Originally published in the March 3 edition of World Tax Daily (Copyrights Tax Analysts – www.taxanalysts.com)
Contract manufacturers in Brazil that operate under the presumed income tax calculation regime (lucro presumido) may face an additional, undesirable tax burden because of a change implemented by the Federal Revenue Department.
Interpretative Declaratory Act (ADI) 20/07, which introduces a differentiation in the tax treatment applicable to contract manufacturers under the lucro presumido regime, was published in Brazil’s official gazette on December 14, 2007, and entered into force on January 1.
Contract manufacturing in Brazil has some peculiarities as compared to other countries.
Because of the many taxes on outputs — including P.I.S. (the Program for Social Integration contribution), COFINS (the Contribution for the Financing of Social Security), the federal excise tax (IPI), and state VAT (ICMS) — clients usually acquire raw materials and components from suppliers and send them to contractors for manufacturing. The taxes on outputs1 are levied only on the manufacturing service provided by the contractor and any materials subsequently added by the client (the manufacturer); any materials originally sent to the contractor by the client are treated as a mere return of goods and are not subject to taxes at the manufacturer’s level.
To illustrate the situation, assume that a client sends $80 worth of materials to a contractor; after the manufacturing process, the contractor returns the manufactured product, still valued at $80, and charges $20 for its manufacturing services, which may include labor, energy, and other materials added to the product by the contractor. Taxes on the $80 value of the product usually are suspended on remittance to the client, and the contractor pays taxes on outputs of $20. For income tax purposes, the tax base is the presumed margin applicable to $20, not the aggregate $100.
Under the lucro presumido regime, taxpayers calculate income tax on a percentage of gross revenues for the entire 12 months of the year (although payments are made quarterly). At the end of the year, no adjustment is made, even if actual profits exceed the presumed profit used to calculate the income tax. To be eligible for this method, taxpayers’ annual gross revenues in the preceding year cannot exceed BRL 48 million (approximately $28.5 million).
For industrial activities, the presumed margin for corporate income tax is 8 percent of gross income, whereas the margin is 32 percent for services activities. For the 9 percent social contribution on net income (CSL), the presumed margin is 9 percent of gross income for industrial activities and 32 percent for services activities.
Before ADI 20/07, contract manufacturing activity was considered to be an industrial activity. As a consequence, contract manufacturers under the lucro presumido regime calculated their income tax based on 8 percent of their gross income (and 9 percent for CSL purposes). In the aforementioned example, that means that the corporate income tax and CSL basis were $1.60 and $1.80, respectively (8 percent and 9 percent of the $20 charged for manufacturing services). Over those bases, income tax rates of either 15 percent or 25 percent and CSL (at 9 percent) would apply.
ADI 20/07 dramatically changed that tax treatment by establishing a limit up to which contract manufacturing will still be considered an industrial activity that is eligible for the presumed tax basis of 8 percent. ADI 20/07 expressly says that if the costs of the materials provided by the client to the contractor account for a greater portion of the total value of the manufactured product than any materials and manufacturing services provided by the contractor, the manufacturing activity carried out by the contractor will be considered as a service activity rather than as an industrial activity.
That recharacterization, however, applies only for corporate income tax and CSL purposes; it does not affect other federal, state or local taxes, such as IPI, P.I.S., COFINS, ICMS, or the municipal service tax (ISS).
As a consequence of the recharacterization, the contractor will not be eligible to calculate income tax at the presumed margin of 8 percent of gross income; instead, it will be required to adopt the presumed margin for service activities, which is significantly higher at 32 percent.
To illustrate the impact of ADI 20/07, assume that Contractor A receives materials worth $80 from the client and adds $20 in materials and manufacturing services, and Contractor B receives $40 in materials from the client and adds $60 worth of materials and manufacturing services. The final costs of the manufactured product are the same — $100 — but the tax consequences to the contractors are different.
Before ADI 20/07, Contractor A would pay income tax of $0.40 (25 percent on a tax base of 8 percent of $20) and CSL of $0.162 (9 percent on a tax base of 9 percent of $20),2 for a total of $0.562. Contractor B, however, would pay income tax of $1.20 (25 percent on a tax base of 8 percent of $60) and CSL of $0.486 (9 percent on a tax base of 9 percent of $60), for a total of $1.686.
Under ADI 20/07, because the cost of the materials provided by the client ($40) to Contractor B is not greater than the value of the manufactured product ($100), Contractor B would face no changes to its corporate income tax or CSL rates.
For Contractor A, however, the tax increase will be significant because the cost of the materials provided by the client ($80) accounts for a larger portion of the total cost of the manufactured product ($100) than the services and materials provided by the contractor.
Therefore, under ADI 20/07, Contractor A would pay $1.60 as income tax (25 percent on a tax base of 32 percent of $20) and $0.576 of CSL (9 percent on a tax base of 32 percent of $20), for a total of $2.176. That is a tax increase of almost 288 percent as compared with the amount under the former calculation method that allowed Contractor A to use a presumed tax base of 8 percent instead of the 32 percent basis required by ADI 20/07.
The change contained in ADI 20/07 will affect several sectors and multinational companies, including those in the electronics (mobile phones and batteries) and machinery and equipment industries, where most of the materials are remitted to contractors by the manufacturers (clients).
Furthermore, ADI 20/07 is interpretative, which means that it may have retroactive effect. As a result, contractors may be required to pay unpaid income tax and CSL from previous years. Taxpayers that carry out contract manufacturing activities should consult with their accountants, auditors, and tax advisers to ascertain their risks and potential tax exposure — past and present — and to find ways to minimize any adverse tax impact.
FOOTNOTES
1 In some cases, IPI and ICMS can be deferred or suspended until the client actually sells the final product?
2 Assuming a corporate income tax rate of 25 percent and CSL of 9 percent.
END OF FOOTNOTES
David Roberto R. Soares da Silva