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COMMENT: Why Brazil must decide if its CFC rules are constitutional

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In 2001, President Cardoso enacted a provisional measure into the Brazilian Tax Code which introduced controversial controlled foreign corporation (CFC) rules in Brazil.

The measure states: “In regard to the tax base of income tax and social contribution on net profits, according to article 25 of Law 9.249/95, and article 21 of this Provisional Measure, the profits received by controlled and associated companies offshore will be considered available to the controlling or associated company in Brazil at the date in which they were accounted through balance sheet, in terms of this code”.

Ever since it was first introduced, the measure has been disputed by Brazilian companies on the grounds that it is unconstitutional.

The Brazilian Federal Revenue Service (RFB) is using the CFC rules to levy income tax on foreign profits of Brazilian multinationals even before such profits have been distributed to the Brazilian branch.

Taxpayers argue that this violates the constitutional concept of income for taxation purposes because it does not take into account the actual time at which these non-distributed profits are available to the Brazilian companies and their shareholders.

The dispute is making it difficult for Brazilian multinationals to compete in international markets.

The world’s second largest mining company, Vale, is disputing $14.8 billion of taxes and penalties with the RFB as a result of assessments made under the controversial CFC rules.

A claim regarding the unconstitutionality of the CFC rules filed by Brazil’s National Confederation of Industry has been taken to the Supreme Court, but following a split decision the trial was suspended.

Four of the Supreme Court judges which voted have since retired and a decision on the matter is now awaiting a new vote following an appeal submitted on March 16 2012.

Further confusion is arising from the RFB’s treatment of profits earned in countries with which Brazil has signed double tax avoidance treaties (DTTs).

Tax dispute cases involving Vale, drink distribution company Eagle, and a number of others, have all seen the RFB attempting to tax income (both active and passive) of controlled companies established abroad irrespective of whether DTTs are in place that should override Brazil’s CFC rules.

The Brazilian tax authorities are by no means alone in adopting an increasingly aggressive stance against international tax planning and treaty shopping.

But the approach they are taking is violating constitutional principles in Brazil and tax treaty provisions and international rules, such as those established in the OECD model convention.

By refusing to align with internationally accepted models of CFC taxation, the Brazilian authorities are creating an uncertain legal environment which is unattractive to foreign investors and harms the international expansion of its domestic companies.

The pending Supreme Court decision could rule that the existing CFC rules are unconstitutional, which would void these rules and require enactment of a new law. But there is presently no indication as to when this ruling will be made.

For the sake of Brazilian taxpayers, the ruling cannot arrive soon enough.

Further reading

Vale case could change the way Brazil taxes foreign profits

What to expect from the Suprem Court in 2012

How Brazil is reacting to international tax planning

Brazil: The current tax challenges for new and old investors

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