Originally published in the August 3 edition of World Tax Daily (Copyrights Tax Analysts)
In an unprecedented decision, a Brazilian court of appeals on June 4 ruled that service payments remitted to Canada, and before 2006 to Germany, are not subject to Brazilian withholding tax because the payments qualify as business profits under Brazil’s income tax treaties with those countries.
The decision,1 delivered by the Regional Federal Court of Appeals for the Fourth Region, was the first ruling on the issue at the judicial appellate level, although the withholding tax on service payments remitted abroad has been a subject of debate between taxpayers and Brazil’s Federal Revenue Department for more than a decade.
The main argument used by the taxpayer, and accepted by the court, is that service payments should fall under the definition of business profits as established in the OECD model income tax treaty and in many tax treaties signed by Brazil, including those with Canada and Germany.2 Under the business profits clause, service income should be considered as business income and, in accordance with the applicable tax treaties, should be taxed only in the country where the recipient is located. That interpretation eliminates Brazil’s jurisdiction to tax service payments to some treaty countries.
The court rejected the interpretation of the business clause in Brazil’s tax treaties offered by the Department of General Coordination of Taxes (COSIT).3 In Normative Act 01 of January 5, 2000, COSIT issued a controversial ruling stating that service payments remitted abroad should be governed by the treaty article dealing with “other earnings,” for which the applicable withholding rate is 25 percent.
COSIT said the 25 percent withholding tax applied to payments abroad for any service agreement under which technical assistance or technical services are provided with no transfer of technology to the Brazilian party and for which no registration is required with the Brazilian patent office or the Central Bank of Brazil.
According to the appeals court, income earned by foreign companies from services rendered to Brazilians, under Brazilian tax laws, falls under the foreign service provider’s business profits. Because Brazil’s tax treaties state that such business profit is taxable only in the provider’s home country, COSIT’s interpretation is mistaken and it cannot treat service income as governed by the other earnings clause, the court said. Therefore, no tax can be withheld on service payments to Canadian and German service providers, it concluded. Similar rationale should apply to service payments to other jurisdictions with which Brazil has not only a tax treaty, but also a similar business profit clause, it said.
With a standard withholding tax rate of 25 percent for service payments, the court’s decision is significant. Because recipient companies cannot always take a credit for the Brazilian withholding tax, challenging the tax in court may become an attractive option.
Because Brazil does not have tax treaties with the United States, the United Kingdom, and, since 2006, with Germany, service payments to those jurisdictions are not (or are no longer) eligible for the withholding exemption.
The debate is far from over, however, as the government will certainly try to take it to higher courts, such as the Superior Court of Justice and the Supreme Court.
FOOTNOTES
1 Case 2002.71.00.006530-5, originally filed by Cia Petroquimica do Sul (COPESUL).
2 After failing to reach an agreement on terms for the renewal of the Brazil-Germany tax treaty, Germany decided to terminate the treaty, and on April 7, 2005, filed a termination notice with Brazil’s Ministry of Foreign Relations, effective from January 1, 2006.
3 The equivalent of the U.S. Internal Revenue Service.
END OF FOOTNOTES
David Roberto R. Soares da Silva