Brazil’s Supreme Court addresses software taxation

 By Francisco Moreira, Partner, Bocater, Camargo, Costa e Silva, Rodrigues Advogados, Brazil & Rachel Mira Lagos, Senior Associate, Bocater Advogados, Brazil

After 20 years, the Brazilian Federal Supreme Court took an important step towards forming a new understanding of software taxation. The judgement in Direct Unconstitutionality Actions 1,945 and 5,659, addressed whether software-related transactions should be taxed by ISS or ICMS. The Supreme Court delivered its judgment on February 24.

The Supreme Court decided, by a majority, that the ISS levy would apply to commercial off-the-shelf software, to subscription-model software, and to software developed to meet the specific demands of a given customer (customized software). The court also decided that no ICMS should be levied on the licensing or assignment of the right to use computer programs. The ISS and ICMS levies are Brazilian indirect taxes.

Brazil’s Supreme Court had not analyzed the topic of the taxation of software licensing since the mid1990s. Up until this time, the prevailing jurisprudence was that the physical support for software sales, when sold in bundles (commercial off-the-shelf software), would become a tangible good, treated as merchandise and, as such, subject to the ICMS.

The commercial off-the-shelf software as a method of sale/purchase is not currently performed, as the majority of the market is moving towards a subscription model.

In addition, transactions involving the provision of goods and services have led to disputes between taxpayers and the Brazilian tax authorities. The digital economy is bringing these disputes to the spotlight, primarily because Brazil’s tax legislation has not been updated to account for this new environment. Because different jurisdictions within Brazil impose the ISS and ICMS (municipalities and states, respectively), the municipal and state authorities have argued over which tax is triggered by a software sale. 

This latest Supreme Court decision brings long-lasting effects going forward (ex-nunc effects). With respect to past transactions, the so-called “modulation of effects” considered various aspects:

• Taxpayers who collected only ISS: Confirmation of the validity of the ISS payment and prohibition of the ICMS being charged by the States. Based on this, states will not be able to charge ICMS;
• Taxpayers who collected only ICMS: The taxpayer will not be entitled to recover the ICMS collected, and the municipality will not be able to charge ISS;
• Taxpayers who did not collect ISS nor ICMS by the eve of the publication of the judgment: Possibility of charging only ISS;
• Taxpayers who collected ISS and ICMS, but did not file a claim for restoration of undue payments: there will be the possibility of refunding the ICMS, even if there is no action in progress, under penalty of unlawful enrichment by the states, and the validity of ISS payment;
• Pending lawsuits taxpayers filed against the States or by the States against taxpayers aiming at the collection of ICMS: Judgment must be carried out in accordance with the Supreme Court’s understanding (ISS levy only), with the possibility of recovering the ICMS in cases where this right is the object of the lawsuits; and
• Pending lawsuits taxpayers filed against the municipalities or by the municipalities against the taxpayers: Judgment must be made according to the Supreme Court’s understanding (ISS levy only), except if the taxpayer has already paid the ICMS.

Commercial off-the-shelf software is well-defined and stable software. It’s developed for widespread use and distribution. It is generally available to the public on a commercial basis or on a non-exclusive basis under standard terms and conditions for a one-time license or an ongoing licensee (subscription). Commercial off-the-shelf software solutions typically require on-site hardware, installation, system validation, back-ups, maintenance, and periodic upgrades. Normally the consumer is responsible for the management and configuration of the software. 

Commercial off-the-shelf software that has been on the market (physical media, CD or DVD) for a long time has been subject to ICMS. After the demise of the physical media technologies and the start of electronic data transfers, a long dispute began between states and municipalities regarding the tax levied on such transactions – primarily because Brazil’s tax legislation has not been updated to account for this new environment. 

In 1998 and 1999, the Supreme Court analyzed two cases regarding the taxation of software. It had the understanding that the commercialization of off-the-shelf software (either by means of a physical copy, or download, directly from the licensor, etc.) is considered a transaction of goods, which would be subject to the ICMS. The court also had the understanding that the development of a customized or tailormade software is considered a service, which could be subject to the ISS. 

The Supreme Court’s decision changed more than two decades of understanding by deciding that the ISS will be levied on the licensing of software of any nature, making the differentiation between commercial off-the-shelf software and customized software irrelevant.

The Supreme Court’s decision changed more than two decades of understanding by deciding that the ISS will be levied on the licensing of software of any nature, making the differentiation between commercial off-the-shelf software and customized software irrelevant.     

As was explained in a previous article, we expect that the Supreme Court may interpret the concept of computer software in accordance with Law n. 9.609/1998 (the Brazilian software law), and the nature of the software licensing contract, and its differentiation between sale and purchase with the corresponding change of ownership.  According to the software law, the use of a computer program in Brazil is subject to a license agreement, regardless of the term (perpetual or limited term) and payment conditions (lump sum or monthly) of such a license. The software law also equates the licensing of software to the licensing of copyright.  

This definition will have ramifications in the analysis of other taxes also levied on such payments, such as the WHT on payments for license or assignment of software.

Given the current stage of leading Supreme Court cases, the interpretation of an intellectual property right (a copyright), rather than the commercialization of goods or services provisions should prevail – such as in the case of software as a service (SaaS).

Until recently, tax authorities used to understand that remittances made abroad for the licensing of commercial off-the-shelf software were not subject to the withholding tax (Private Letter Ruling COSIT n. 149/2013), aligned with the understanding of the Supreme Court, seeing standard/ commercial off-the-shelf software as merchandise. If considered as a good, the import of such a type of software was not subject to WHT, including if there were no physical media (downloaded software). But the latter jurisprudence supercedes this understanding.

In 2017, the Conflict Resolution Ruling 18/17 began to reassess this understanding, stating that the licensing of commercialization and the distribution of software differs from licensing for the right to use the software. Payments Brazilian companies made abroad for the right to commercialize software would fall under the concept of royalties, which are subject to the withholding tax. On the other hand, withholding tax is not levied on licensing for the right to use the software.  

Recently, the Brazilian IRS (Receita Federal) published Private Letter Ruling COSIT n. 43 of March 23 (after the judgment of ADIs 1,945 and 5,659), expressing the same understanding that the payments Brazilian companies made abroad for the right to commercialize the software should be included under the concept of royalties, which are subject to the withholding tax.

Regarding the social contribution taxes (PIS and COFINS), the Conflict Resolution Ruling 2/2019, which consolidated the understanding of the Brazilian IRS, concluded that PIS/COFINS should not be levied on amounts paid, credited, delivered, or sent to individuals or legal entities domiciled abroad as remuneration of the copyright related to software. The Private Letter Ruling COSIT 43/2021, mentioned above,

However, it should be noted that although the Private Letter Ruling COSIT 43/2021 was published after the judgment of ADI 1.945 and 5.659, the Brazilian IRS has not mentioned the understanding the Supreme Court established. Besides, since the differentiation between commercial off-the-shelf software or customized software is no longer applicable, it is possible that this understanding will be modified in future rulings. On April 6, 2021, a Consultation Solution COSIT n. 99001/2021 confirmed that payments for software as a service (SaaS) should be treated as technical services and, thus, be subject to the Income withholding tax – so we expect this change in understanding will be reflected in other taxes, such as PIS and COFINS, as well.