Taxation of royalties in Brazil:any redress for past grievances?

Denis Borges Barbosa (1994)

Forsome decades, Brazilian restrictive taxation upon patent and trademark royalties and technical fees preventedforeign investors and providers of technology to take full profit from their licensing with local parties, especially their own affiliates. Recent changes in the Brazilian laws, however,brought the country’s tax environment much to the same situation foreign investors may expect from their home countries. Some even hope that pastlosses of profits could be compensated under the new law.

This study provides for an overview of the Brazilian Tax System in regard to royalties and technical fees,stressing such points that may interest aforeign licenser whose home countryhas no double taxation treaty with Brazil - as it happens with the United Kingdom and United States.No specific analysis is, therefore, provided on the effects of the changes upon the treaty-covered payments.

TheBrazilian Tax System

The taxation of income, including royalty and technical fee income, 31 is covered by Federal Law 32. Other relevant taxes are the Federal tax on exchange and in some very restricted cases the municipal tax on services.

Income taxation on royalties and technical fees existed all over the relevant period, both as a corporate or individual levy and a withholding charge on various payments, including on payments effected to the benefit ofany person located abroad.For some periods, corporate taxation included a tax on profits, an additionaltax on distributed profits and a further supplementary tax on remittance of profits to a beneficiary located abroad.

Prior to 1958

After the 1958 Income Tax Law, some relevant provisionsof the Brazilian Law have a striking similarity with the comparable US Law, especially in which it regards to deductibility of expenses.In certain egregious cases, the Brazilian counterpart seems a literal translation of the US statute.

There were no special provisions in Brazilian Tax Law regarding royalties and technical fees before 1958. The exchange legislation, however,provided for detrimental exchange rates incases where profitremittances exceeded 10% over the registered capitalwithin the fiscal year 33, what seemed to encourage the remittances of profits as sundry expenses, specially royalties and technical fees.

The Brazilian IRS by 1958 concentrated the efforts of a special task force against such artificially beefed up remittances, as documented by the legal commentators 34 and by a remarkable decision by the Supreme Court 35, which statedthat the royalties and technical fees of the period, as remitted to the defendant’s parent companyseemedentirely disproportionate to the actual needs of the Braziliansubsidiary, mentioning that this was a pattern not uncommon at the time.

A study on the matter was requested by IRS from a well known Tax Law professor and attorney 36. The resultingproposal was included in the 1958 Income Tax Law 37and remains in force to date; it isincluded in the 1994 Income Tax Regulations (RIR/94) 38.

1958 rate limitations

Under the 1958 Law deductibility of royalties and technical fees are limited each year to a proportion of gross receipts according to the essentiality of the industry to national development. The deductible payments had a statutory limitation of five percent (or one percent in case of trademarks)butaccording to the Department of Treasury rules the actual level allowable to individual industries varies from the maximum five percent - as in the case of communication equipment- to musical instruments, which got the lower one percent allowance 39.

The original rules issued in 1958 were never revoked, and remain as official standards both for the period 1958-1970 (before the INPI review) and thereafter.However, its guidelines received a very restrictive application since 1970, when INPI started reviewing contracts, and were applied with more flexibility after 1993. A significant difference in approach, therefore,must be indicated to the 1970 criteria (when the 1958 rules were taken as a top limitation, almost never actually reached) and the later ones.

Takingas example the case of shaving or tooth cleaning articles, which were classified at the 2% level in 1958 Rules: from 1970 to 1990 INPI never allowed (to the best of our knowledge) any payments reaching that higheither for patent royalties or technical fees; more probably, authorizations, if any, would stand at the0.5 to 1% level 40.Therefore, it seems that any technology agreement (or technical assistance agreement, as the then official terminology would classify it) signed in May 1958 would be allowed a 2% level of fees for such shaving or tooth cleaning items until any extensions or amendments subject it to INPI review after 1970 41.In case there were, for instance,royalties for trademarks and technical fees over the same basis, the maximum allowed payment would not exceed the 2% level prescribed by the 1958 rules.

The 1962 restrictions

In September 27, 1962 entered into force the first inclusive foreign investment statute ever issued in Brazil 42. It ensured full repatriation and remittance of every financial and risk capital registered with the Federal agency charge (now, the Central Bank); it also regulated the purchase offoreign currency needed to effect payments abroad of royalties and services, including technical assistance. The essential items of the 1962 regulatory apparatuswere:

  • A supplementary income tax was assessed over any yearly remittances of profits and like payments in excess of12% ofthe registered capital;
  • No remittances of royalties for patents and trademarks from a subsidiary company or establishment to its parent abroad were allowed;
  • Remittances in connection with royalties (when otherwise allowed)service fees and other payments to beneficiaries located abroad are only effected by authorization from the Federal agency in charge;
  • Fees paid for technical assistance agreements after five years counting from the start up of a new industrial establishment or from the introduction of a new productive process are deemed to be undeductible, except by special authorization by the National Monetary Council.

It must be stressed that the absolute ban on licenses of the 1962 Law only prevented payments of royalties but not of service fees, including technical assistance;being primarily an exchange,not a tax provision, such prohibition amounted to a denial of official supply of convertible currency.However,those payments that could not be remitted also could not be deducted for income tax purposeseven if paid locallyto the benefit of the foreign payee43.

A further income tax provisionheld as beingdistributedprofit the payments for trademarks to the benefit of any person located abroad, parent company or not; that is to say,those payments could not be remitted to any person abroad, including the payer’s parent company, and though not remitted,they were taxed as profit at corporate rates,taxed again by a tax on distributed profits, and taxed a third time at withholding rates 44.

The supplementary income tax was imposed on any actual remittances abroad in excess of 12% of the average registered capital ofthe last three year period. The tax rate mounted from 40% to 60% of tax basis(remitted amounts)according to the level of excess payment, importing in an effective deterrence of profit (or profit equivalent 45) payments abroad, even in thosecases the payment was otherwise allowed 46.

All those exchange and tax provisions were consistently enforced by the Federal Government. From 1962 on, the agency in charge began screening all license or technical assistance contracts before authorizing remittances abroad. This jurisdiction was eventually transferred to INPI after 1970.

The 1964 Tax Law

The 1964Tax Law introduced a new standard of deductibility for payments of services and technical assistance 47.Confirming the restrictions set by the 1958 and 1962 Laws, it also held as undeductible the paymentsfor technical assistance due by a subsidiary company in Brazil to its parent abroad.

From 1964 on, therefore, both royalties for patents and trademarks and technical fees were held as undeductible whenever paidto parent companies abroad; no restriction whatsoever was imposed either by that law or by the ensuinglegislation to the payment of services (other than technical assistance) effectivelyrendered.

The INPI era

From1970 on, the screening of contracts dealing with trademarks, patents, technical assistance and technical services other than technical assistance was transferred from the Central Bank and IRS to the INPI. The tax and exchange authorities retained the power to check on the performance of the contracts 48, but due deference was granted to the technical expertise of the Contracts Directorate of the Patent Office 49.

INPIalmost from start refused registration to contracts providingfor payments between a subsidiary in Brazil and its parent company abroad, whenever the indicated tax restrictions existed 50.The Central Bank practice supported such a policy.

Particularly from 1979 to 1990,INPI screening jurisdiction employed a substantive analysis, considering:

  • The availability of alternate sources of the same technology within the country;and
  • The nationalneed of the technology (as distinct from firm’s private requirements).

INPI ‘s Contract Directorate was staffed all the time by civil servants trained in economics;technical advice whenever required was provided by the patent examiners, outside technical consultants and by the industry-related institutions, what ensured an emphasis on the macroeconomics or at least on anindustry sectorialperspective.

The 1971 Industrial Property Code

The 1971 Code introduced some provisions that practically excluded royalty payments for trademarks as a measure of substantive Law 51.Apart of the exchange and tax provisions alreadymentioned,the Code disallowed any payments for trademarks that had been registered in Brazil without the benefit of the priority provided for by Paris Conventions and for those registered for more than ten years.

The restrictions as an authorized act of Government

Thelegal restrictions to the payment of royalties andother fees, such as technical service fees, from a controlled subsidiary in Brazilto a foreign parent during the years atissue were indicated in the previous section.The question now under analysis is whether those restrictions were an authorized act of Government.

All over the period 1958-1990 Brazil was under a Constitutional rule of some nature. The 1946 Constitution ruled from 1958 to 1967;1967 Constitution was voted by Congress, even though under the Military Government that took power in 1964;in 1969, the First Constitutional Amendment,promulgatedby a Military junta,preserved the basic constitutional structure,although somewhat restricting the bill of rights. The current 1988 Constitution is an instrument fully democratic as to origin, kind and practice.In no moment during the relevant period taxpayers were deprived of administrative and judicial protectionor the tax, exchange or regulatoryauthorities exempted from the dueprocess of law requirements.All relevant statutes were the result ofCongressionalelaboration.

INPI’s practicein connection with contract screening withstoodSupreme Court review as to legality and constitutionality 52although the requirement of submitting said contracts to the agency for tax deductibility purposes (a different legal issue)was sometimes questioned in Federal and Administrative TaxCourts53.To our knowledge,the restrictions related to the payments from a controlled subsidiary to a foreign parent during the years at issuewere neverheld unconstitutional by any court of record.

As mentioned, the restrictions resulted from initiatives of the Brazilian IRS and were appliedregularly, without exceptions or discriminations and within the boundaries of the law.Either during 1958-1962 period, when the quantitative restrictionswere enforced by IRS alone, or during the 1962-1970period , when the exchange authorities started an ex ante examination of contracts to enforce the parent remittance restriction,or during the later period, when INPI tookjurisdiction,the restriction was applied as a mandatory, non discretionary measure.

Some restrictions directed to license or technical agreements during the period under analysis, especially in the INPI era, were discretionary in nature, albeit never arbitrary 54.However,the parent remittance provision was never administered on a discretionary fashion. Only non-technical assistance agreements (for instance, equipment assembly contracts) were allowed between parent and subsidiary duringmost of the period 55.

The scope of the restriction

The parent remittance provision, as introduced by the 1962 Law was both an exchange and a tax rule, whereby remittances of royalties for patents and trademarks from an establishment or a subsidiary in Brazil to its parent abroad were not allowed and payments not remitted were undeductible.By the profit equivalent doctrine (see infra 14) the payments of royalties whenever undeductiblewere deemed to be distributed profits and taxed as such, including for the purposes ofthe supplementary income tax. By the 1964 Tax Law, also the technical assistance payments to a parent company abroad were held to be undeductible.

No parent remittance restriction was generally enforced as to service contracts other than technical assistance contracts, although these agreements were from 1970 on, especially between 1982 and 1990, subject to a local availability rule. Under Central Bank practice until 1992, undeductible payments could not be registered as foreign capital; therefore, such amounts, in case they were paid into capital of a Brazilian Corporation would not be utilized as repatriation or remittance basis.

Parent control level

The question now is whether the restriction applied to only those foreign parents owning 50% or more of the subsidiary. This is a quite complicated issue.

The 1962 Law 56restricted payments to parent companies abroad in the followingcases:

  • when the payment should be effected to the principal office located abroad of a company established in Brazil;
  • when the payment should be effected by a company located in Brazil to its parent company located abroad;
  • When the majority of the capital of the company effecting the payment was held by the persons entitled to receive the payments abroad.

As already stated, the 1962 provisions were both exchange and income tax rules.

The 1964 Tax Law 57had a different wording. Royalty and technical assistance payments were undeductible:

  • when they are paid by the establishment in Brazilof a company with headquarters abroadto the benefit of its parent office;
  • When paid by a corporation with headquarters in Brazil to a person domiciled abroadthat holds direct or indirect control of its voting capital.

The 1964 Tax Law did only revoke the tax provisions of the 1962 Law; therefore, prior standards remained applicable as to the exchange aspects of the payments, whereas the new standards were to be applied to the tax aspects of the same payments.

That is a very important issue, as Executive Order 55.762/65, which provided for the regulations to the 1962 Law after the 1964 Tax Law defined as restricted only those payments effected to a foreign company holding more than 50% of the voting capital of the payer.

INPI practice, probably reflecting prior IRS and Central Bank practice,was to consider a slightly modified version of the 1964 standard as applicable, thus rejecting payments to those persons holding directly or indirectly more than 50% of the voting capital of payer 58.The test as to the direct or indirect clause was howevermore or less inclusive depending specially on the information available.

Under INPI standards, the secondor third tier controlling shareholder would be prevented from receiving royalties or technical fees from its Brazilian subsidiary, provided that at each tier the 50% test was applicable. The extension of such criteria to joint controlled corporations or other related corporate affiliates was always contingent on the obviousness of the relationship or on the conspicuous nature of the agreement itself 59.

We have indicated in a prior section on thederegulation oflicensing and technical assistance agreementsthat there has been an easing of the restriction in years subsequent to the years at issue. This change included the revocation of the supplementary income tax on remittance of profits,what was closely intertwined with parent remittance restrictions by reason of the profit equivalent doctrine 60.

The changes also provided for revocation of the restriction on deductibility and remittances of royalties and technical assistance fees and the lowering of withholding taxes to 15%, the level applicable to almost all double taxation agreement in force with Brazil 61.Only the contracts signed after December 31, 1991 are benefited by the new legalstandard, what may or may not prevent any retroactive effects, depending on the INPI practice 62.

As the recent 1993 INPI rules 63purport eliminating all restrictions as to prices,contract period or the content of the technology, the new agreements shall certainly follow such lead to provide for corporate standard or arm’s length,market level payments.

However, as the tax statutes as they remain in force do notprovide full support to INPI self-initiated deregulation, and all restrictions not revoked are in force, it must be anticipated that foreign owned Brazilian companies shall as a rule refrain from exceedingly high contract payments on individual licenses or contracts.

The deregulation of licensing

The new Federal Administration inaugurated in 1990 started a deregulation process in the Brazilian economy that in due time impacted into the tax, exchange and regulatory aspects of the licensing of industrial property rights and of the provision oftechnical assistance.

The Resolution 22 issued by INPI in 1990indicated a complete turnaround as to INPI policies toward the contracts brought to its analysis.The contract prices were subjected to new, less strict quantitative limitations than those established in 1958 rules, albeit no statutory authority could be indicated for such changes.The national-interest standards previously applied also gave place to a more private oriented criterion.Normative Act 122, issued by INPI in December 22, 1993 practically eliminated the remaining screening administered by the agency.

But the restrictions imposed by the 1962 and 1964Laws were only addressed at a statutory level by the 1991 Income Tax Law 64 , which allowedroyalty and technical fee payments from Brazilian establishments and subsidiaries of foreign companies to their controlling shareholders abroad.The same law revoked the Supplementary Income Tax provisions of the 1962 Law 65 and reduced the withholding tax on the relevant profit and dividend payments from 25% to 15% 66.From January 1st, 1996, effective withholding tax on dividends (but not upon royalties and fees) were brought to zero 67. Recent Central Bank regulations 68 admitted registration of intellectual property rights as foreign investment in Brazilian corporations.