Introduction
A combination of factors is putting pressure on the Brazilian government to quickly conclude the drafting of a bill with the new Brazilian transfer pricing rules and submit it to Congress at the earliest opportunity. Admittedly, 2022 would not be the best moment to hasten Congressional review of intricate tax reforms. Still, the sudden changes in the US foreign tax credit regulations have lit a fire under the government, urging the alignment of Brazilian TP rules to the OECD standards.
Both the Brazilian Receita Federal and the OECD teams have already dedicated substantial efforts in an ongoing project for the full adoption of the OECD Transfer Pricing Guidelines as a necessary step on the roadmap for the accession of Brazil to the OECD. But this relatively slow-moving project gained importance and additional momentum as adopting the arm’s length principle and redesigning the Brazilian transfer pricing rules to fully embrace the Guidelines became urgent measures to unlock the restrictions against the creditability of Brazilian withholding and corporate taxes in the USA. As a result, a spotlight has been put on the abyssal disparity between the Brazilian corporate income tax rules and those adopted by the major economies, and this factor may also instigate additional reforms in other areas of the Brazilian corporate income tax in 2023.
Given the forthcoming federal elections, the hurdles for obtaining Congressional approval tend to be larger than usual. That is, at least, how the “election-year Congress do-nothing” cliché goes. Nevertheless, the Brazilian Congress has been exceptionally responsive in crucial tax initiatives sponsored recently by the present government, pushing bills forward to quickly approve complex tax changes aimed at curbing fuel prices. In the area of transfer pricing, unconfirmed reports suggest that the government is considering issuing a Provisional Measure, since this fast-track procedure would help expedite the Congressional discussions around the new TP rules and achieve the desired legislative goal in 2022. Nevertheless, even in this best scenario, these rules will only apply in 2023.
The formal draft of bill with the Brazilian TP rules has not been unveiled yet, but the Receita Federal showcased its main features in public sessions conducted with a clear intention of testing the waters and gathering inputs from several private sector representatives. The comments below are based on my impressions gathered at some of such meetings.
In with the old, out with the new?
Brazil is notably a latecomer to the world of the OECD TPG. Among the 20 world’s largest economies, it will be the last country to incorporate the arm’s length principle and the OECD’s TP methods in its legislation. Nearly 40 years after the launching of the 1995 Guidelines, Brazil will now fully embrace the standard versions of the traditional and transactional TP methods without modifications or remodeling of any kind.
But this late adoption of the Guidelines creates a feeling of anachronism. The methods that will now be transplanted into the Brazilian legislation are somewhat archaic in the current debate, and they will replace the renowned Brazilian-crafted fixed margins approach – an innovative TP approach that became an important component of the set of mechanisms proposed for the global formulary apportionment of profits.
To put it more precisely, the prescriptive fixed margins approach can still be portrayed as a robust simplification measure that promotes legal certainty, cost-efficiency and equality, but its scope must be carefully designed to cover similar companies acting in the same business sector with similar FAR profiles, etc. In this sense, the Brazilian experience with this fixed margins approach failed in putting theory into practice. As a result, the approach was merely an ideological concept that did not prove advantageous in practice. The success of a model with fixed margins depends on their restricted scope, relative precision and implementation as a rebuttable presumption. In addition, fixed margins must stem from data analyses, be as varied as possible and be updated periodically. In the past decades, however, Brazilian taxpayers were faced with a reduced number of margins that were either set too high or too low when compared to the actual business practice (leading to litigation in times of high prescriptive margins).
It is not the case for complete desertion of this approach. Adopting safe harbors for TP will provide a place for the Brazilian fixed margins. The new Brazilian TP rules may allow a category of taxpayers, e.g., limited risk distributors, to streamline their TP compliance obligations by opting to apply a prescribed method with a given profit range. Such a range would likely be based on fixed margins tailored for very specific business sectors and a tolerable deviation (the “divergence margin”).
Narrowing the Distance to the OECD TP Practice
The announced changes in Brazilian TP rules are a cause for celebration. They confirm a policy decision towards full alignment with the OECD TP Guidelines and a clear commitment of the Brazilian Federal Revenue to take the necessary steps on the roadmap for the accession of Brazil to the OECD. Brazilian and foreign MNEs that are used to applying the TPG elsewhere will benefit from adopting standard TP rules in Brazil, given a whole new set of mechanisms that allow a greater degree of customization in the TP analysis. Brand new tools include the possibility of applying a basket approach, electing a foreign tested party, performing all sorts of comparability adjustments, customizing transfer pricing methods or devising new ones, etc.
When full convergence to the Guidelines takes place, Brazilian taxpayers will be faced with the challenging opportunity of switching their TP practices with a view to potential advantages of both the old and the new rules.
First, enshrining the arm’s length principle in the law will represent a significant change and set the scene for discussions around the adequacy of methods and production of proof. The current Brazilian TP practice is acquainted with the possibility of free choice of methods without the need for a prior meticulous functional analysis. Adopting the Guidelines will set certain boundaries to this old habit by demanding careful analysis with a view to determininge the most appropriate method based on the facts and circumstances of each transaction. Nevertheless, the adoption of the ALP sets up a broad notion that may leverage deviating and more liberal practices.
One good example of potential distortions that may occur when we combine the current Brazilian practice with the idealized OECD methods is the application of the CUP method. In international practice, this method may be hard to apply when, e.g., the products under comparison present differences in their content that significantly affect the sales price. But the current Brazilian rules and practice are more relaxed on both the comparability and sample formation requisites. In the past years, resorting to the CUP method was an easy escape for Brazilian importers who could not cope with the minimum prescriptive fixed margins of the Brazilian version of the RPM method. Case law in Brazil already encompassed a broad notion of comparability that will be hard to change and adapt to the new OECD standards.
Sample formation in Brazil nowadays is commonly based on a handful of internal comparables purposely selected to justify the intercompany prices. Jumping from this practice to find a satisfactory comparable under the methodical sample selection of the TPG world will not be easy. Especially because Brazilian companies in many business sectors have no access to public databases with comparable market prices and have little or no experience in using commercial databases for transfer pricing benchmarking under the auspices of the Guidelines.
The hurdles for applying the RPM and CPM methods in an OECD fashion, or even the TNMM, will not be smaller. Apart from the difficulties in finding comparable data for gross or net profit margins, these methods also demand the proper consideration of deviations in accounting practices of the Brazilian landscape and that of the country where the comparable data was extracted from. For example, according to the current Brazilian accounting rules and practice, many items of indirect costs are treated as part of the cost of inventories, whereas in many countries such disbursements are booked directly to the profit and loss account as an expense. These variations affect the comparability of gross margins and demand careful analysis by taxpayers and tax authorities alike.
Borrowing data and experience from other companies within the same multinational group will be the fastest way to absorb the TPG practice. The adoption of the same Guidelines in both ends of the transactions allow efficiency by curtailing local TP work, providing them with a starting point for the functional analysis and accurate delineation. Electing a foreign tested party, for instance, is an option that, when feasible, avoids duplication of work by allowing the utilization of the same TP analysis performed abroad.
Innovations in the New Brazilian TP Rules
The Brazilian international tax policy has traditionally depicted a distinctive character, combining inventiveness with irreverence, what creates a unique laboratory for testing new solutions. Nevertheless, apart from the safe harbors and a special focus to transactions involving commodities, the draft bill for adoption of the TPG offered very few innovations from a global perspective. From the local perspective, the number of innovations that full convergence brings is already overwhelmingly huge enough to handle.
The two major striking changes in the Brazilian TP rules are adopting transactional profit methods (TNMM and TPSM) and redesigning the royalty deduction limitations. These radical changes will offer brand new tools for the performance of TP analysis but will also demand enormous efforts for the Brazilian taxpayers who are newcomers in this field.
In a world that favors transactional profit methods over traditional methods, Brazil is almost an unchartered land in terms of scarcity of data and knowledge. Taxpayers who are used to prescribed formulas and fixed margins will experience an unprecedented level of freedom in the evaluation of transactions, functional analyses and ultimately in the sample formation. Capacity building will be in high demand in the short term and a great dose of creativity will likely flourish in the first years of application of these methods.
In the case of royalties and intangibles in general, the effects of the adoption of the TPG are enormous, as we will be shifting from severe deductibility restrictions to a scenario where not only the transaction prices are scrutinized but the whole activity of the tested entity. Applying the ALP for an accurate delineation of transactions may result in the disregard or recharacterization of transactions contractually performed and also in the recognition of non-formalized relationships with intangibles. Identifying the DEMPE functions may result in the attribution of income that deviates from the underlying agreements involving the funding and exploitation of intangibles. This substance-over-form approach of the ALP will step into the controversial arena of anti-avoidance measures, where the Brazilians still debate whether our legal system has or not a GAAR in place, mainly due to the lack of regulation of art. 116 of the Brazilian Tax Code. This article requires clear procedural rules for the exercise of the power to disregard contracts by the tax authorities, and the TP bill inevitably must address this issue to allow the proper use of the ALP.
The new Brazilian TP rules are obviously focused on corporate income taxation and the new law must be clear in setting these boundaries. Still, some side-effects may arise due to the different outcomes in qualification by separate sets of rules involving other taxes. The application of substance-over-form approach of the ALP may depict consequences that contrast with the characterization of facts and contracts for purposes of other federal and subnational taxes. When the functional analysis concludes, for instance, that a Brazilian entity selling goods is also performing additional services, part of the income attributable to such entity will be labeled as service income. However, the qualification for the federal and subnational taxes paid under the visible contractual forms is one related to sales of goods (PIS, COFINS, IPI, ICMS) and a requalification to services would cause taxation by other taxes and other rules (PIS, COFINS, ISS). For exporting entities under the presumed profit approach, the prescribed net profit margin will be different if their activities involve goods or services. Similar problems may occur when additional functions and remunerations are identified, resulting in a price split. We could of course live with a tax system where concepts are secluded (e.g. off-the-shelf software is a service for ISS purposes but a merchandise for federal taxes), but this approach is far from the ideal of simplification.
The diversity and complexity of these new TP rules bring questions on the timing of their adoption and the necessity of inserting grandfathering or transitional provisions in the bill. Up to now, the Brazilian tax authorities made no explicit announcement on their intent to propose such measures, but in practical terms this solution may also be proposed by representatives of the private sector during the Congressional discussions. For companies that transact with the USA, postponing the adoption of the Guidelines will hamper the desired effects of cost reduction with the use of foreign tax credit in the USA.
