In recent years Brazil’s oil and gas production has greatly expanded due to new discoveries in offshore waters and opening of the sector to private companies through concession of exploration and production blocks. This trend is poised to intensify with the recent discoveries of huge new oil and gas reserves under salt layers in offshore basins (called ‘sub-salt’ reserves). Some of these new discoveries have already proven economic to exploit, and will produce a bonanza of revenues for governments and profits for companies, above the substantial growth already achieved. However, as is normal in such situations, this actual and prospective wealth has also caused conflicts over the benefits. These can be classified into two categories: (i) the contention between the federal government and the governments of the states and municipalities onshore of these reserves for the division of the royalties and other forms of participation in the production results; and (ii) the battle among the states for tax revenue from sale of oil and refined products. This short article focuses on an important aspect of this second point of contention.
The taxing powers of the federal, state and municipal governments in Brazil are determined by the 1988 Federal Constitution. The main revenue source for the states is ICMS, a value-added tax on the circulation of goods and the provision of interstate and intermunicipal transportation and communication services. The tax is assessed under a mechanism of offsetting debits and credits at each stage of the distribution chain, where each transaction generates a debit on the sale price which can be set off against the tax paid on the previous acquisition. Each state is free to set its own ICMS rates within lower and upper limits set by federal law or regulations.
However, on interstate transactions there is an equalisation mechanism by which the tax is paid at a nationwide interstate rate to the revenue authority in the origin state and the difference between this rate and that in the receiving state is paid to that state’s tax authority, in each case with offsetting debits and credits under the non-cumulative calculation mechanism. For the interstate sale of petroleum and refined products, however, the Constitution establishes that all the ICMS is paid in the destination state. The objective of this provision is to equalise revenues between producing and consuming states, in service to the aim “…to reduce social and regional inequalities” (Art. 3, III, of the Constitution).
The root of the problem is the interpretation of tax provisions, in the sense that a company may not take any offsetting credit from the previous transaction when the subsequent one is tax-exempt or otherwise untaxed (such as the case of tax incentive programmes). Under a broad interpretation of this principle, the tax authorities in some states where petroleum products originate have lately been trying to prohibit companies from taking offsetting credits on sales of petroleum derivatives to other states, under the argument that no tax is paid in the state of origin. This is illegal and unconstitutional, because the subsequent transaction is effectively subject to tax. As can be imagined, disallowance of the credits in the state of origin generated by sales in other states creates a significant added expense for the taxpayer.
The policy of disallowing ICMS credits in the state of origin violates the very foundation of the non-cumulative nature of the tax. It is one thing to rule out taking credits when there is no tax on the subsequent transaction. But in transactions with petroleum and refined products, the subsequent transaction is taxed, albeit all in another state. If the states of origin feel they are losing undue revenues because of this constitutional provision, their recourse is to convince federal lawmakers to amend the Constitution or to pass legislation to share more federal royalties or other revenue, not to place an illegal and unconstitutional burden on private enterprises.
As interstate transactions involving petroleum and refined products expand, this interpretation by some state tax authorities will become a more critical issue for companies. Combined with this is the fact that in Brazil the doctrine of stare decisis is very new and limited, only upon declaration of a binding precedent (súmula vinculante) by the Supreme Court, after repeated decisions in analogous cases. This makes it likely that many future lawsuits will be filed by companies either seeking court orders (such as writs of mandamus) to assure their constitutional right to take credits or defending themselves against tax deficiency assessments by the revenue authorities in states of origin. Because this dispute is intimately involved with constitutional issues, it is very likely that many of these cases will eventually work their way up to the Federal Supreme Court, and perhaps even elicit enough decisions favourable to taxpayers to prompt the court to exercise its new power to issue a binding precedent on the matter.