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Controversies regarding the Brazilian Goods and Services Taxes on Digital Goods

Addressing the taxation of goods and services in Brazil has been a challenge for several decades, especially in view of the multiplicity of taxes and the great amount of laws from each one of the government levels (Federal Union, 27 States, and 5500 plus Municipalities), as well as the multiplicity of tax authorities at different levels of government with their own approach towards tax laws in favor of their own tax collection.

The main challenge in this regard arises from the fact that Brazil does not have a single Value-Added Tax or Goods and Services Tax. Rather, it splits the taxation of goods and services between the State VAT (ICMS) – levied on transactions with goods, interstate and intermunicipal and communication services, even from abroad – and the Municipal Service Tax (ISS) – levied on other services not subject to the ICMS.

Accordingly, transactions involving the provision of goods and services historically give rise to disputes between taxpayers, state tax authorities and municipal tax authorities, as such tax authorities tend to interpret the transaction in a way that best suits for the levy of the ICMS or ISS, respectively. There are also federal taxes whose levy may vary according to the object of the transaction (good or service), but the main controversies arise from the conflict between ICMS and ISS, which we will address in this article.

Such controversies have taken even greater proportion in connection with the taxation in the digital economy, mainly because the Brazilian legislation is not clear as regards the nature of the transacted digital goods (if it is a good or a service), and the fact that the ICMS and ISS national guidelines rules (Supplementary Laws 87/1996 and 116/2003, with some changes carried out in 2016) are obsolete, and unfit for addressing the digital economy.

To this effect, Supplementary Law 87/1996 generically states that the ICMS is levied on transactions with goods, neither providing a definition of goods, nor addressing digital goods in any manner. Supplementary Law 116/2003 states that the ISS is levied on the provision of services indicated in its attached list, among which we highlight the development of computer program, licensing or assignment of the right to use computer programs, and provision, without permanent assignment, of audio, video, image and text content via the internet (streaming).

In 1998 and 1999, the Brazilian Federal Supreme Court (STF) analyzed two cases regarding the taxation of software, understanding that: (a) the licensing of the rights to use a software between its owner (licensor) and the licensee is not a transaction with goods subject to the ICMS; and (b) the sales of physical copies (in diskette or CD) of standard software in stores is a transaction with goods subject to the ICMS. Also, it was acknowledged that it is possible to request the development of a software from scratch (the so-called "tailormade" software), which could typify a service provision.

Based on these decisions (which are the only merit decision rendered by the STF on the matter), the lower courts case law, federal and state tax authorities, and the jurists' opinion, have construed an interpretation of the tax legislation in which: (a) the commercialization of standard software (either by means of a physical copy, or download, directly from the licensor, etc.) is considered as a transaction of goods, which would be subject to the ICMS; and (b) the development of a software by order ("tailormade") is considered as a service, which could be subject to the ISS.

As an example of such understanding, we point out the State of São Paulo State Treasury Office Normative Ruling 04/2017, which states that only the development of tailormade software is subject to the levy of the ISS; thus, if the software is not customized, the transaction will be subject to the ICMS. They also claim that the installation of the standard software (from a physical or virtual store or download) on the acquirer's hardware or use "in the cloud" through the internet (streaming) does not de-characterize the legal nature of the transactions with goods.

Nevertheless, municipalities do not agree with such interpretation, stating that, as transactions with software involve a licensing of the rights to use it, and the licensing of software is legally considered as a taxable service, all transactions with software should be subject to the ISS, and not to the ICMS.

In this sense, the Municipality of São Paulo issued Normative Opinion 01/2017, stating its understanding (binding to its tax authorities) that the licensing or assignment of the right to use software, by means of physical support or by electronic transfer of data ("software download"), or when installed on an external server ("Software as a Service – SaaS") – in this last case, part of the SaaS agreement may be typified as other services subject to the ISS –, is considered as a service subject to the ISS. Furthermore, it also states that such understanding is applicable regardless of whether the software has been programmed or adapted to meet the specific needs of the service receiver ("tailormade software") or standardized ("standard software").

As it can be seen, each state and municipality interpret the legislation in its own benefit, disregarding the taxpayers, who are left in the middle of a tax jurisdiction conflict, not knowing with legal certainty which tax is due.

In our opinion, it will take a long time for this discussion to be settled, especially because: (a) the only merit decision rendered by the STF is outdated, as they considered transactions with physical copies of software (uncommon today); (b) the segregation of software between standard and tailormade is also outdated, as technology evolves, and new modalities of software arise (such as the SaaS); (c) the municipal tax authorities' understanding is too extreme, as it narrows down software to a mere licensing; (d) and the tax legislation is not up to date with nor catching up with the technological advancements.

Another major controversy involving the taxation of digital goods is related to the levy of the ICMS on transactions carried out by means of download. This is because, as the ICMS is a state tax, to establish a uniform and harmonic treatment of such tax in all 27 Brazilian states, the Brazilian Federal Constitution determines that a supplementary law (a law which requires a higher legislative quorum for approval) must provide its general guidelines, especially the state to whom the tax is payable and who is the liable taxpayer.

This uniformization is highly necessary on transactions with digital goods, for example, when considering that the parties involved, such as seller, buyer, and server from which the software is downloaded, may be in different states, thus causing confusion regarding to which state the tax should be paid, and who should pay, among other unclear matters.

To solve such controversy, the states entered into ICMS Agreement 106/2017 (published on October 5, 2017), defining that, in transactions with digital goods, such as software, programs, electronic games, applications, digital files and the like, which are standardized (even if they have been or can be adapted) and sold by means of electronic data transfer, the ICMS: (a) will be due to the state where the acquirer is domiciled or established; and (b) must be paid by the legal entity that owns the website or digital platform that sells or provides the digital goods.

Furthermore, the state agreed that transactions with digital goods sold by electronic data transfer that happen before the sending to the end-consumer will be exempt from ICMS. Thus, in practice, in the transactions at issue, only the sales of digital goods to the end-use will be taxed by the ICMS.

Although the enactment of ICMS Agreement 106/2017 has the good intention of enabling the levy of the ICMS on transactions with digital goods by download, it gives rise to more controversies, such as: (a) defines aspects of the ICMS that should be addressed by a supplementary law (liable taxpayer and the state to which the tax should be paid), as requested by the Brazilian Federal Constitution, and not an agreement (this matter is already being discussed by some taxpayers in court); and (b) maintain the conflict of jurisdiction between the Brazilian states and municipalities, as the municipalities will still charge the ISS on these transactions.

In summary, there are several challenges to be addressed in Brazil in connection with the taxation of the digital economy. Although some matters that inevitably must be settled in courts, it is clear that the Brazilian tax law must be updated in order to address the current technological reality, and be flexible to handle new technologies that might come.