The deductibility of royalties paid abroad: The new environment in Brazil

From a practical standpoint, the Brazilian Patent Authority (INPI) until last year held the role of determining the maximum deductible and payable amounts of royalties due to foreign parties, upon registering the relevant contracts. This reality, however, changed last July.

Below we summarise the evolution of the legislation and the prevailing practical environment that taxpayers face, taking into account the change of the regulatory rules for registration of contracts with the INPI.

In 1958, Law 3.470 was enacted, listing specific provisions for royalties and technology fees to be considered deductible expenses within the Brazilian tax system. Originally, this law created a limit for the deductibility of payments in consideration of trademark and patent licences and technical assistance, limiting it to a cap of 5% over the gross sales of the products manufactured under the licence and establishing that the cap should be further regulated by the Ministry of Finance.

One month later, Ordinance 436/58 came into effect, establishing specific maximum caps for the tax deductibility of payments due in consideration of the trademark or patent licence agreements, and technical, scientific, administrative or similar assistance. For trademark licences, the limit was set at 1% of the sales of the products manufactured or services rendered under the agreement. For other payments, the maximum cap varied from 1% to 5% of sales, according to the industry.

In 1962, Law 4.131/62 – focusing on foreign exchange control – was enacted, reinforcing the 5% cap (with compliance with ordinances issued by the Ministry of Finance) and establishing further requirements and limitations for the remittance and deductibility of royalty-related payments. Article 14 of this law also expressly prohibited the payment and deduction of royalties payable for the licensing of patents and trademarks between a branch or subsidiary established in Brazil and a parent company or majority shareholder domiciled abroad.

In 1964, Law 4.506/64 was enacted, further regulating the deductibility of royalties for the use of trademarks and patents as well as technical assistance/the supply of technology, and reiterating certain restrictions already established by the tax and exchange control laws. This law also established some general conditions for the deductibility of royalties. In summary, Article 71 determined the following requirements for the deductibility of royalties for the use of trademarks and patents paid or credited abroad: (i) royalties will be subject to an agreement registered with the Currency and Credit Superintendence (SUMOC) and will be in accordance with the Industrial Property Law (as applicable); and (ii) the deduction is limited to the caps fixed periodically by the Ministry of Finance for each activity or group of products according to their essentiality levels and with the specific legislation on the remittance of payments abroad. The same article also stated that the royalties paid to beneficiaries domiciled abroad that did not comply with the Industrial Property Code (Decree-Law 7.903/45) were non-deductible. (Decree-Law 7.903/45 was later replaced by another law that regulated industrial property, Law 5.772/71, which in turn was replaced by the prevailing Industrial Property Law [Law 9.279/96], but the same requirements for registration still apply.) The code provided that the registration of trademark licence agreements with the INPI was a condition for having such agreements effective vis-à-vis third parties.

In connection with technical assistance and similar agreements, Article 52 of Law 4.506 established requirements similar to those listed above for trademarks and patents. Its sole paragraph prohibited the deduction of payments between a branch or subsidiary established in Brazil and a parent company or majority shareholder domiciled abroad.

In 1991, Law 8.383/91 was enacted and partially revoked the abovementioned prohibitions effective January 1 1992. In summary, it allowed the deductibility of royalties for the licensing of trademarks and patents and payments for the supply of technology and technical assistance by a Brazilian company to its parent and controlling company abroad, within the limits imposed by the deductibility caps established by Ordinance 436/58. However, it expressly established the obligation of registration of the relevant agreement with the INPI and the Central Bank of Brazil in the case of remittance of payments to a parent company abroad for technology, licensing of trademarks and patents, and technical assistance.

Therefore, since January 1992, deductibility and the remittance to a foreign related party of royalties derived from patent and trademark licence agreements and of fees for the supply of technology and technical assistance have been permitted, provided that the relevant agreement is registered with the INPI and with the Central Bank of Brazil, and that the former limits established in the law and regulations/ordinances have been complied with.

No relevant changes have been introduced in the tax system since the enactment of Law 8.383/91. Accordingly, any time a Brazilian company wishes to remit payments related to royalties and the like to foreign parties, the company must register a contract with the INPI.

In fact, upon analysing the relevant contracts, the INPI used to evaluate the feasibility of the registration of the agreement and also to opine on the conditions of payment established privately by the parties. More specifically, the INPI used to adopt the parameters of the tax regulation that deals with the tax deductibility of royalties to decide on the amounts of royalties that could be payable abroad to a foreign-related party.

In other words, the INPI would analyse the contracts in accordance with the industry classification listed by Ordinance 436/58, defining in which industry the specific intellectual property right was inserted from a technical perspective. This analysis used to result in the determination of the maximum percentage of royalty payable to a related party abroad in each specific agreement, which also used to be considered the maximum deductible amount.

The perception of the market in certain cases was that by applying the limitations provided in the tax legislation, the INPI was interfering in private contractual aspects involving the payment of royalties, and imposing limitations on the remittances to related parties abroad without the necessary legal basis to do so.

From a practical standpoint, however, the taxpayers used to be in a 'comfortable' position in the sense that the interpretation adopted by the INPI and stated in the registered contract was respected by the Brazilian tax authorities for deductibility purposes (and for remittance purposes). This procedure lasted for approximately 15 years, until an important change was introduced by the INPI itself.

Normative Instruction 70/17 (IN 70/17) issued by the INPI, limited the INPI's power to analyse the percentage of the remittance of royalties abroad in trademark, patent licences, technology transfer and related agreements. More specifically, Item XI of Article 13 established that the certificate of registration of agreements must be issued by the INPI with the following note: "The INPI has not analysed the agreement from a tax or exchange control perspective."

Thus, as from July 1 2017, the INPI began registering agreements for the licensing or transfer of industrial property rights without analysing the conformity of the percentage established in the agreement as royalty payable with the parameters provided in the tax and exchange control regulations for deductibility and remittance purposes, respectively. Any percentage/amount established in the agreement for remittance and/or deductibility purposes was maintained in the agreement and it was neither challenged nor changed by the INPI upon formally registering the agreements.

At first, the market received this development with enthusiasm as it apparently reduced the interference of the INPI. In other words, there had been a perception that the amounts payable as royalties privately agreed by related parties would be respected and no longer subject to advance analysis as a condition for the registration of the agreement with the INPI.

Despite the fact that this was indeed true for the purposes of registering such agreements with the INPI, this new rule could trigger more scrutiny from the tax authorities (and possibly from the Central Bank of Brazil) in the subsequent years upon analysing the deductibility (and remittance) of such payments. Crucially, there has been no change in the tax and exchange control rules. The same limitations and restrictions in place before July 2017 still apply.

In our view, the change in the INPI ruling means that in order to ensure compliance with the limitations for deductibility purposes, the tax authorities will have to make a judgement call to determine if the percentage established in the agreement is in accordance with the parameters imposed on a specific industry. The analysis also requires a judgement as to whether some technology or intellectual property rights relate to one specific industry to the detriment of another. This may be especially sensitive in the case of new technologies that are not clearly covered by the 'old concepts' established under Ordinance 436/58.

In addition, other potential tax issues, which have already been interpreted by the INPI in the past and accepted by the authorities, may also be brought up for discussion again. This might include the understanding that it is not possible to simultaneously deduct payments in consideration for both the supply of technology and trademark licensing if those payments and relevant agreements refer to the same product and/or technology.

Due to the statute of limitations period, it may take up to five years for the tax authorities to start challenging the deductibility caps applicable to taxpayers or for the Central Bank to initiate administrative procedures to determine the conformity of certain royalty remittances with exchange control rules.

We believe that taxpayers should be cautious about the analysis on which types of payment may be remitted abroad and considered deductible in Brazil, and about the caps applicable in each agreement. It will be important to have means to support the application of a certain cap if there is any room for controversy. On the other hand, specific opportunities may also apply, depending on the case. It is now solely up to the taxpayer to proceed with this analysis and to support its position to the tax authorities.

Clarissa Giannetti Machado

Trench Rossi Watanabe Sao Paulo Tel: +55 (11) 3048 6786 clarissa.machado@trenchrossi.com Clarissa Giannetti Machado joined Trench Rossi Watanabe in 1999 and became partner in 2007. She worked at the Baker McKenzie Chicago office in 2002, and at the Baker McKenzie Amsterdam office in 2005/2006. She has been recognised as a leading tax lawyer by Chambers for the past 10 years and as a pre-eminent figure in global transfer pricing deals by Euromoney. Clarissa advises multinational companies with business operations in Brazil on transfer pricing, real estate transactions and general tax planning. She helps clients develop and implement tax-efficient structures in international transactions, including acquisitions and sales of business operations, and financial and related transactions. She holds a law degree from the University of São Paulo (USP), a business administration degree from Fundação Getúlio Vargas (1997), and an LLM from Columbia University School of Law of New York (2002). She was admitted to practise law in the State of New York – US (approved by the New York Bar in 2002).

Juliana Porchat de Assis

Trench Rossi Watanabe Sao Paulo Tel: +55 (11) 3048 6926 juliana.assis@trenchrossi.com Juliana Porchat de Assis joined Trench Rossi Watanabe in 2004 and became partner in 2012. She has extensive experience in tax planning in Brazil. She concentrates on corporate reorganisations and mergers and acquisitions, international tax planning, taxation of financing transactions, and transfer pricing. Her background in corporate law and exchange control matters allows her to have a multidisciplinary approach in defining and building efficient tax structures for local and cross-border transactions. Juliana has advised clients in several projects involving joint ventures and/or acquisitions for major corporations in various industries, including pharmaceutical, IT, automotive, and energy. She graduated from the school of law at Faculdades Metropolitanas Unidas, SP in 1999. She completed an extension course in corporate law at the Pontificia Catholic University of São Paulo (PUC/COGEAE-SP), SP in 2001, and obtained an MBA in finance in May 2004 from the Else School of Management at Millsaps College, Jackson, Mississippi, US.