also to be taken into consideration (such as which entity negotiated the importation, where the contracts were signed and so on). Hence, there may be cases in which one state will claim the ICMS amounts based on the constitutional provisions while another will claim the corresponding value based on Agreement 130/07.
Although the constitutional grounds should ultimately prevail, substantial litigation will most likely be required (the case will probably only be settled in a definitive manner by the Brazilian Supreme Court).
Hence, a general recommendation would be to try to avoid, whenever possible, having the importer ("true acquirer") in a different location than that of the "economic use".
Regarding item ii) (the possibility of a second state charging ICMS), its provisions are absolutely unconstitutional, regardless of the criteria used to interpret said provisions.
Indeed, if seen as a designation of the authority to charge ICMS, such rule could never be set forth by a mere agreement, especially considering the existence of constitutional rules in the contrary.
If the relevant rule were seen as an attempt to establish a new tax-triggering event for ICMS purposes, such rule would be equally invalid, since the cases in which such state tax can be levied are specified in the Federal Constitution in a detailed manner.
Despite the absence of conclusive case law on the matter, the unconstitutionality of the relevant rule seems clear and has even been informally admitted by representatives of the state government in academic conferences and similar events.
The focus of this article is merely to bring to the attention of the reader some of the main controversies surrounding the state REPETRO rules in Brazil. If any reader is currently applying the rules discussed in this article, a specific review by a Brazilian specialist is recommended to avoid risks.
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Gustavo Brigagão is a senior partner at Ulhôa Canto Advogados. He is a professor of postgraduate courses at Fundação Getúlio Vargas, a General Council member of the International Fiscal Association (IFA), secretary-general of the Brazilian Branch of IFA, director of institutional relations of the Centre of Law Firm Studies (CESA), vice president of the British Chamber of Commerce (Britcham), and head of the Legal Committee of Britcham.
Av. Presidente Antônio Carlos, 51 - Centro
Rio de Janeiro – RJ – CEP 20020-010
Bruno Lyra is a partner at Ulhôa Canto Advogados. He is a professor and teaches postgraduate courses at Escola Superior da Advocacia (ESA), as well as being a director of the Brazilian Branch of IFA, a member of the Central Committee of the Young IFA Network (YIN), and a member of the Legal Committee of the Brazilian Bar Association in Rio de Janeiro (OAB-RJ).