Foreign exchange fluctuation and its impacts within the context of transfer pricing

Many countries around the world have transfer pricing regulations and guidelines. However, Brazilian laws and regulations are unique, and considered too complex by specialists, not to mention their clearly revenue collection-oriented nature.

Introduced by Law 9430/1996, these rules became effective in 1997 and, although they were significantly revised in 2012 with the enactment of Law 12715, there are still numerous challenges for taxpayers, including with regard to foreign exchange fluctuations, which occur mainly during severe economic instability.

One of the assumptions underlying transfer pricing calculations by Brazilian entities is that these calculations must be made in Brazilian reais. The most commonly-used methods, both by Brazilian importers and Brazilian exporters, are those that require minimum profitability margins in both import and export transactions, namely the resale price less markup (PRL) method and the acquisition or production cost plus taxes and income (CAP) method, respectively.

In summary, the first method, applicable to imports, requires that a local entity report a statutorily predetermined gross profit (ranging from 20% to 40%, depending on the industry) generated by goods, services, or rights imported from related parties, when resold to third parties. However, these profits can vary significantly since they are directly linked to how foreign exchange fluctuations affect the import prices and, consequently, the cost of sales.

In other words, every time the local currency depreciates, the import prices in reais increase and, as result, profit margins drop, thus leveraging potential taxable adjustments.

On the other hand, and based on the same reasoning, there is an adverse impact on exports when the Brazilian real appreciates.

The impact, however, occurs when the CAP method is applied, since this method requires that a Brazilian taxpayer add a fixed gross markup of at least 15% to the cost of all goods, services or rights exported to its related parties.

However, specifically with regard to the CAP Method – as well as one of the Waiver of Proof criteria applicable to export transactions; the Federal Government allowed, under previous administrative rules, exporting taxpayers to use the adjustment mechanism applicable to transfer pricing so as to mitigate the impacts arising on the appreciation of the real against foreign currencies.

Thus, in accordance with said administrative rules, taxpayers were able to apply foreign exchange adjustment factors on revenue generated by exports to related parties in different calendar years.

In summary, the Brazilian Government has allowed exporters to add targeted percentages (which vary depending on the year) to the prices actually charged in order to increase the sales prices and, as a result, decrease or even eliminate a possible gap between the price charged on exports and the benchmark price, whether by applying the transfer pricing method itself (CAP) or the Waiver of Proof criterion.

We highlight that the Administrative Rule in force does not provide for the use of the same mechanism when other transfer pricing methods, such as PVEx (export sales price), PVA (wholesale price in the country of destination, less profit) and PVV (retail price in the country of destination, less profit), are applied. This is because if the goal is to mitigate the impact of foreign exchange fluctuations, it does not make sense to apply this adjustment in methods that already use as pricing basis foreign currency-denominated amounts and, consequently, somehow already contemplate some type of adjustment in light of the foreign exchange rates used. This is not the case, however, for the CAP method, which uses the costs incurred in Brazil for pricing purposes.

From an economic standpoint, the Federal Government's approach of seeking to eliminate or at least alleviate the distortions caused by foreign exchange fluctuations, thus avoiding making unreal adjustments to export prices, is quite reasonable, not to say commendable.

We emphasise, however, that the Federal Government does not allow for the same type of flexibility in the case of imports. This inflexibility often exposes taxpayers to economic hardships that are beyond their control and cannot be mitigated with good management or a sound transfer pricing policy.

Even though foreign exchange is a variable that escapes taxpayers' control, there are some alternatives and procedures that can be adopted to mitigate or even eliminate possible transfer pricing tax adjustments, even in a foreign exchange fluctuation scenario.

One of these alternatives is for the Brazilian entity's management to negotiate with its related parties the possibility of conducting import and/or export transactions in Brazilian reais. This way, the foreign exchange risk would remain overseas and the profit margins could be negotiated in advance in order to comply with the prevailing laws and regulations and maintained without any interference from economic drivers.

The use of simple price benchmarking methods or other methods that size the maximum profit margin earned by related companies abroad with which a Brazilian entity conducts business, could also constitute an option for organisations that seek to scale down their own taxable adjustments.

Since there is no benchmark for a price charged in a foreign currency with a benchmark price calculated based on costs incurred or revenue recognised in Brazilian reais, as in the cases of the CAP and PRL methods, respectively, foreign exchange fluctuations do not tend to have any impact on taxable adjustments.

However, the use of any other method basically requires having access to foreign information, which in practice can be a barrier, mainly when the relationship between the Brazilian entity and the related parties that hold such information is not close.

When a taxable adjustment to transfer pricing is identified it is not uncommon to resort to the use of the so-called 'credit notes' to reduce such taxable adjustment.

It is worth noting, however, that Brazilian tax legislation does not acknowledge the use of credit notes and, consequently, their use for the purpose of scaling down transfer pricing adjustments can be challenged by the tax authority.

Even though many address the matter rather simplistically, there are numerous aspects that should be taken into consideration when assessing the use of a credit note to make sure that the intended outcome is achieved, with a high level of certainty that it will be accepted. The most relevant of these aspects include:

• the note issue timing;

• supporting documentation for the imported goods to which the note will make reference;

• the technical treatment used to calculate the price charged and the benchmark price; and

• customs and other impacts.

Even though, as mentioned above, the use of a credit note requires care, discretion, and moderation, this alternative should be considered, especially when the primary goal is to reduce or eliminate the impacts of the double taxation commonly produced by transfer pricing adjustments.

Without disregarding the possibilities described above as alternatives to soften the impacts of transfer pricing, the periodic monitoring of import and export prices is key for any taxpayer subject to these rules.

Even though there is an annual obligation to file transfer pricing calculations, adopting price monitoring as a recurring practice on a monthly basis, or at least every quarter, coupled with price renegotiation is still one of the most efficient ways of avoiding transfer pricing adjustments.

As the calculations are made using average prices charged per item, theoretically these could be renegotiated, adjusted, or previously offset against each other, according to the outcomes of the partial adjustments determined for each calculated period.

Obviously, in order for this to happen it is necessary to monitor impacts from a customs standpoint and make sure that the foreign related companies are flexible enough to engage in such price renegotiations throughout the year.

Based on this quick overview of the impacts of foreign exchange fluctuations, we can see how important it is for taxpayers to have a detailed knowledge of Brazilian transfer pricing rules and be aware of the options which can be explored to soften their impact.

Finally, we emphasise that the foreign exchange impact is but one of the numerous aspects to be observed and that there are many other equally or even more complex issues that if not appropriately grasped, handled and addressed could result in a high tax burden or severe penalties for a taxpayer.

Carlos E. Ayub Tax partner – transfer pricing Deloitte Touche Tohmatsu Av. Dr. Chucri Zaidan, 1.240 4th to 12th floor São Paulo – SP – 04711-130 Tel: +55 11 5186-1227 Fax: +55 11 5181-3693; +55 11 5181-2911 Email: carlosayub@deloitte.com Carlos Ayub is tax partner based in São Paulo, Brazil, focused on Transfer Pricing services. He provides services to local, European, Asian, Latin and North American clients operating in various industries such as automotive, chemical, pharmaceutical, electronic, and more. Carlos has more than 26 years of professional experience in areas including accounting audits, corporate tax and transfer pricing services. In 2001, Carlos was transferred to Deloitte's Mexico City office to work on transfer pricing projects under the OECD approach, matching Brazilian and international rules. He has authored various articles on transfer pricing for reputable magazines, newspapers and other publications of national and international circulation. Carlos is a member of Deloitte's Brazilian transfer pricing group, which has been recognised by different institutions for several years as one of the best transfer pricing teams in Brazil. He has been recently quoted as one of the best references in transfer pricing in Brazilian territory by Expert Guides, the most recognised publication in the world in its area. Carlos is registered at the CRC – Accounting Regional Council, is the coordinator of the tax commission for the French-Brazilian Chamber of Commerce, and is a member of the transfer pricing technical group of the Federação das Indústrias do Estado de São Paulo (FIESP). He holds a bachelor's degree in accounting and and MBA from the Faculdade de Ciências Econômicas de São Paulo – Fundação Álvares Penteado and an MBA from Fundação Getúlio Vargas, as well as a degree in law from Universidade Paulista. Carlos speaks Portuguese, English and Spanish.