On February 26, the Brazilian Supreme Federal Court (STF) ruled that the municipal service tax (ISS) does not apply to contract manufacturing (industrialization by order). In a 10-to-1 decision in Extraordinary Appeal No. 882,461, the Court held that charging ISS on these operations is unconstitutional, following the opinion of Justice Dias Toffoli.
However, the Court limited the effects of its ruling, determining that the ISS exemption will only take effect from the date the judgment minutes are officially published, preventing taxpayers who have not already taken legal action from seeking refunds of ISS previously paid.
Background of the Case
The taxpayer argued that the transaction qualified as industrial activity, subject to the state VAT (ICMS), while the municipality claimed it was a taxable service under ISS.
Justice Toffoli found that Complementary Law No. 116/03, by imposing ISS on industrial activities without excluding goods intended for resale or further industrialization, overstepped municipal taxing authority and resulted in unlawful double taxation alongside federal excise tax (IPI).
The STF thus established the following binding precedent on the matter (general repercussion thesis):
“It is unconstitutional to levy ISS, as provided in item 14.5 of the list attached to Complementary Law 116/03, when the goods are intended for industrialization or commercialization.”
Implications of the Ruling
The decision clarifies that contract manufacturing is part of the production chain and should be taxed either under ICMS or IPI, depending on the destination of the goods:
- ICMS applies when goods are intended for resale.
- IPI applies when goods are meant for the company’s own consumption.
Due to the limitation (modulation) of the decision’s effects, only companies that filed lawsuits before the ruling will be able to claim a refund of ISS unduly paid. Other taxpayers will not be entitled to past refunds but are also protected from retroactive tax assessments for other taxes.
Possible Clarifications and Future Guidance
The National Treasury Attorney General’s Office (PGFN) may still file motions for clarification, especially concerning IPI taxation. However, the STF’s ruling is expected to guide lower courts and Brazil’s Federal Revenue Service (Receita Federal) on how taxes should be applied in contract manufacturing scenarios going forward.
Cap on Late Payment Penalties
Another important aspect of the ruling was the discussion on late payment penalties. The STF set a limit of 20% of the tax amount due, invalidating higher penalties imposed by some municipalities. The Court reaffirmed that excessive fines amount to confiscation, violating the principle of proportionality in taxation.