Tax officials in Spain monitor the status of the Brazil-Spain treaty

The tax treaty between Brazil and Spain was upheld by a Spanish high court, which could result in an increase in income from Brazilian subsidiaries.

In July, the High Court of Justice of Catalonia decided in Appeal 53/2022 that the Brazil-Spain double tax agreement should be fully applied to dividends paid by a Brazilian firm to a Spanish person.

The impact of this development, according to some tax directors in Madrid, may increase business income from Brazil, while others claim it is too soon to tell.

This is simply one effect, a managing director at a large international bank in Madrid emphasizes. "It is still too early to tell, but I do not think any group would restructure in a post-BEPS era because of this high court ruling," he says. 

The high court's decision on July 18 establishes a precedent that enables significant corporations in Spain to take use of the participation exemption provided by the treaty for earnings transferred from Brazilian subsidiaries.

For businesses with operations in Spain, the court's decision to give the treaty provisions precedence over local legislation is significant because a broader implementation of the participation exemption provided by the treaty might boost group cash flow.

"The Superior Court determined that the dividends received by an individual should not be taxed in Spain under Article 23 of the treaty, even if the dividends are not subject to tax in Brazil," says Marcos André Vinhas Cato, a partner at the So Paulo law firm Maneira Advogados.

Under Article 23, which addresses strategies to prevent double taxation, dividends from a Brazilian corporation to a Spanish person receive a favorable tax treatment. However, a portion of that revenue is subject to Spain's personal income tax laws.

Dividends are not exempt from personal income taxation in Spain, however there is a participation exemption for dividends from certain subsidiaries under the corporate income tax law. On cross-border revenue, the local legislation already offers a layer of tax protection.

For international corporations, the ramifications might be enormous, according to Alvaro Santos Garcia, tax M&A manager at EY in London.

"The impact of this judgment for corporate taxpayers must be considered, especially the possibility to claim that dividends received from Brazilian subsidiaries should not be affected by the limitations that apply to the domestic participation exemption," according to Garcia.

Although the effects of the July judgement from Spain on the treaty and local legislation appear to favor taxpayers, advisers claim that it is still too early to offer their clients any concrete tax advice because it may take several months to fully comprehend the new consequences.

Many tax advisors, however, believe that the decision may allow businesses that receive specific sorts of income from Brazil to take advantage of greater treaty benefits.

Whether a tax resident who receives profits from a Brazilian company can take advantage of the treaty's advantages to reduce local tax obligations is the subject of the Spanish high court's appeal.

The taxpayer claimed a reimbursement of the local taxes they had already paid, even though dividend income is classified as exempt under the treaty, even though dividend income is taxable under the Spanish personal income tax regulations with no local exemptions.

Prior to this case, the taxpayer's claims were rejected by Spain's tax administration Agencia Tribuitaria and local tax courts on the basis that dividends must be taxed at a minimum rate of 10% in order to qualify for treaty advantages.

However, according to sources, the treaty's formal language merely needs that the dividend be potentially taxed in Brazil in order to qualify for the exemptions.

There are conditions, emphasizes Jose Bustos, partner at EY in New York. According to Bustos, the only prerequisite for the participation exemption is the possibility that the payout will be subject to withholding tax in Brazil.

"It is worth noting that the treaty’s exemption does not refer to the domestic provisions for avoiding double taxation," the author continues.

The participation exemption of the treaty did not restrict withholding tax at the source in Brazil, according to the legal theory that the Spanish high court relied on in its decision. Therefore, Spain's tax authority was unable to impose local taxes to nullify the treaty's exemption.

Since the wording of the treaty between Brazil and Spain is more ambiguous than it is in previous agreements that the two nations have in place, tax policy specialists have criticized it. The practical ramifications for businesses could readily change depending on how the pact is interpreted.

For instance, under the Brazilian tax administration's interpretation of the agreement, the word "beneficial owner" is abbreviated to "beneficiary." According to sources, this more inclusive phrasing has increased taxpayers' access to benefits.

Only Brazil's tax agreements made in the previous 10 years have stricter restrictions on the application of benefits, according to advisors, despite the fact that the deal was signed over 50 years ago.

According to Manuel Paz, international tax and transaction services partner at EY in Madrid, "the Brazil-Spain tax treaty includes certain parts which make it different from others in the Spanish tax treaty network like a tax sparing clause and an unusually broad definition of royalties."

tHe continues, "the impact of this decision to other situations must be analysed carefully, but in any case, this is an interesting case in the higher courts."

A windfall for some taxpayers may result from this decision together with another made by a Brazilian high court in February 2014 that categorized interest on equity paid by Brazilian firms as dividends.

The classification of income under the treaty is significant since it affects the tax rate. For instance, interest only qualifies for a 20% tax credit but royalties are eligible for a 25% credit.

The tax code was changed to reduce the exemption to 95% of the income that qualifies for it, effective with the fiscal years starting on January 1 2021.

According to Garcia, "the authorities’ interpretation of double tax treaties are famously known to cause difficulties to multinational groups with presence in Brazil."

Since the treaty takes precedence over local regulations that limit the exemption to 95% of income, there are technical economic grounds in favor of the exemption on 100% of dividend income from Brazilian subsidiaries. The top court's argument would be supported by this.

In a news conference for the EU, Spain's secretary of state for commerce, Xiana Méndez, said that the prospects provided by Brazil's "good economic conditions" have made Spanish companies "hungry to invest" there.

"They have offered us all kinds of information and our responsibility now is to transmit this to companies so that they are also excited and decided to consider the Brazilian market," she said.

Some Spanish group tax heads who are already in charge of operations in Brazil anticipate that their companies would boost investments and take part in forthcoming Brazilian concession auctions. The infrastructure, telecommunications, and energy sectors are likely to experience this.

According to Garcia, acquisitions have increased in Latin America over the past five years and Spanish companies still have a healthy cash flow for mergers.

Brazil has also attracted additional attention since it was placed on a timeline to join the OECD in June 2022, a move that will require the nation to modify its distinctive local tax laws to meet the standards established by the intergovernmental organization.

The Spanish high court verdict and the positive outlook for M&A activity in Latin America may stimulate corporate interest in acquiring target companies in Brazil. However, companies looking for similar opportunities in Brazil must adhere to certain standards.

By fLEXI tEAM