Tax Strategy: Reduced Tax Liability under the Deemed Profit Method

MANHÃES MOREIRA ADVOGADOS
Authors: Lucas Kurtz, Daniel Takaki and Ricardo Ciconelo
Research Assistance: Martin Mahlstedt

Companies with high profit margins and previous annual revenue of less than R$ 48,000,000 often realize significant tax savings by electing to pay corporate tax under the Deemed Profit Method (also know as “Lucro Presumido”). Here, rather than paying tax on the company’s actual profits, a universal predetermined profit margin is used to calculate the company’s taxable income. 8% of revenue is the predetermined profit margins range for the sale of goods and 32% of revenue used for the sale of service. [1] Eligible companies selling goods at profit margins greater than 8% and those selling services at profit margins greater than 32%, can use the Deemed Profit Method to lower their taxable basis and reduce tax payments.

While the Deemed Profit Method regime was enacted to simplify tax calculations and compliance for small businesses, many companies use the regime to generate significant tax savings and increase profits. Understanding the principles behind the Deemed Profit Method and strategies for implementation help minimize Brazilian tax.

A company with previous fiscal year revenue less than R$ 48,000,000 has the option of paying income tax under either the Actual Profit Method (also known as “Lucro Real”) or Deemed Profit Method.[2] While the corporate income tax rates are equal under the two methods, the taxable basis may vary greatly. [3] Companies with revenue greater than R$ 48,000,000 will want to evaluate whether it is tax efficient and legal to realize revenue in separate entities.

The Actual Profit Method is the traditional regime. As one might expect, the company’s corporate income tax calculation is based on profits before tax and allows the company to deduct certain costs and expenses.[4]

Unlike traditional income tax calculations, actual profits and operating expenses are irrelevant under the Deemed Profit Method. Rather, taxable basis is calculated by using the predetermined profit margin corresponding to the company’s commercial activity.[5]

To illustrate, let’s look at a hypothetical company which sells goods and has a pre-tax profit margin equal to 30%. The company has R$ 10,000,000 in revenue and deductable cost and expenses equal to R$ 7,000,000.

The tables found below use the above mentioned hypothetical numbers to compare Actual Profit Method and Deemed Profit Method.

|Actual Profit Method | |Deemed Profit Method |
|Revenue |10,000,000 | |Revenue |10,000,000 |
|Costs and Expenses |7,000,000 | |Costs and Expenses |7,000,000 |
|Profits Before Tax |3,000,000 | |Profits Before Tax |3,000,000 |
|Taxable Income |3,000,000[6] | |Taxable Income |800,000[7] |
|Income Tax Liability |996,000[8] | |Income Tax Liability |248,000[9] |
|Tax proportional to Revenue |9.96% | |Tax proportional to Revenue |2.48% |
|Profits After Tax |2,004,000[10] | |Profits After Tax |2,752,000[11] |

Under the traditional Actual Profit Method, the company’s taxable income is R$ 3,000,000, the corporate tax payment is R$ 996,000 and profit after tax is R$ 2,004,000. However, under the Deemed Profit Method, the company’s taxable income is only R$ 800,000, the corporate tax payment is reduced to R$ 248,000 and profit after tax is increased to R$ 2,752,000.

Here, under the Deemed Profit Method, the company increases its profit after tax by 37%.[12]
Now, let’s look at a hypothetical service company with a pre-tax profit margin equal to 70%. The company has R$ 10,000,000 in service related revenues and deductable cost and expenses equal to R$ 3,000,000.

The tables found below use the above mentioned hypothetical numbers to compare Actual Profit Method and Deemed Profit Method.

|Actual Profit Method | |Deemed Profit Method |
|Revenue |10,000,000 | |Revenue |10,000,000 |
|Costs and Expenses |3,000,000 | |Costs and Expenses |3,000,000 |
|Profits Before Tax |7,000,000 | |Profits Before Tax |7,000,000 |
|Taxable Income |7,000,000[13] | |Taxable Income |3,200,000[14] |
|Income Tax Liability |2,356,000[15] | |Income Tax Liability |1,064,000[16] |
|Tax proportional to Revenue |23.56% | |Tax proportional to Revenue |10.64% |
|Profits After Tax |4,644,000[17] | |Profits After Tax |5,936,000[18] |

Under the traditional Actual Profit Method, the company’s taxable income is R$ 7,000,000, the corporate tax payment is R$ 2,356,000 and profit after tax is R$ 4,644,000. However, under the Deemed Profit Method, the company’s taxable income is only R$ 3,200,000, the corporate tax payment is reduced to R$ 1,064,000 and its profits after tax is increased to R$ 5,936,000.

Here, under the Deemed Profit Method, the company increases its profit after tax by 27.8%.[19]
Companies with revenue exceeding R$ 48,000,000 may want to consider spinning off entities in order to create one or more eligible entities.[20] This will allow the company the opportunity to pay corporate tax under the Deemed Profit Method. Depending on the facts and business operations it may be justifiable to have separate entities for various regions and product lines. In addition, companies generating revenue through both services and the sale of goods may want to consider separating business lines into two distinct entities.

Companies entering the Brazilian market and those generating moderate revenue in Brazil, need to question their global tax advisors regarding whether widely accepted jurisdictional profit shifting strategies are cost effective when considering the companies commercial activities, revenues and pre-tax profit margin. Too often companies attempt to reduce their effective global tax rate by shifting profits to jurisdictions which provide corporate tax rates lower than the standard Brazilian rate of 34%.[21] However, the lowest effective tax rate is often located in Brazil because the predetermined profit margin under the Deemed Profit Method often reduces the company’s taxable basis.[22] Realizing the profits in Brazil, also eliminates the costs associated with additional taxable transactions and alleviates many transfer pricing related headaches.

Since the Deemed Profit Method was created to simplify tax compliance for small business operations, companies receive the added benefit of not being required to maintain detailed accounting records and supporting documentation. The simplified tax calculation and low compliance requirements allow companies to reduce tax compliance costs.

Before electing what regime will govern their Brazilian corporate tax liability, companies should analyze projected financial performance under both the Actual and Deemed Profit Method. In many cases, companies can utilize the Deemed Profit Method to reduce tax payments and effectively increase profit after tax. In addition, the Deemed Profit Method can often provide greater global tax savings than jurisdictional profit shifting tax strategies. Companies with revenue exceeding R$ 48,000,000 and companies generating revenue through both services and the sale of goods should consider spinning off entities in order to unlock the tax savings opportunities available under the Deemed Profit Method.
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[1] Predetermined profit margins: (1) Resale for final consumption of fuel and natural gas – 1.6%; (2) Sale of goods – 8%; (3) Cargo transportation services – 8%; (4) Hospital services – 8%; (5) Real estate sales completed by companies in the real estate industry – 8%; (6) Printing industries – 8%; (7) Civil Construction – 8%; (8) Transportation services other than transportation of cargo – 16%; (9) Services provided by companies with annual gross income under R$ 120,000 – 16%; and (10) Other services – 32%.
[2] Each year companies must elect which tax regime they will follow. The election can be altered each year based on projected revenues and costs.
[3] 34% corporate income tax rate is levied on profits greater than R$ 240,000, while the rate of 24% is levied on the initial R$ 240,000.
[4] Allowable deductions include net operating losses from prior years, with some restrictions.
[5] See footnote 1.
[6] Taxable income under the Actual Profit Method equals revenue minus deductible costs and expenses (R$ 3,000,000 = R$ 10,000,000 - R$ 7,000,000).
[7] Taxable income under the Deemed Profit Method equals the presumed profit margin multiplied by revenue [R$ 800,000 = R$ 10,000,000(.08)].
[8] Corporate income tax liability is equal to 24% of the first R$ 240,000 of taxable income plus 34% of taxable income exceeding R$ 240,000 [R$ 996,000 = R$ 240,000(.24) + (R$ 3,000,000 – R$ 240,000)(.34)].
[9] Corporate income tax liability is equal to 24% of the first R$ 240,000 of taxable income plus 34% of taxable income exceeding R$ 240,000. [R$ 248,000 = R$ 240,000(.24) + (R$ 800,000 – R$ 240,000)(.34)].
[10] Profit after tax is equal to profits before tax less than income tax liability. [R$ 2,004,000 = R$ 3,000,000 – R$ 996,000].
[11] Profit after tax is equal to profits before tax less than income tax liability. [R$ 2,752,000 = R$ 3,000,000 – R$ 248,000].
[12] Proportional increased profit after tax equals the difference between profit after tax under the Deemed Profit Method and profit after tax under the Actual Profit Method divided by profit after tax under the Actual Profit Method [0.3732 = (2,752,000 – 2,004,000) /2,004,000]. Calculations are based on revenue of R$ 10,000,000. Proportional increase will vary slightly depending on revenue. See below for calculations pertaining to profit after tax under the Actual and Deemed Profit Methods.
[13] Taxable income under the Actual Profit Method equals revenue minus deductible costs and expenses (R$ 7,000,000 = R$ 10,000,000 - R$ 3,000,000).
[14] Taxable income under the Deemed Profit Method equals the presumed profit margin multiplied by revenue [R$ 3,200,000 = R$ 10,000,000(.32)].
[15] Corporate income tax liability is equal to 24% of the first R$ 240,000 of taxable income plus 34% of taxable income exceeding R$ 240,000 [R$ 2,356,000 = R$ 240,000(.24) + (R$ 7,000,000 – R$ 240,000)(.34)].
[16] Corporate income tax liability is equal to 24% of the first R$ 240,000 of taxable income plus 34% of taxable income exceeding R$ 240,000. [R$ 1,064,000 = R$ 240,000(.24) + (R$ 3,200,000 – R$ 240,000)(.34)].
[17] Profit after tax is equal to profits before tax less than income tax liability. [R$ 4,644,000 = R$ 7,000,000 – R$ 2,356,000].
[18] Profit after tax is equal to profits before tax less than income tax liability. [R$ 5,936,000 = R$ 3,200,000 – R$ 1,064,000].
[19] Proportional increased profit after tax equals the difference between profit after tax under the Deemed Profit Method and profit after tax under the Actual Profit Method divided by profit after tax under the Actual Profit Method [0.2782 = (5,936,000 – 4,644,000) /4,644,000]. Calculations are based on revenue of R$ 10,000,000. Proportional increase will vary slightly depending on revenue. See below for calculations pertaining to profit after tax under the Actual and Deemed Profit Methods.
[20] Spin-offs should be grounded on economic substance or business reasons.
[21] This is generally achieved by selling products to the related Brazilian company at inflated prices. This practice decreases the Brazilian operation’s profit margin and taxable income, while increasing profits in the jurisdiction with a lower corporate tax rate.
[22] The R$ 48,000,000 revenue restriction applies.