Victory of taxpayers in the Federal Administrative Tax Court: overlapping of Double Tax Treaties and Brazilian CFC rules

Recently, the highest level of the Federal Administrative Tax Court (CSRF) changed its longstanding view on the overlapping of Article 7 of the Double Tax Treaty (DTT) and the Brazilian Controlled Foreign Corporation (CFC) rules, now favouring taxpayers. 

Under the Brazilian CFC rules previously in force, profits accrued by foreign controlled entities were subject to corporate income tax (IRPJ) and social contribution on net profits (CSLL), at a combined rate of 34%, on an accrual basis, regardless of distribution. These rules applied to profits arising from all foreign controlled entities, including operational entities located in high-tax jurisdictions. 

Historically, Brazilian tax authorities have tended to challenge the application of DTTs when they reduce the taxation imposed by Brazilian legislation, and CFC rules are no exception. In the tax authorities’ opinion, Brazilian CFC rules aim to tax profits accrued by the Brazilian controlling company by means of its investment in the foreign controlled entities. This rationale heavily relies on the accounting method adopted by Brazilian GAAP for controlling companies to evaluate investments in controlled entities: the equity pickup method. Using this method, profits accrued by controlled entities are automatically recognised in the P&L of the controlling entity.   

Based on this interpretation, tax authorities sustained that CFC rules did not overlap with Article 7 of the DTTs signed by Brazil. According to them, whereas Article 7 prevents Brazil from taxing profits accrued by its foreign controlled entities, Brazilian CFC rules would not be limited by the DTTs as they target profits accrued by the Brazilian controlling company. 

Despite strong questioning by taxpayers throughout the years, decisions issued by CSRF used to favour the tax authorities. In some cases, the decisions issued by the CSRF were tied and ultimately decided by the qualifying vote of a judge who represented the tax authorities. 

The most recent decisions, issued by the court at the end of 2021, took a turn in the opposite direction. In the cases involving DTTs with Argentina, Ecuador, and Spain, CSRF understood that Article 7 of DTTs should prevail over Brazilian CFC rules, since both deal with profits earned by a company abroad. 

This scenario was made possible due to an alteration promoted in 2020 to the way ties were treated in Brazilian administrative tax courts. As of this amendment, a tie in the votes of the counsellors now results in a decision favourable to the taxpayer. Even though the new understanding is very positive, taxpayers should be wary, given the fact that the constitutionality of this change to tiebreaker rules is still being evaluated. 

This controversy is particularly relevant amidst the current talk on the implementation of Pillar Two rules. Although there is as of yet no news as to how Brazil plans to deal with this matter, MNEs with Brazilian controlling entities would, technically, have to evaluate whether Brazilian CFC rules could be considered as being equivalent to qualified income inclusion rules in order to determine Pillar Two effects. 

Moreover, if no changes are made to Brazilian CFC rules currently in force, practical issues could arise for the offsetting of taxes paid abroad under Pillar Two rules, considering that the taxation in Brazil is generally levied on profits accrued by each controlled entity individually. 

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