Brazil VAT implementation; Senate approval

Senate approves proposal for Federal & State VAT replacement of myriad of indirect taxes

The Brazilian Senate on 8th November approved a 10-year implementation plan to introduce VAT PEC 45/2019 . The Bill now goes back to the Chamber of Deputies to review the Senate amendments for approval this year.

The Bill introduces two new indirect taxes to replace four existing state and federal taxes starting from 2026 and completing by 2033:

1. CBS (Contribuição sobre Bens e Serviços – Contribution on Goods and Services) federal tax on consumption – replacing PIS and Cofins
2. IBS (Imposto sobre Bens e Serviços – Tax on Goods and Services) state and municipal taxes – replacing ICMS and ISS

This will enable a change from the current origin basis of taxation to destination basis, and so following the global norm.

The Senate has already introduced extra exemptions that could push the final consolidated VAT rate from the original Finance Ministry’s estimate of 27% to a maximum of 27.5%.

This will be the highest standard VAT rate amongst any major economy. Although it should be kept in mind that Brazil puts a high burden on consumption taxes over personal income taxes which are relatively low compared to the rest of South America and Europe.

Aug 2023: likely Brazilian VAT final rate 25.45% to 27%

The Brazilian Finance Minister has published a technical note indicating a final VAT rate for the Chamber of Deputies plan (see below). The minimum will be 25.45% based on a VAT Gap (missing revenues compared to budget) of 10%. This Minister called this ‘feasible’. If this is assumed at 15%, termed ‘conservative’, then the rate would b2 27%. This compares to the estimated 34.6% rate based of the myriad of overlapping taxes.

The reform is planned to be phased in over seven years starting in 2026, with CBS starting at 0.9% and IBS at 0.1%, gradually increasing. PIS, COFINS, and IPI (except for products from the “Manaus Free Trade Zone”) will end by 2027. By 2029, ICMS and ISS will be reduced while CBS and IBS rates rise. The full implementation of the new regime is targeted for 2033.

According to the study, in the best scenario, the CBS will correspond to 8.53%, and the IBS to 16.92%, totaling the 25.45% VAT rate. In the most pessimistic simulation, 9.05% of CBS and 17.95% of IBS would be charged.

July 2023 Brazil’s lower house, Chamber of Deputies, agrees dual state IBS and federal CBS VAT implementation from 2026 to 2032; potential 28% standard rate

On 6 July 2023, the lower house of parliament in Brazil agreed to constitutional amendments to implement a new VAT regime. There will be an 8 year transition period, starting in 2026 for CBS and IBS to replace PIS and Coffins, and ICMS and ISS, respectively.

The existing IPI tax will be replaced by a new Selective Tax (Imposto Seletivo, IS), a federal excise tax to be levied on goods and services that are considered harmful to public health and the environment.

The two main changes from the exiting multiple indirect taxes will include:

• Right for businesses to deduct taxes on their inputs, and so ending most cascading of taxes and so undermining the internal Brazilian economy; and
• A shift from the existing source-based taxation to destination or consumption-based taxation as adopted in most countries. There will be two compensatory funds for the states losing out from the tax base shift.

Headline rate may hit 28% following inclusion of reduced and zero rates, plus exemptions

Whilst no indicative standard rates have been published, there was a widespread belief it would be 25%. However, agreement on various discounts before the House vote mean that 28% may be more likely (Ipea study).

The transition to the dual VAT system is expected to occur over a seven-year-period, as follows:

• 2026: CBS rate of 0.9% and IBS rate of 0.1% as from 2026;
• 2027: Termination of PIS and COFINS and IPI;
• 2029: Gradual reduction of ICMS and ISS; and
• 2033 final rates of around 28%.

The following supplies will receive some discounts:

• Reduced rates of 40% of standard rate: public transport; artistic and journalistic; education; medical; health;
• Zero-rated: eggs; fruit; vegetables; certain medicines and medical supplies
• Exempt: public transport
• Special tax regimes: fuels; financial services; hotels and restaurants;

VAT proposal next moves to Senate upper house

This proposal now transfers to the upper house, the Senate, for voting and acceptance, changes or rejection. The change, which is expected to benefit Brazil’s wealthier and more populous states, is likely to encounter stronger opposition and calls for broader compensation measures in the Senate, where state governors hold greater influence.

June 2023: Compensation funds for states as Brazil proposes to consolidate myriad of indirect taxes into two regional and federal VAT’s

Brazil’s new government had presented 22 June 2023 constitutional amendments to introduce a two-level VAT regime, based on the PEC 45 reforms. This includes a move from origin-based taxation to tax in the state of destination / consumption – with subsidies from government for states which lost revenues as a result. It seeks the following new indirect taxes to replace existing taxes over a period of 8 years.

Compensation funds to win political acceptance

To help where other attempts to reform the system has failed, it is proposed that there will be two compensation funds:

• 40 billion reais per annum for states’ development
• 160 billion reads States funds for tax benefits already granted

Shift to consumption-based VAT; reduced rates and exemptions

The major change would also be a shift the indirect tax basis from the origin (where goods produced) to destination (where goods consumed). This would withdraw much of the tax distortions in the current regime which undermines the country’s internal market. The reforms would also consolidate a large number of overlapping federal and state indirect taxes.

There will likely be reduced rated for some goods and services related to health, education, public transportation, domestic flights and agricultural supplies.

Jan 2023 – New government may unblock VAT implementation plans to reform complex indirect tax regime

As part of his newly installed government, President Lula of Brazil has appointed Bernard Appy as his special secretary for tax reform, which has been highlighted will be a priority in the new government. He held a similar role in the ministry from 2007 to 2009, in the second term of the last Lula government. Appy was one of the backers for the implementation of VAT in Brazil (PEC45, see below), and it can be expected that he will push one of the two options to reform possibly the most complex indirect tax regimes in the world. These include :

• PEC 110 to reform state and federal taxes.  In the Senate; and
• PEC 45 to reform federal-only taxes. In the Chamber.

An agreement to impose VAT to replace several overlapping and byzantine taxes was almost reached in 2020. But the effects of COVID and wider political uncertainties led to a stalling of the competing initiatives. Below is a summary of the progress of some of these proposal, and which current taxes they may replace, including: COFINS; PIS; IPI; ICMS; ISS; and others.

In June 2022, Brazil signed an OECD accession plan. This includes supporting adoption of reforms of the Brazilian indirect tax regime to OECD standards on VAT and GST Guideline – covering best policies and practices.

Brazil’s indirect tax maze today

Currently, the major Brazilian consumption taxes are administered across the federal, state and municipal levels.

1. Federal

• COFINS, Contribuição Social para o Financiamento da Seguridade Social – the federal tax contribution to the Social Security Financing paid on company revenues. The rate can be up to 7.6% on monthly revenue depending on the activities of the company.
• PIS, Programa de Integração Social, at a rate 1.65% with COFINS together comprise the social contributions levy applicable to transactions.
• IPI, Imposto sobre Produtos Industrializados – the federal tax on manufactured goods. The rate can be up to 300%. The ad valorem rate is set by HS product code and  can be up to 300%.  The average rate is 10%.

Originally, COFINS and PIS were business turnover taxes. They have been partially reformed for some businesses at 3.65% and 9.25% rates.

2. 26 States

• ICMS, Imposto sobre Operações Relativas à Circulação de Mercadorias e Serviços de Transporte Interestadual e Intermunicipal e de Comunicações – the tax which applies to the movement of goods, transportation, communication services and other general supplies of goods. The current tax level is between 7% and 25%. A major challenge of ICMS is that it is not levied on the destination basis like most VAT regimes; instead on the origin basis.

3. Municipalities

• ISS, Imposto sobre Serviços – the municipal tax on the provision of services. The rate ranges to up to 5%.

Brazilian indirect tax blockers

They current consumption taxes are often in conflict, giving rise to many disputes and compounding of taxes on businesses. The blockers to reform have included:

ICMS (see above) is levied on the origin basis instead of the typically VAT/GST destination basis. This encourages states to give hefty taxpayer incentives to attract businesses to relocate to their states. It also creates a major block to simplification and a single, federal tax as states firmly protect their tax shares and right to control revenues.

Services typically enjoy a lower indirect tax rate. There is tension between the municipalities and states on their service taxes, ISS and ICMS. The municipalities only charge up to 5% ISS whereas states get around 18% through ICMS. This problem is exasperated by some service companies paying 3.65% on the old combined COFINS/PIS rate.  Any combined VAT proposed would be around 12% to 16%. What is unclear is if the taxpayers will be able to pass this extra VAT onto the consumers.

States are also reluctant to give up on ICMS since services offer the major growth opportunities for the Brazilian economy. So, states are hugely incentivised to hold onto their taxes.

Possibly the biggest blocker though is legal. Reforms need constitutional amendments since they affect the states and municipalities’ rights to raise taxes and maintain their autonomy. Given the points above, gathering support for a simplified federal-level VAT, as adopted in 170 countries around the world, has proved impossible in the past 40 years.

Alternative Federal Government July 2020 proposal – replacing IPI and COFINS

To try and seize the initiative the government issued its own Bill (No. 3,887/2020, National Congress) to implement a federal VAT (‘CBS’) at 12% on goods and services. This would create a dual VAT system, similar to Canada’s GST and HST regime. Whilst complex, it would not require the states and municipalities to approve constitutional reforms.

This would exclude ICMS and ISS tax. CBS would replace the complex PIS and CONFINS federal taxes. Following this first tax reforms phase, IPI would be replaced and reformed.  The new tax, Contribuição sobre Bens e Serviços ‘CBS’, will be simpler and easier for businesses to implement and consumers to understand. It will be imposed on imports and domestic sales of goods and services. This would include intangibles imports – so B2C digital services by non-resident providers. Exports will be exempted. There would be the right to deduct CBS incurred by taxpayers. Any credits – excess CBS incurred in a reporting period – would be refunded or offset against other federal taxes.

There are also unresolved issues on the design. Firstly, whether the federal government can tax the supply the supply of goods and services at the transaction level under the constitution. It may certainly tax business turnover. Secondly on the status of digital or intangible services. This includes: downloads of music/video; app’s; e-books; online journals; software downloads or cloud based; web advertising services. Court rulings have left the status of such supplies as undefined still. Thirdly, the treatment of Financial Services is still unclear, with lots of details missing.

Blockers to Brazilian tax reforms

The Brazilian government will push ahead with CBS. But it is simultaneously courting the states and municipalities on IBS. This may require a complex and expensive compensation and equalisation funds as the tax pie is recut. COVID will not help to support this requirement.

The chief challenge then, as India found out when it took over 10 years to agree a similar consolidation of its consumption taxes, is agreeing a governance framework between the three stakeholders. This may need the establishment of an independent non-governmental organisation to keep some degree trust. In India, the tax rates, rules and regulations are governed by the GST Council which consists of the finance ministers of the central government and all the states.

Once resolved, the management of the transition on tax sharing will be agonising. Agreement around rates and revenue splits will stir-up old animosities and grudges. The combined rates between the federal and state taxes could be well over 25% based on current tax revenues.

Public service disputes aside, most of the business sectors would welcome the simplifications. However, the services sector fears increased taxes. They escape lightly under the present regime, so will canvass heavily for delays or extra reliefs.