State Tax Incentives and the tax war

Brazil is one of the biggest countries in the world. As a consequence, the Brazilian territory is divided in several States, some of them completely different in economic, cultural and other aspects. Moreover, each State has certain autonomies, such as in the political, legislative and economic areas.

In order to attract industries for their states, reinforce the local economy through employment generation, increased production of goods and services and consequently increase tax collections, the States began to grant ICMS (State VAT) tax incentives, which reduce the monthly amounts payable.

In accordance with the applicable federal legislation, State tax incentives can only be granted after a formal approval by the other Brazilian States, a requirement which was not observed in several of these tax incentives. Although tax incentives were granted without the necessary approval from the other States, many companies decided to install themselves in, or even move to, States offering benefits.

Because some States began to lose potential and existing taxpayers, those that felt harmed filed lawsuits in order to question the validity of those tax incentives. It is important to stress that these judicial disputes have a political component which made the outcome unpredictable.

Despite the fact that such lawsuits became common in Brazil and nowadays several tax incentives are under judicial disputes, there is no consolidated case law in this regard in the Brazilian Supreme Court. However, there are precedents in which the tax incentives granted contrary to the Federal legislation were ruled unconstitutional. In these cases the States, as a result of judicial orders, must revoke the tax incentives and demand payment of the ICMS previously exempted.
In addition, some States also started to disallow tax credits recorded by companies receiving goods benefited by tax incentives granted in other States, which increased the ICMS monthly tax payment of such companies.

Although the tax incentives, in a M&A transaction analysis, have some advantages, such as reduction of the tax burden, improvement of cash flow and increase of profitability, any decisions unfavorable to the target company handed down by the Supreme Court may lead to significant tax contingencies.

The disputes related to the granting of irregular tax incentives may lead to an uncertainty that impacts a M&A transaction and must be taken into account in the analysis of the financial and tax aspects of the deal, as any potential invalidation of the tax incentive may change all projections and studies of profitability, EBITDA and ability to generate cash, besides tax contingencies that may arise, as mentioned above.

By Marcos Tabatschnic and Rita Canto, M&A Tax Managers
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