Originally published in the April 20 edition of World Tax Daily (Copyrights Tax Analysts)
In a majority vote, Brazil’s Supreme Court (STF) on March 25 held that a restriction created in 1995 that limits the use of net operating losses to offset up to 30 percent of corporate taxpayers’ taxable income is not in violation of Brazil’s Constitution.
The decision (Extraordinary Appeal 344994), which was summarized April 3 in the judiciary official gazette, is important because it may end a dispute initiated more than a decade ago.
The STF upheld a decision of the Federal Regional Appellate Court for the 4th Region,1 which had ruled in the government’s favor.
Articles 42 and 56 of Law 8,981/1995 limit corporate taxpayers’ ability to use 100 percent of existing NOLs to offset taxable income in a given year and reduce the corporate income tax and 9 percent social contribution on net income (CSL).
Previously, taxpayers had been able to carry forward NOLs to reduce all taxable income in subsequent years, but unused NOLs expired within five years after being generated. No NOL carryback was allowed.
Under Law No. 8,981/1995, NOLs no longer expire, but they can only offset up to 30 percent of a taxpayer’s taxable income in a given year. In other words, for each BRL 1 of taxable income, BRL 0.70 of the corresponding tax must be paid in cash even if the taxpayer has NOLs.
The NOL use restriction became effective for taxable income generated on or after December 31, 2004. However, as soon as the restriction was put in place, taxpayers started challenging its constitutionality.
The most common argument was that Brazil’s Constitution guarantees that income tax and CSL will be levied only on “true” taxable income, free of any past NOLs. A restriction on the full use of NOLs in a given year results in the levy of income tax and CSL on artificial taxable income improperly inflated because of the partial deduction of NOLs, critics contend.
That is a violation of the constitutional concepts of profit and taxable income, which require that only the company’s profit (not artificially inflated) be subject to corporate income tax and CSL, they say.
The STF got involved in 2004 when Justice Marco Aurelio Mello voted in favor of the taxpayer, but only for the calendar year that ended on December 31, 1994 (the year the NOL use restriction was created). At that time, five other STF justices disagreed with Mello’s position and voted in favor of the government.
In the March 25 session, Justice Ellen Gracie argued that the use of NOLs against taxable income is a tax “favor” granted by the government that can be limited to any extent possible as established by law. And the law, according to Gracie, allows for NOL use restrictions to any extent — against 10 percent, 20 percent, 30 percent, or even 100 percent of taxable income.
Gracie’s opinion was favored by four other justices in the same session, resulting in a 10-1 vote upholding the constitutionally of the NOL use restriction established by Law No. 8,981/1995.
The STF’s decision — at least for now — is binding only on the relevant disputing parties, but no one can deny that it will provide a strong precedent for lower courts reviewing similar cases.
Tax practitioners contend that the decision did not cover all the arguments normally raised by taxpayers in the dispute. Further, they say the argument that the constitution prohibits taxation of artificially inflated profits was not subject to the Court’s review in the relevant case. They have said they will attempt to raise that argument before the STF in other cases in an effort to reverse the unfavorable precedent.
FOOTNOTE
1 The Federal Regional Appellate Court for the 4th Region has appellate jurisdiction for federal cases tried in the southern states of Rio Grande do Sul, Santa Catarina, and Paraná.
END OF FOOTNOTE
David Roberto R. Soares da Silva