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Brazil’s Supreme Federal Court rules on CFC regime


Mauricio Pereira Faro
Barbosa Müssnich & Aragão

As has been widely reported in the specialised media, Brazil's Supreme Federal Court recently decided Direct Action for Declaration of Unconstitutionality (Ação Direta de Inconstitucionalidade – ADI) no. 2588, which challenged the application of income tax and the social contribution on net profit (contribução social sobre lucro líquido – CSLL, a kind of income surtax) to income earned by controlled and related foreign companies. Although the reasons for decision in ADI n. 2588 have not yet been released, it can already be said that the Supreme Federal Court has put an end to some controversies, but that some questions remain open.


The taxation of income earned by controlled and related foreign companies has become an increasingly important question as Brazil's economy develops, since a growing number of Brazilian businesses now have investments in foreign companies that constitute a relationship of control and/or affiliation.

Some countries within the Organisation for Economic Co-operation and Development (OECD) have adopted the controlled foreign corporations (CFC) taxation model to prevent abuses, such as the deferral or non-payment of taxes on earned income, without, at the same time, undermining the competitiveness of businesses that invest abroad.

In Brazil, taxation of controlled foreign corporations was dealt with by Law 9532 of 1997, which quite correctly linked payment of tax to the effective legal and economic availability of the income subject to taxation.

However, this system was radically changed when Provisional Measure 2158-35 was issued in 2001. Article 74 of the Provisional Measure established that income from controlled and related companies becomes subject to tax at the time the profit is shown on their balance sheets, regardless of whether the income is actually made available to the shareholders.

Furthermore, Complementary Law 104/2001 added a new paragraph two to article 43 of the National Tax Code, providing that profit is subject to income tax and the social contribution on net profits (CSLL) at the time it is earned in Brazil, regardless of whether the profit is actually distributed to the shareholders.

Supreme Federal Court judgment

ADI no. 2588 was brought by the National Confederation of Industries (Confederação Nacional da Indústria) to challenge the constitutionality of article 74 of Provisional Measure 2158-35. In particular, the confederation disputed the application of income tax and CSLL as of the date of the balance sheet on which the income is shown, arguing that the taxes should apply only when profits are effectively distributed.

In addition to ADI no. 2588, the Supreme Federal Court also judged Appeals no. 611.586 (filed by the Coamo Agroindustrial co-operative) and no. 541.090 (filed by the federal government).

The judgment session began with ADI no. 2588, which had been pending before the court since 2001, with nine justices of the court (many no longer sitting) having voted on the action.

The chief justice of the Supreme Federal Court, Justice Joaquim Barbosa, who was the last to vote, held that the action was well-founded in part. According to Justice Barbosa, when interpreted in accordance with the Federal Constitution of 1988, article 74 of Provisional Measure 2.158-35/2001 only applies to the taxation of legal entities domiciled in Brazil whose controlled or related companies are located in tax havens, that is, countries that offer favourable taxation, without sufficient corporate and tax controls. The result of the judgment in the case remained pending however, because it was not clear whether any of the decisions given by the various judges had achieved an absolute majority of six votes.

Before Justice Barbosa issued his decision, four judges – Marco Aurélio, Sepúlveda Pertence (retired), Ricardo Lewandowski and Celso de Mello – had voted in favour of granting the ADI, while another four – Nelson Jobim (retired), Eros Grau (retired), Ayres Britto (retired) and Cezar Peluso (retired) – took the position that the action should be dismissed. The judge responsible for reporting on the case, Ellen Gracie (retired), had issued a decision granting the action in part, finding that the inclusion of the words "or related [companies]" in the initial part of article 74 of Provisional Measure 2.158-35/2001 was unconstitutional.

Thus, after more than a decade of controversy over the issue, the judges of the Supreme Federal Court finally ruled on Direct Action for Declaration of Unconstitutionality no. 2588 and declared, by a majority of six, that the rule under article 74 of Provisional Measure 2.158-35/2001, which provides that income tax and CSLL attaches to the income of controlled and related foreign companies as of the date of the balance sheet on which the income is shown, applies to controlled companies located in tax havens, but not to related companies that are located in countries that are not tax havens. This decision is binding on all lower courts and on the departments and agencies of the executive branch of government.

The judges of the Supreme Federal Court also held that the retroactivity provided for in the sole paragraph of article 74 of Provisional Measure 2.158-35/2001 was unconstitutional. The paragraph provided that "profit earned by a controlled or related company on or before December 31 2001 will be deemed to have become available on December 31 2002 unless, prior to that date, any of the events in which profits become available under applicable legislation have occurred."

On this point, the Supreme Federal Court made it clear that retroactivity does not operate for either controlled or related companies, regardless of whether they are domiciled in a tax haven.

However, the court did not achieve a majority on two other important questions raised in the action: the application of article 74 to controlled companies that are not in tax havens and to related companies that are located in tax havens.

Although the judges of the Supreme Federal Court did not attain the majority needed for a definitive decision on the taxation of controlled companies outside tax havens in ADI 2588, the issue was also addressed in the judgment of Appeal 541.090. This judgment, however, only produces binding effects with respect to the parties involved in the litigation.

In Appeal 541.090, the controlled companies were located in China, Italy and Uruguay, and for that reason chief justice Joaquim Barbosa, reporting on the case, found in favour of the taxpayer, since the foreign companies were not located in tax havens and the tax audit did not reveal any lack of business purpose or tax evasion. According to Justice Barbosa, the literal terms of article 74 of Provisional Measure 2.158 are not enough to support taxation.

Justice Teori Zavascki disagreed with the reporting justice and decided to grant the federal government's appeal in part, finding that the taxation of controlled companies is constitutional, even if they are not located in tax havens. In Justice Zavascki's opinion, the taxation provided for in article 74 of Provisional Measure 2.158 is simply taxation on an accrual basis, with early application of income tax, which has existed in Brazil for some time with respect to foreign branches and offices of Brazilian companies; article 74 does not more than extend the same treatment to controlled and related foreign companies.

Justices Rosa Weber, Dias Toffoli, Carmen Lúcia and Gilmar Mendes concurred with Justice Zavascki, and Justices Lewandowski, Marco Aurélio Mello and Celso de Mello concurred with reporting justice Joaquim Barbosa. The outcome, by five votes to four, was that the Supreme Federal Court held that article 74 of Provisional Measure 2158 is constitutional with respect to the taxation of income originating in controlled foreign companies, even if they are not located in a tax haven. Only the sole paragraph of the article was held to be unconstitutional because it violates the principle prohibiting retroactive effects.

The justices then briefly debated the application of treaties to avoid double taxation made between Brazil and various other countries, in order to determine whether, in such cases, the rule under article 74 would give way to the provisions under the tax treaties, which provide (in article 7), that income is taxable only in the countries where it was effectively produced.

Although some of the judges of the court expressed their opinion on the issue, most decided that the matter should be appreciated first by the relevant court of second instance (the Fourth Region Federal Appeals Court in this case) before being judged by the Supreme Federal Court. The Fourth Region Federal Appeals Court had not considered the application of tax treaties because it had held that article 74 was unconstitutional.

Only nine of the 11 justices took part in the judgment of Appeal 541.090, since Justice Luiz Fux had recused himself because he had taken part in judgment of the appeal before the Superior Court of Justice, and no one had yet been named to replace Justice Ayres Brito, who had retired a short time before.

Importantly, the Supreme Federal Court's decision on taxation of income from controlled companies located in countries that do not have favourable tax regimes under Appeal 541.090 was not issued pursuant to article 543-B of the Civil Code of Procedure, which provides that decisions by the Supreme Federal Court in appeals determined to have general repercussion are universally binding. Accordingly, the lower courts and departments and agencies in the executive branch are not required to comply with the decision in Appeal 541.090.

Although the reasons for decision in ADI 2588 and Appeal 541.090 have not yet been published, the results of the judgment session strongly suggest that the Supreme Federal Court, in a panel composed of all its 11 judges, will return to the issue of taxation of foreign income in order to come to a definitive decision on whether profits produced by controlled companies located outside tax havens and by related foreign companies are subject to taxation in accordance with article 74 of Provisional Measure 2158.

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