Brazil is going through several modifications in political areas, such as fiscal arrangements to address global economic trends and to stabilise the public finances. One of these instruments is Provisional Measure No. 1,152 (MP No. 1,152/22), which, although having transfer pricing (TP) as its main subject, has also set provisions about the deductibility of royalties from the corporate income tax assessment basis.
Notwithstanding that MP No. 1,152/22 also addresses royalties, it is the reform of the TP rules that will be covered in this article.
Approval process
The formalisation of the new legal framework for the Brazilian TP rules began with the publication of MP No. 1,152/22 on December 28 2022. On June 14 2023, MP No. 1,152/22 was converted into Law No. 14,596/23, by sanction of the president of the republic, without any relevant changes in the text approved by the Federal Senate. On June 15 2023, it was published in the Federal Official Gazette as Law No. 14,596 of June 14 2023.
In general, the new TP model aims to be in accordance with the OECD baselines, so that it may help to integrate Brazil into global value chains, and mitigate cases of double taxation and double non-taxation.
The model may be adopted by Brazilian taxpayers as early as 2023, in an optional way. Taxpayers have a window to choose this option before the Brazilian Federal Revenue (RFB) between September 1 and 30. In January 2024, the adoption of the new model will be mandatory for all taxpayers.
There is an expectation that the RFB will start a public consultation in the coming weeks, initiating a debate on the practical application of the new rules.
TP evolution
The Brazilian TP rules were first edited in 1996 with the primary goal of preserving the national tax base against harmful shifts of profits through the manipulation of prices in transactions between Brazilian and foreign related parties.
Although the explanatory statement of the relevant legislation indicates that the rules were inspired by international standards, in practice, the Brazilian TP system was unique and had distinctive features that departed from the OECD Transfer Pricing Guidelines and the arm’s length principle.
In short, the updated Brazilian TP system granted freedom to taxpayers to select the method to be applied (the best method approach), provided such election was restricted to one of the methodologies set forth by the law. Brazilian methods in general used to prescribe fixed, predetermined mark-ups that applied to all taxpayers, so they did not put an emphasis on the peculiarities of specific sectors and industries.
Other distinctive features of the Brazilian system include the use of mutual agreement procedures in TP and the strict ‘item-by-item approach’.
Historically, the Brazilian TP approach was considered against the grain in the international context. However, in 2019, Brazil drastically changed its position, resulting in several developments and policy discussions around the design of new Brazilian TP rules that would align with international standards.
One may say that one of the reasons for this shift was the Brazilian intention of joining the OECD. The old TP rules were identified as one of the key areas where an alignment with the OECD standards was necessary to adhere to a core aspect of the OECD’s international tax policy.
Consequently, the RFB and the OECD jointly launched a TP project and released a joint report on December 18 2019, identifying a large number of gaps and divergences between the Brazilian TP system and the international TP standards. It pointed out convergence options as well. On April 12 2022, the RFB and the OECD held a public joint meeting and presented the main features of the policy decision to achieve full alignment with the OECD standards.
Besides that, one may contend that a stimulus for the TP discussions was the update in the US foreign tax credit regulations (Treasury Decision 9959), which provided, among other requirements, that a foreign tax will be creditable in the US only if any allocation of income, gain, deduction or loss between a resident taxpayer and a related or controlled entity under the foreign country’s TP rules follows the arm’s length principle.
Therefore, the recent changes in the Brazilian TP system have become highly relevant for companies that have counterparties or are part of multinational enterprises with US operations. This aspect was mentioned in the explanatory statement of MP No. 1,152/22, to justify its relevance and the urgency of that legislative option.
The trade-off of the new model
The Brazilian TP system could be considered to have significant weaknesses, notably because of the absence of special considerations for more complex transactions, among others:
Transactions comprising business restructurings;
Transactions involving the use or transfer of intangibles; and
Intra-group service transactions.
The fixed-margin approach and the freedom of selection of the method, among others, could also be considered as weaknesses.
However, some of these characteristics could also be seen to enhance practicality, predictability and tax certainty. In other words, some of them could be perceived as attractive qualities with respect to providing simplicity, such as:
The absence of the need for comprehensive comparability (including functional and risk) analysis;
The freedom of selection of the method; and
The use of the fixed-margin approach.
In accordance with the RFB and OECD joint report – notwithstanding the unintended consequences of certain aspects of the TP legislation in Brazil, which negatively affect the ability of the country to attract trade and investment and lead to losses of tax revenues – the Brazilian system is recognised by its ability to bring simplicity and practicality to the process of performing TP analysis.
The methodology applied in Brazil overcomes challenges related to the lack of information available on comparable uncontrolled transactions and profitability levels and requires only limited resources to be applied, and the prescriptive nature of the rules also potentially reduces the costs and time involved in litigating TP cases.
So, the debate is whether this trade-off is worthwhile: while the use of old methods (such as fixed margins) presents a number of advantages in terms of simplicity and practicality, it could result in a lack of accuracy and inappropriate outcomes. The lack of transparency under which the margins have been developed (in terms of the data employed and the criteria used) and the evidence of failure to reflect the economic reality in numerous cases indicate that the old parameters used do not lead to arm’s length outcomes.
Final thoughts
This article does not argue that reform of the current TP standards is a problem itself, but only poses a question if in 2023 it makes sense for Brazil to use assumptions that in 1996 (the first time a TP system was regulated nationally) were already a result of old discussions.
Greater alignment with international standards, such as the OECD’s, is undeniably important for the country's evolution; however, this process could have been performed taking into account the practical experience of countries that have adopted conventional guidelines (mostly countries in the northern hemisphere) and the experience of developing countries (with more similarities to the Brazilian scenario).
