Originally published on the march 16 edition of World Tax Daily (Copyrights Tax Analysts www.taxanalysts.com)
A possible presidential veto of the Brazilian Senate’s amendment to a law project affecting the characterization of service agreements has started a fierce debate over the use of personal service companies by Brazilian individual taxpayers. A decision on the veto is expected in the next few days.
Law Project 6,272/2005, which merges Brazil’s Social Security Revenue Service and Federal Revenue Department, contains a provision — added by the Senate and approved by the House — that requires a decision from a labor court for revenue agents to be able to recharacterize a service agreement as “employment” and assess the corresponding income and social security taxes on payroll.
While lawmakers and the private sector support the amendment, the Ministry of Finance and unions representing the tax agents have asked the president to veto it in order to preserve employment and prevent schemes that could be harmful to employees. They argue that personal service companies have been used to bypass employment relationships and avoid the payment of social security and income taxes (on compensation and payroll). Tax agents should have the power to disregard service contracts if elements of an employment relationship are deemed to exist, and to assess not only social security taxes on payroll, but also withholding income tax on compensation, the finance ministry says.
The core issue behind the dispute is the burdensome taxation of employment in Brazil, where the total cost of labor and social charges and income taxation can reach as high as twice the amount of a company’s payroll (for employers). Even for employees, income tax and social charges can exceed 25 percent of an individual’s taxable income.
As a result, professionals and other individuals form personal service companies to provide services to their own employers or other companies, thereby reducing their overall taxation. Because profit distributions to equity holders are tax-exempt, the use of personal service companies may reduce the employees’ taxation from more than 25 percent to as low as 11.3 percent, depending on the service rendered and the location of the service company.
If the restriction contained in Law Project 6,272/2005 is vetoed, many professionals such as dentists, physicians, attorneys, and accountants may have their contracts with clients (or in some cases, with a single client) disregarded and their service income recharacterized as employment income, with adverse tax consequences for both the clients and the service providers.
However, the government may adopt a third alternative: While safeguarding professional service companies, it may assess an even higher tax on individuals who use (or abuse) personal service companies solely to minimize their tax liability. That scenario might apply, for example, to artists, journalists, and athletes who create personal service companies to minimize taxation and avoid social security charges (similar to the case of Leavell v. Commissioner, 104 T.C. 140 (1995)).
The government is considering increasing the taxation of those types of personal service companies under the argument that if the artist or athlete is not available to render the services, no other person is able to replace him or her, and therefore, the tax treatment should not be the same as for any other service company.
Sources in the executive branch have said the president might veto the restriction in the law project and at the same time issue a provisional measure to regulate the use of service companies. The measure would include a tax increase for some personal service companies, although the amount of any such increase has not been disclosed.
David Roberto R. Soares da Silva