Chamber of Deputies approves 7-year rollout by 2033 of VAT replacement of world’s most complex indirect tax regime
The Brazilian Chamber of Deputies approved on 16 December 2023 the implementation of a modern VAT regime (PEC 45/2019). The reform will now be signed into law in a joint session of Congress expected to take place next week.
The reform includes two new main indirect taxes to replace four existing state and federal taxes starting from 2026 and completing by 2033:
- CBS (Contribuição sobre Bens e Serviços – Contribution on Goods and Services) federal tax on consumption – replacing PIS and Cofins
- IBS (Imposto sobre Bens e Serviços – Tax on Goods and Services) state and municipal taxes – replacing ICMS and ISS.
The existing federal IPI excise tax will be replaced by a new excise Selective Tax (Imposto Seletivo, IS), to be levied on goods and services that are considered harmful to public health and the environment.
The new tax structure will enable:
- a change from the current origin basis of taxation to destination basis, and so following the global norm; and
- the right for businesses to deduct taxes on their inputs, and so ending most cascading of taxes and so undermining the internal Brazilian economy
To offset these changes, the reform introduces various funds and compensation mechanisms for states.
The Finance Ministry has estimated that the combined rate could eventually rise to 27.5%. Changes by the Deputies to the version proposed by the Senate will keep the rate below 28%. This includes not accepting a wider range of exemptions for: basic foods; medicines; and public services. This rate will be the highest standard VAT rate amongst major economies. 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. 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.
Seven-year VAT transition
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;
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
Brazil’s indirect tax maze today
Currently, the major Brazilian consumption taxes are administered across the federal, state and municipal levels.
- 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.
- 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.
- 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.
