The Brazilian tax chaos and reform proposals

Dear investors,

Much of the political tension related to the new government has revolved around the issue of fiscal responsibility. In summary, the new government declared the spending cap law inadequate and presented a new fiscal framework that resists the idea of cutting spending and, consequently, depends on increases in tax collections to eliminate the fiscal deficit. In turn, the increase in revenue can only come from two sources: either from the growth of the country's economy, or from a higher tax rate actually charged by the government. Both paths are difficult, as economic growth does not depend only on the government and there is a lot of resistance to increasing tax rates in Brazil, where the tax burden is already among the highest among emerging countries.

This problem caused the government to rekindle an old Brazilian political debate: the need to carry out a broad tax reform, which could, at the same time, boost the country's economic growth, through the productivity gains that the simplification of our tax system would provide. ; and increasing the effective rate of taxes collected, not by raising base rates, but by eliminating a series of tax benefits that exist today. It is no wonder that this agenda has been gaining strength in recent months.

We believe that this topic is of interest to all entrepreneurs and investors operating in Brazil, although it is not one of the most exciting to learn about, as the tax reform would affect all companies operating under Brazilian jurisdiction, both in terms of calculating and collect your taxes as well as the amounts due. Thus, we will talk about the main problems of our current tax system, the most recent proposals for tax reform and how we are considering these factors in our investment decisions.

The problems of the current Brazilian tax system

Imagine that a residential condominium decides to abandon its traditional flat fee per apartment model and “evolve” to a fairer fee system. A first point is that apartments with more residents tend to use the common areas more, so it makes sense to have a rate based on the number of residents in each unit. The playground is only used by children between 2 and 8 years old, so there will be a fee for apartments where children in this age group live. Those who receive many visitors or orders demand more concierge services, so there will be a small fee per visit or per order received. In order to keep track of all these fees, an extra fee will also be charged to maintain a team to verify and monitor what each condominium owner owes.

If it is possible to create such confusion in an environment as simple as a residential condominium, imagine what the practice of evaluating specific points, without taking into account the broad impact of each new rule and the cost of complexity itself, can cause in a country. It is through dynamics of this type that Brazil has been creating, over decades of disorderly evolution of our tax legislation, an enormity of specific rules and exception regimes that have transformed our tax system into one of the most complex and dysfunctional in the world.

Two symptoms illustrate the size of the problem well: a Brazilian company spends, on average, around 1,500 hours to calculate and collect all its taxes throughout the year. This time is almost 10 times longer than in the 38 member countries of the OECD, where companies spend, on average, 164 hours per year for the same purpose. The other symptom is that the value of tax contingencies in Brazil (amount disputed between companies and tax collection bodies) is equivalent to a percentage of GDP about 60 times greater than the average for this same indicator in OECD countries, as a result of the amount of possible different interpretations existing in our current tax legislation.

The main problematic points of the current Brazilian tax system are:

– Several different taxes are levied on the same calculation basis. For example, there are 5 taxes that can be levied on a company's revenue: IPI, PIS, COFINS, ICMS and ISS. Each is governed by a different set of laws, detailing separate tax assessment and collection procedures. ICMS, a state tax, may have different rules in each state and the municipal ISS may vary according to the municipality in which it is charged. As a result, Brazilian companies, especially those that operate in several states and municipalities, need to consider a tangle of rules to determine what percentage of their revenues must be paid as taxes.

– The same tax may have different rates depending on the category of product or service in question. This practice creates unnecessary complexity related to the classification of a product of dubious nature between categories that may have very different taxes. There are numerous multimillion-dollar litigations, originated by these differences in tax treatment, around discussions that are completely superfluous, except for their tax impact. For example, in 2022 two discussions became famous: the first was whether Crocs shoes should be classified as “household footwear (slippers)” or as “other footwear with outer soles and uppers made of rubber or plastics”, whose answer caused a difference a few tens of millions of reais in import taxes; the second was about Sonho de Valsa chocolate, which, after a change in its packaging, was reclassified from “bonbon” to “wafer” and became exempt from IPI (vs. 5% for bonbons).

– State and local taxes are charged according to the origin of the sale, that is, taxes are paid to the state and municipality in which the company that made the sale is located. This system has the merit of facilitating the calculation of taxes for the company, but it generates the very serious problem of fiscal war between states and municipalities. A common example of a result of the tax war is companies that have their main market in São Paulo moving to cities in other states (near the border) to pay less ICMS. This type of arrangement is clearly unproductive, as the sub-optimal logistics increases the real cost of the product (before taxes) and this value is simply wasted. That is, the government of one state encourages this unnecessary cost so that it is possible to capture taxes that would naturally be collected by the neighboring state.

– There are many tax benefits in place, which affects the competitive dynamics in the country. As a result of high tax rates and tax wars, there are benefits so great that inefficient companies become competitive in the market, compensating for their inefficiency with a reduction in the amount of taxes paid after applying the benefits. Thus, in some sectors the ability to negotiate tax benefits becomes a more important competitive factor than being efficient in the main activity of the business. This dynamic tends to elect the wrong champions, bureaucratic entrepreneurs at the head of inefficient businesses, which prosper supported by tax incentives and protectionist laws that defend them from international competitors.

There are numerous other specific problems arising from legislative complexity, but, from a broader point of view, the central problem is the damage caused to economic efficiency. In addition to the deviations caused by the dynamics of the free market, millions of hours of businessmen, accountants, consultants, inspectors, lawyers, judges, etc. are devoted annually to tax-related issues, which are naturally unproductive activities. That's why comprehensive tax reform can spur Brazil's economic growth.

Next, let's talk about the current reform proposals under discussion today.

Tax reform proposal under discussion

There are currently two PECs on tax reform: PEC 45/2019, from the Chamber of Deputies and PEC 110/2019, from the Senate. Although both are recent, this reform is a very old agenda. PEC 110/2019, in particular, was based on PEC 293/2004, prepared by a special commission almost two decades ago. Although there are differences between the two proposals, both share a very close conceptual basis. We will then focus on these common aspects, bearing in mind that the specifics must still be changed before the eventual approval of a definitive reform.

The central objective of the reform is to bring about a radical simplification of taxation on consumption. The proposals are based on some conceptual pillars:

– Unification of the 5 taxes currently levied on revenue (IPI, PIS, COFINS, ICMS and ISS) into just one value added tax, which is the taxation model adopted by most countries in the world. Here, this tax would be called IBS (Tax on Transactions with Goods and Services). In addition to the IBS, the IS (Selective Tax) would also be created, which would be levied on products harmful to health or the environment, whose consumption would be discouraged.

– Maintenance of the tax burden equivalent to the replaced taxes. The IBS rates would be calculated so that the total amount collected is equivalent to what would be collected if the currently existing taxes remained unchanged. Thus, the reform is not about increasing or reducing the tax burden, only changes in the way and management of collections.

– Application of uniform rates for revenues of any nature, eliminating discussions about classification of products and services or about different natures of revenues. Even the rates charged on the sale of services and products would be equalized. PEC 110 would allow the existence of different rates for some classes of products, while PEC 45 suggests total unification, but both follow the principle of having unified rates as a general rule.

– Multi-phase and non-cumulative IBS taxation. The new tax would be applied to all stages of the production chain on a non-cumulative basis, that is, any inputs consumed by a business would generate credits to be deducted from the total IBS amount levied on the company's revenue. The IPI and ICMS already work this way, but the PIS and COFINS vary from case to case and the ISS is cumulative, which generates higher taxation if there are more links in a production chain that consumes services. The advantage of the non-cumulative regime is greater transparency on the total amount of tax charged along the production chains. Multi-phase taxation (charging on any sale instead of just on sale to the final consumer) generates extra complexity, but favors efficient inspection, by providing greater visibility on the stages of each chain and by requiring that two entities report the same information ( the selling company and the buying company), allowing cross checks.

– Payment of taxes to the place of destination of the sale, that is, the principle is adopted that if a consumer in the city of São Paulo buys something, the consumption taxes paid by him must be destined to purposes that benefit him and, therefore, collected for the place where he himself lives. In addition to this principle of using the tax to benefit the population that paid it, the logic of taxation by destination puts an end to the tax war between states and municipalities, as it no longer matters where the company that made the sale is located.

– Reduction of tax benefits. PEC 45 prohibits any type of benefit involving IBS and PEC 110 limits it to a few categories of products and services. The idea of both is to drastically reduce the number of existing tax benefits in Brazil, making the tax burden more equal among companies.

– IBS refund mechanism for low-income taxpayers. To counterbalance the social impact of eliminating tax benefits, which are often advocated as a way to reduce the final cost of essential products for the low-income population, both proposals suggest a refund mechanism for the IBS paid by low-income consumers. In this way, the subsidy would be better targeted to the target population and the issue of social impact is isolated from the discussion of social benefits for specific companies or sectors.

If the renovation is so good, why is it taking so long?

Although the reform proposals are clear evolutions in relation to our current tax system and beneficial for the country as a whole, it does not mean that it is beneficial for each taxpayer, especially in the short term. Thus, there are some political factors that hinder its approval and implementation. The main ones are:

– By unifying the rates, half of taxpayers will pay more taxes. As the concept of the reform is to make everyone pay the same rate that keeps total revenue unchanged, taxpayers who paid an effective rate above the average will have their tax burden reduced and those who paid an effective rate below the average will pay more taxes. That is, half of taxpayers, when assessing the immediate impact for themselves, have incentives to take a position against the reform.

– The unification would also reduce the collection of part of the federative entities (Union, States and Municipalities), which join the resistance. Analogously to the previous point, by equalizing rates and changing the taxation regime from the place of origin to the place of destination, several Municipalities and States would have revenue losses. To mitigate this problem, current reform proposals suggest rules for distributing the IBS among federal entities and include elaborate mechanisms for refunding tax collections to the affected federal entities, which would remain in force for long periods, to soften the impact of the reform and reduce political resistance of these federative entities. In any case, this discussion further increases the complexity of approving the new tax system.

– The elimination of tax breaks pits several influential companies against reform. As a rule, those with more tax benefits are the economic groups with greater political influence, necessary to conquer them. With that, the reform would harm precisely those groups that have greater political strength to create resistance to its implementation.

In the midst of these conflicts of interest and 19 years after the presentation of the first PEC on the tax reform, until today a proposal has not been reached with enough support to be approved by the National Congress.

How to make investment decisions in this context?

It is difficult to know when a tax reform will be implemented in Brazil. The priority that the new government is giving to this agenda could mean that, this time, it will be approved by Congress in the short term, but, given that the discussion has been going on for two decades, it is not prudent to rule out the possibility that the topic will continue without resolution for several years to come.

Despite the uncertainty surrounding approval, the format of the reform is reasonably mature, so it is plausible to adopt the premise that, if approved, the reform will maintain the founding principles of the proposals contained in PECs 45 and 110. The exact impact that the new system will have tax would have on the valuation of each company is difficult to calculate, but it is possible to know whether this impact would be positive or negative, and to have a good notion, in relative terms, of which businesses would be most affected. In summary, in the scenario where the reform is approved, there are two factors that we can adopt as guides to interpret the impact on each company:

– Companies that currently pay below-average excise taxes will be hurt, and companies that pay higher-than-average taxes will benefit. This effect is an immediate result of the principle of unifying rates for all types of income. The clearest case is that industrial businesses, subject to IPI and ICMS, should have their rates reduced and service businesses, subject to ISS, should have their rates increased.

– Tax benefits must lose value. Since the current benefits are related to the 5 taxes that currently exist, as these taxes are replaced by the IBS, the benefits lose value. For example, a 70% exemption from ICMS due will no longer be valid when ICMS ceases to exist.

So that these impacts are not so drastic, which could cause price shocks and frustrate investments made assuming the tax regime in force, both proposals provide for transition periods (of 6 or 7 years, in the most recent drafts). However, softening the impact does not change its direction.

When evaluating new investment opportunities, a rule of thumb can be: the lower the effective rate that a given company collects as excise taxes, the greater the risk that it will be negatively affected by the tax reform. Similarly, the higher the effective tax rate paid by a company, the more it can benefit from the reform.

The complexity surrounding this topic is a good example of why the Brazilian stock exchange is a difficult environment for individual investors, who generally cannot dedicate the time necessary to analyze issues of this type, which, even though they are quite extensive, represent only a small portion of everything. that needs to be evaluated before making an investment with due prudence.

Despite the extra difficulties generated in investment analyses, we welcome the tax reform proposals. Its approval would represent a tremendous advance for the Brazilian tax system, which should bring productivity gains, greater economic growth and, consequently, greater potential for appreciation for companies listed on the stock exchange.

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