As the world moves through a pandemic, it would seem rather anti-climactic to debate tax reform in Brazil, or transfer pricing (TP) and other aspects of Brazil's accession to the OECD, as well as any themes that are not related to COVID-19 relief measures. However, it would not be an overstatement to posit that the most powerful stimulus package the Brazilian economy can receive to face the downturn caused by the global pandemic is precisely the enactment of much-needed structural tax reforms, ranging from consumption taxation to business profits, and tackling domestic and international tax issues.
In this Brazil Special Focus by ITR, a series of relevant articles are offered covering topics that are very significant for any multinational and any firm doing business in Brazil. Two of the overarching topics addressed in this issue have received substantial coverage in local media, and some international coverage: tax reform (often with the meaning of consumption tax or VAT reform), and TP reform (often with the meaning of convergence to OECD standards through the adoption of the OECD TP Guidelines).
A note of caution
This foreword is offered with a note of caution – any predictions and views offered in this guide as thoughtful and insightful as they may be, are entangled in an environment of great uncertainty – greater than usual. Not only because any tax reforms are inherently uncertain. Not only because Brazil's accession to the OECD is as much a technical challenge as a political issue. Not only because Brazil is still Brazil. And not only because of the global pandemic and its uncertain effects on tax policy and administration everywhere. But mainly because Brazil is maturing into a vibrant democracy also for tax policy design, wherein tax changes are no longer enacted overnight through provisional measures edited by the revenue service, but where the legislative branch is a leading actor in tax policy and the main author of tax reform.
Brazil's legislative branch is increasingly as diverse as Brazilian society. Left and right are broadly represented, as are Brazil's diverse geographies and interest groups. Agribusiness, industry and extractives, the financial sector, the service sector, are all represented, as are civil servants and labour unions. As one would expect, interests are often not aligned with detailed tax policy choices, be it in a domestic context or concerning international matters.
Brazil is living through a new state-building paradigm in tax policy design. Prior to 2018, Brazil's system of checks and balances was grotesquely broken by the corruption schemes famously uncovered by the Federal Prosecution Service (Ministério Público) and Federal Police. The executive branch and the legislative would align in non-republican ways, in a form of government euphemistically referred to as "presidency by coalition". Federal tax policy would be designed by the revenue authorities (Receita Federal do Brasil), often with a revenue-raising bias; and would often find its way to enactment into law through the legislative process, irrespective of technical merits or issues, without a proper, public debate.
Now it is as if Brazilians are in a 'tea-partyesque' mode: "no taxation without representation", as it goes in America. Congress is now taking the lead in redesigning the system, as it should, and the debate is now more public than before. That is, the general public is now engaged in the tax policy debate, and this is making the entire process, and the reforms that are being designed, more legitimate. Nonetheless, this is a new environment for Brazil, navigating through uncharted waters (although following a course familiar to other nations, we are doing it in Brazil). Hence, the evolution and the mechanics of shaping legislation in respect to all tax reform matters, as well as the precise content of tax reforms, be it on VAT and excise taxation, corporate tax, or international tax, is still highly uncertain.
What is certain, however, is that reforms will take place. There is a broad political consensus that Brazil's tax system hurts Brazilians and insulates the Brazilian economy, and therefore must change. There seems to be consensus that the system is particularly unjust and regressive. There seems to be consensus that reforms that are pro-business, pro-investment, and pro-growth are in order (this consensus should become certain given the economic downturn caused by COVID-19). In fact, the 2018 elections resulted in a loosely configured centre-right pro-growth alignment between Congress and the Presidency, somewhat similar to the environment observed in the US prior to the enactment of the Tax Cuts and Jobs Act (TCJA) of 2017. This makes a pro-business tax reform virtually certain.
Federal and state budgets, however, are still unbalanced. The Brazilian public sector is massive; budget deficits persist irrespective of the very significant social security reforms enacted since 2019. Social security reforms and, in particular, the restructuring of civil servants' pensions and benefits schemes represented the first critical step to revert the economic crisis that plagued Brazil in the wake of the Great Recession and that is still here. A much broader administrative reform is still needed to reduce and streamline the Brazilian public sector, which is yet to occur alongside a massive privatisation programme. Without a broad administrative reform that addresses such fiscal imbalances, however, no pro-business tax reform should yield significant tax cuts to the Brazilian economy.
That is, the political choice now seems to be first and foremost one of simplifying the Brazilian tax system, facilitating compliance and administration, reducing uncertainty, and ideally reducing the number of taxes. It is possible that a reduction of consumption-based taxation may be implemented, if it is offset by an increase of personal income taxes (and property or wealth taxation), which would serve as a very sustainable stimulus to economic growth. Increased consumption caused by reduced consumption taxes, leading to increased investments and to increased employment, would be a much-needed pro-growth tax reform in Brazil. It would, however, pose administrative challenges and increase risks of collections, given that that the personal income tax base is not as broad as consumption, and that personal taxation relies more heavily on voluntary, self-assessment. Hard to count, therefore, on such fundamental change to Brazil's tax system in the short term, but perhaps the reforms will pave the way for such transformational change. Corporate and business taxation should decrease, nonetheless, as perhaps would payroll taxes, while the risk of reintroduction of a broad-based financial transaction tax still exists, to keep budgets in balance.
Consumption and income taxation
There are two broad categories of consumption tax reform in debate, one more prevalent than the other. The more prevalent category would advocate in favour of a complete overhaul of the system through a constitutional amendment, to phase-out multiple federal, state and local taxes, and to phase-in a new, yet truer, value-added tax (VAT) or Imposto sobre Bens e Serviços, IBS (literally, goods and services tax, GST) and a new excise tax (Imposto Seletivo, IS). There are two main constitutional amendment proposals (PEC) leading the charge, one in the lower house (PEC 45/2019) and one in the Federal Senate (PEC 110/2019).
PEC 45/2019 would replace federal levies PIS/COFINS and IPI, state levy ICMS, and municipal levy ISS, by a new, single, centrally collected federal IBS/VAT, and by a new federal excise tax IS (highly selective, on goods with negative externalities), over a 10-year transition period for taxpayers. A single IBS rate of 25% would be targeted, yet such a rate would only be feasible if all existing industry and regional effective rate differences (and incentives) embedded in the current system could be eliminated, which is quite a political challenge. The new IBS would be a broad-based, full-credit VAT system, under a 'destination principle' – rigorously, a more perfect VAT.
As proposed, states and cities could determine their own rate within a given 'band' – this would be intended to preserve their autonomy as members of the federative union (this implies, however, multiple rates, at most one for each of the 5,570 cities in Brazil). State governments have conditioned their political support of PEC 45/2019 to their control of the new administrative body that would administer the IBS (taking such control away from the federal government); alternatively they have also signaled their support of a 'dual system', whereby the federal government would administer a new federal IBS and federal excise tax (replacing PIS/COFINS and IPI), while the states and municipalities would administer a new state IBS (replacing ICMS and ISS).
This counter-proposal by states of a dual system, while supportive of PEC 45/2019, is also broadly aligned with statements by the federal government as to their intended reform plans (a phased approach, whereby federal taxes would be reformed first into a new IBS, paving the way for state and local taxes to be replaced later). PEC 45/2019 is the leading proposal and tends to incorporate and be reconciled against the terms of PEC 110/2019 from the Federal Senate. Some important differences exist, as PEC 110/2019 would include more taxes and a different transition term, and a broader excise tax. It should be noted that Brazil is indeed a federative state and it does not have state and local income taxes, as do other federative countries. Instead, Brazil has federal, state and consumption taxes. This makes a reform that unifies all levies particularly challenging; imagine depriving California, New York, or a German state, or a Swiss canton, from their tax policy autonomy in respect to income taxation. This is the equivalent of limiting Brazilian states (and cities) in their tax policy autonomy in respect to consumption taxation. Note: the ICMS tax is the biggest revenue raiser in Brazil, while cities and states are currently disputing their claims over revenues arising in the digital economy.
The less prevalent category of consumption tax reform in debate, which has not materialised into proposed laws, would advocate in favour of a significant overhaul of the system through infra-constitutional law changes without the introduction of new taxes. Instead of introducing one or two new IBS levies, and a new IS, that would coexist with the current system for 10 years or more, the alternative proposal would be to reform the existing levies, with the same broad objectives of the broader reforms. That is, PIS/COFINS would be reformed into a true federal VAT, while IPI would have a reduced scope and turn into a highly selective excise tax. Infra-constitutional legislation governing ICMS would create a unified code for all states to reform their systems, thereby also transforming the ICMS into a truer VAT (e.g. broad-based, full credit system, less discrepancies among states) modelled from the European Union's VAT Directive.
Perhaps a combination of measures would need to be taken, particularly in light of the very long transition terms for the inception of a new IBS system (whether single or dual). The old system would need to be reformed anyway, along the lines of the infra-constitutional reforms advocated by some sectors and commentators. Some assurance as to the liquidity of existing credits accumulated by taxpayers must be embedded in the reforms, if not a full transferability of credits from the old to the new IBS system. In any case, any unification of rates would raise up sectorial issues. Some sectors will end up with a reduced burden on revenues and sales (e.g. industrial products, and others), while others will end up with an increased burden (e.g. services and food). Consumers should benefit as should the broader economy in the long run, as relative prices would likely change and adapt to the new reality (e.g. the price of utilities, energy, telecommunications should decrease alongside industrial products, while the price of consumer services and some food items would increase). Nonetheless, in the short term, the impact of such relative price changes may be felt through increases to food prices and perhaps real estate rents, which is rather regressive.
The regressive features of the current system became evident in the reform debate and are highlighted in the short term by the prospect of increases to food prices. As such, the consumption tax reform debate unfolding creates a necessary pressure for the reform of personal income taxation, and payroll taxation. Brazilian payroll taxes are among the highest in the world. Therefore a compensatory measure to tackle the potential increase in food prices and rent may be the reduction of Brazil's payroll burden, which should at least partly translate into wage increases. The rate schedule of personal income taxes is also under scrutiny. Lower income, wage earners would need to have their personal income taxes reduced, to compensate for the most regressive facets of Brazil's consumption tax system, particularly if increases to food prices and rent are expected.
The debate over Brazil's taxation of business profits is also at the forefront. Numerous proposals exist to reintroduce a withholding tax on dividends. The political appeal of such reforms is the argument that profits earned by capitalist investors are exempt from taxation. Two of these proposals have gained momentum recently in the Federal Senate, Project of Law (PL) 1,952/19 and PL 2,015/19, seeking to reintroduce a dividend withholding tax at 15% without a corresponding decrease to corporate tax rates. The timing of such income tax reform proposals is not coincidental, as the consumption tax reforms have reignited the debate of how regressive the Brazilian system is.
Brazil's corporate income tax rate of 34% (40% for the financial sector, soon to be increased to 45%), however, was designed to replace a classical double-tax system, so that all business profits are taxed at the corporate level, and not at the shareholder level. That is, dividend distributions are exempt because business profits are subject to a high-enough tax rate at the corporate level. Furthermore, Brazil's corporate tax rate under the current system was originally set in 1995 at approximately 30.5%, which was perceived as competitive and inducive to investments, considering the OECD average at the time and the 35% US federal rate in force until 2017. Right or wrong, later increases to 34% still considered the US rate of 35% as a benchmark. Having a competitive corporate tax rate is relevant to foster investments particularly in the manufacturing sector and especially in export-oriented industries.
Higher corporate tax rates may overburden reinvestments of retained earnings, especially if designed to replace and substitute shareholder-level taxation. If a new withholding tax on dividends of 15% is to be reintroduced, it would be coherent to reduce the corporate tax rate to 20%, as the author defended in public hearings in the Federal Senate. Nonetheless, reintegrating the personal income tax system not only for inclusion of dividend distributions in the personal income tax base, but also to revamp base definitions, and perhaps to create higher income brackets beyond the relative low top rate of 27.5%, may enable a tax cut to lower income brackets, which may be necessary to enable the consumption tax reforms being debated (unless a broad-based financial transaction tax is reintroduced, which would be a mistake). While the debates seem separate, they are in fact one and the same.
Given all that is happening in respect to domestic tax reforms, all aspects of international reforms (which are also much needed) are not the most pressing priorities. OECD accession in all its tax aspects, transfer pricing convergence, taxation of services and royalties, the adequacy of Brazil's tax treaty policy and administrative practices, are absolutely critical issues to be addressed by tax policymakers, but this will only occur after the main critical items of domestic tax reform are resolved.
Numerous reforms to international provisions are indeed critical. Brazil's broad system of high withholding taxation under domestic law may be useful for non-treaty countries and are certainly useful against harmful tax practices by opaque jurisdictions. However, such systems should be widely changed under bilateral tax treaties. It is not sensible for Brazil to overtax transactions with treaty partners, by imposing high withholding on all gross payments, as opposed to enforcing permanent establishment taxation and transfer pricing under the arm's-length principle. As it is not sensible for Brazil to adopt a full-inclusion rule (TBU) with respect to active profits earned by its multinational companies abroad, it should instead take controlled foreign corporation (CFC) best practices targeting passive income only.
Reforming transfer pricing, TBU/CFC, and withholding taxation policies, as well as administrative practices under tax treaties for dispute resolution (mutual agreement procedures (MAP) and even arbitration) can be powerful reforms to increase foreign and domestic investment in Brazil, to increase productivity, and to enable Brazil's participation in global value chains. All this, however, will only take the forefront in the tax policy debate after the domestic reforms find their way through Congress. Even then, contrary to historical practices, it will not be up to the tax administration to dictate the terms of international reforms.
As much technical input as the OECD or Receita Federal provide on such highly technical issues, it will be necessary for wider stakeholders within the government to be involved as these international tax matters relate to broader trade and economic policies. There is clearly a mandate for OECD accession to be achieved during this first presidential term, but these reforms may well go beyond OECD requirements for accession and may take a life of their own as national interests (and bilateral relations) are considered and play out. As it is happening with domestic tax reform, it is expected that the legislative branch, lower house and the Senate, will get deeply involved in the design of international tax reforms.
|Romero J S Tavares|
+55 11 3674 2880
Romero J S Tavares is the lead international tax services (ITS)/transfer pricing (TP) partner at PwC Brazil and is a part of the PwC global team on tax policy and administration.
He is an international tax attorney and tax policy consultant with a career spanning 26 years (10 of which were in the US and Europe). He has served as a tax policy advisor to Brazil's Confederação Nacional da Indústria (CNI) since 2012, and has been heavily engaged in Brazil's OECD accession. While on his mid-career academic sabbatical in Austria, he received his PhD from the Vienna University of Economics and Business, worked as a professor, and also served as a tax policy advisor to the World Bank Group.
In addition to his PhD, he holds a master's degree from the University of Detroit, and has attended postgraduate programs at INSEAD, Leiden, and Harvard Law School.
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