Almost thirty years from the beginning of its operation, the Treaty to Avoid Double Taxation (Doppelbesteurungsabkommen) entered into between Brazil and Germany was denounced by the German government in April 07th, 2005.
Since 1975, the treaty has been beneficial for those German companies and investors doing business in Brazil and also very useful to the development of Brazil, once such investments have directly resulted in technology transfer. From a tax point of view, the Treaty has been used mainly to reduce the tax burden on profits (Unternehmensgewine), earnings (Dividenden), interest (Zinsen), royalties (Lizenzgebühren) and capital gains (gewinne aus Veräuberung von Vermögen).
Mainly after the year 2000, both countries started to debate about some possible changes to adapt the Treaty to the present economic situation, which was clearly resulting in heavy losses to Germany, and also to establish an unanimous interpretation of treaty dispositions according to the interpretation used by the OECD (Organization for Economic Cooperation and Development). Even after a visit in February 2005 of a German commission, no settlement could be reached, since the Brazilian government did not accept to reduce the assessment of taxes related to the import of goods and services (since 1975 the Brazilian government has established several new taxes on this area).
According to the German Finance Department (Bundesministerium der Finanzen) the treaty was denounced based on the fact that its dispositions are no longer in accordance with the German international tax policy and could no longer produce the practical, juridical and economical effects expected by the country. In spite of that, the German Finance Department has informed that German government is still open to discuss a new treaty based on such new international tax police.
Hereinafter, we will make the analysis of the tax impact after December 31st, 2005, when the treaty’s denouncement will start to produce its effects on the business operations between these two countries.
Brazilian Investments in Germany
According to the Treaty dispositions, the German taxes to be levied on the Brazilian investments are: (i) the Income Tax (Einkommensteuer) and its Surtax (Ergänzungsabgabe); (ii) the Capital Tax (Vermögenssteuer); and (iii) the Commercial Tax (Gewerbesteuer).
In general terms, we can note by analyzing the German tax system that this country establishes different kinds of rates to tax business activities. In principle these rates are higher than the Treaty limits (15% in general).
According to the German legislation, Germany levies a tax rate of 20% on Royalties payments; a tax rate of between 25% and 35% on payment of interests (it depends on the source); and finally a tax rate of 20% on payment of dividends.
After the taxation above, according to the Brazilian Income Tax Code (section 395), the Brazilian legal entities can offset all the amounts paid up to the limit of the corporate income tax. So, after the Treaty termination, we believe that there will not be any losses for the Brazilian companies, once the offset will still be allowed.
However, for Brazilian individuals, the Treaty termination will result in double taxation, since there will be no dispositions allowing the offset all the amounts paid in Germany.
As a result, the Treaty termination will reflect immediately only on the Brazilian individuals who have investments or other business activities in Germany, once they will be facing double taxation.
German Investments in Brazil
Contrary to the minor effects on Brazilian investors, the German ones will be facing some changes that can burden their investments even more, and based on that the different situations will be analyzed separately as follows:
Transfer Pricing Issues – Section 9th of the Treaty
Since the enactment of Law No. 9,430/96 (which has established the Brazilian Transfer Pricing Rules), in spite of the provisions of Section 9 of the Treaty, the Brazilian Federal Tax Bureau always has argued that “arm’s length principle” should not be applied to the transactions between Brazil and Germany, i.e. these transactions should follow the same transfer pricing rules established to the transactions between Brazil and other countries.
So, based on the Treaty dispositions and the Tax Bureau interpretation, the taxpayers have filed judicial claims against the Brazilian government arguing that the arm’s length principle should be applicable according to Section 9 of the Treaty. However, this will be no longer be possible after the Treaty termination, once the legal ground for the taxpayers’ interpretation will be removed from the Brazilian legal framework.
According to the Treaty’s dispositions (section 11) a 10% tax rate shall be levied if a German financial institution grants a loan for specific purposes and for a period of at least seven years. These specific purposes are to finance the following operations: (i) public works; (ii) researches; (iii) purchase of industrial equipment; or (iv) purchase and installation of industrial or scientific sites. Moreover, the Treaty establishes a tax exemption in cases of interest paid to the German government or any agency and political subdivision owned by such government.
So, the Treaty termination will reflect directly on the loan agreements actually in force, and will possible reduce the loan volumes coming from Germany, since the tax rate to be levied will increase to 15% and the German legal entities will no longer use a matching credit of 20%.
In spite of the lack in the Treaty of a ruling regarding the withhold of income tax to non-technical agreements rendered by and paid to German residents, the Brazilian Federal Tax Bureau by using its own interpretation of Section 7 applies the tax on payments for these services This tax appliance is being contested by several taxpayers but after the Treaty termination there will be no longer possible once the legal ground will also be removed.
Regarding the tax credits, the German government policy is to grant such credits only if a German resident render non-technical services via a permanent agent or establishment in Brazil. Nevertheless, the taxes levied by the Brazilian government can actually be deducted as expenses by the German services provider, i.e. the taxes withhold can be used as a “benefit” for those residents.
As an immediate effect of the Treaty termination, the German Government will no longer grant matching credits regarding the royalties income.
Besides that, after the termination, both countries will be able to establish new rates to the royalties’ taxation, once there will be no more restrictions as actually established between the parties.
As a result, by considering the fact that there will be no more matching credits and that the Brazilian government will withhold the income tax at a rate of 15%, maybe there will be the need to the German companies to renegotiate some contracts with legal entities and individuals in order to receive the whole contract value, without the taxes withheld.
In spite of the Treaty provisions, the Brazilian government does not levy taxes on the dividends (Law No. 9,249/95), i.e. the German legal entities will not have their earnings taxed on the amounts remitted. So, with the Treaty termination there will be no taxation by the Brazilian government, but the German one will be able to levy taxes on the dividends.
After the short comments above, we believe that the German investors will have to analyze some contract terms in order to reduce the tax impact on their investments, but we also believe that the Treaty termination will not necessarily means that the countries collaboration and business integration will be reduced.