Commodity operations and their complexities in Brazil’s new TP landscape

On January 1 2024, a new era began for all Brazilian organisations operating with related parties due to the new transfer pricing legislation that came into force in the country.

This measure, aimed at aligning national rules with the standards adopted by the member countries of the OECD, opens doors to the international market and increases investor confidence, as it allows the country to be included in the same context as the global policies of multinational groups.

However, as a result of any transformation to such an extent, these organisations face several challenges because of this adaptation, and it may be necessary to redesign their operations, review prices, rethink internal policies, and establish new contracts and documentation.

And although there are countless economic advantages that the insertion of Brazil into this new model brings to the country, and despite the desire of taxpayers to quickly adapt to it, it is necessary to remember the coexistence of Brazilian entities for a period of 26 years with a different legislation that is far from international precepts.

Therefore, a change of this magnitude called for the granting of a period during which local entities could adapt to the requirements. However, the Brazilian government disregarded companies’ need for an adaptation period, granting taxpayers only the option of remaining adherent to the old rules or applying the new rules in 2023, but compelling them to immediately fulfil the new obligations from 2024, with the delivery of the respective information in the income tax return before July 31 and the respective local file, master file, and country-by-country report before December 31 2025.

Despite the immediate effects of the new legislation, it creates several practical grey areas that have already been revealed to those who are in the day-to-day of this topic, in addition to other matters that will certainly arise as companies begin to mould themselves to its requirements.

This article will focus on one area in which Brazilian entities have been placed in an uncertain position regarding the treatment of their operations in light of the new rules. Special reference is made to entities that trade commodities, the applicable transfer pricing methods, and, finally, an assessment of the possibility of enquiring with the Brazilian Federal Revenue Service in certain cases regarding the choice of method and other treatments for the evaluation of their prices.

It is undeniable that the recently introduced OECD-based Brazilian transfer pricing legislation represents a milestone in Brazilian tax regulation that aims to align the jurisdiction with international standards and combat tax evasion in a manner consistent with the practices adopted in other countries. However, one of the matters of concern that remains is the lack of clarifications about commodity operations, which account for a significant part of international trade.

Commodity trading is characterised by its volatility, complexity, and price variation, which makes transfer pricing challenging. In this context, it is crucial to select the most appropriate pricing methods. To move forward, it is necessary to know the methods available under the new regulation.

Since the creation and implementation of transfer pricing rules in Brazil as of January 1 1997, taxpayers have experienced the challenge of applying the rules to transactions involving commodities due to the peculiarities of this market, which, in general, presents low levels of profitability compared with the high fixed margins required by the old legislation.

Justified by the particularities that restrict the commodity market, in 2012, upon the enactment of Law 12,715, the Brazilian government formally recognised that such operations required the adoption of specific methods to measure their prices that, despite the challenges in their application, have the benefit of considering reference market prices based on quotations from commodity and futures exchanges or disclosed by internationally recognised research institutions.

On the other hand, the newly introduced Law 14,596/23 provides for methods that must be carefully evaluated before being elected to justify commodity transactions, namely (initialisms based on the terms in Portuguese):

• Comparable uncontrolled price (PIC);

• Resale minus (PRL);

• Cost plus (MCL);

• Profit split (MDL); and

• Transaction net margin (MLT).

Article 13 of the law states that "when there is reliable information on comparable independent prices for the commodity traded, including quotation prices or prices charged with unrelated parties (internal comparable transaction), the PIC method will be considered the most appropriate." “Reliable information” for application of the PIC method comprises prices, fees, indices, and margins in comparable independent transactions.

However, as mentioned, the new legislation also refers to other methods, which cannot be ignored, since they can be construed as options in the assessment of transactions involving commodities.

A description of each method is provided below.

The PIC method is the preferred option for commodity transactions. Under this method, the arm's-length price for a related-party commodity transaction can be determined by reference to:

• Comparable transactions between independent parties; or

• Comparable independent-party agreements, represented by the quotation price.

Whenever comparable transactions between independent parties are available, the prices of those transactions may be used as a reference to establish the price under competitive conditions for commodity trading with related parties.

The quoted price-based PIC method is appropriate when the quoted price is widely and routinely used in the normal course of business in the industry to negotiate prices for independent-party transactions comparable to commodity transactions with related parties. Thus, depending on the facts and circumstances of each case, the prices quoted may be considered as a reference to fix selling or buying prices for a commodity.

To apply the PIC method reliably, the economically relevant characteristics of commodity transactions with related parties and transactions with independent parties or quoted prices must be comparable.

Where differences exist and those differences significantly affect the commodity transaction price of the related party examined, reasonably accurate comparability adjustments shall be made to ensure that the economically relevant characteristics of the transactions are comparable.

However, it can be difficult to find transactions between independent parties that are sufficiently similar to commodity transactions with related parties. This is especially true when agreements pertaining to commodity transactions are generally highly confidential and not publicly available. In addition, the commodity industry often involves complex structures between companies and value chains that can make use of the PIC method inappropriate. In such situations or when reasonably accurate adjustments cannot be made without affecting the reliability of the PIC method, it may be necessary to select another method.

The possibility of applying the PRL method may be suitable where the related party's commodity transaction involves trading transactions, and market evidence also shows that independent parties engaging in comparable transactions are remunerated by reference to the sales values and receive a percentage discount (or resale price margin or gross margin) on a sales price.

The application of the PRL method in the documentation of commodity transactions is uncommon but cannot be entirely discounted.

The MCL method is appropriate where costs are a relevant indicator of the value of the commodity trading activities carried out by the entity in a commodity transaction with related parties, taking into account the assets used and the risks assumed. Typically, the method is suitable when the commodity trading activities are services that do not require significant expertise, risk taking, or commodity-related risk control functions.

In addition to the MCL method, the MLT method, taking the profit level indicator (PLI) that evaluates gross profitability (i.e., based on the costs incurred by the tested party), may also be appropriate when the related party's commodity transaction involves the characterisation of a ‘contract manufacturing’ or ‘toll manufacturing’ arrangement.

The reliability of cost-based transfer pricing methods may, however, be reduced where the commodity trading activities undertaken by the entity in a transaction involve significant value, including decision-making capacity, ability to exercise authority, or risk-taking or risk control functions. These activities affect business outcomes, and therefore their value to related parties may be correlated to revenues or profits rather than costs.

In addition, if the undertaking genuinely takes risks in the transaction when carrying out these activities, the application of cost-based transfer pricing methods may distort transfer pricing, as the entity is prevented from encountering upward or negative consequences of risk outcomes, both of which should generally be expected from a risk-taking entity. Depending on the facts and circumstances of such cases, the PIC method or transactional profit methods (MDL and MLT) may be more appropriate.

The MDL method is appropriate when the entity's interaction with its related parties and its contributions to the commodity transaction with related parties are highly interrelated and integrated. Added to this, the entity and its related parties make unique and valuable contributions to the commodity transaction with related parties, unique intangible assets exist that make it difficult to find reliable third-party comparables, or the entity and its related parties share the assumption of one or more of the economically significant risks in relation to the commodity transaction.

Because it considers highly specific situations, the application of the MDL method in the documentation of commodity transactions is unusual.

The MLT method, considering the operating margin as the PLI, may be appropriate where sales are a relevant indicator of the value of the functions performed by the entity, taking into account the assets used and the risks assumed. The assessment of the operating margin can reliably be based on comparable independent-party transactions.

The entity trading commodities may purchase commodities from its related parties for resale, and then the sales are an indicator of the value of its trading activities. In this case, the following relevant considerations should be made:

• In addition to the assessment of operating margin under the MLT method being appropriate for distribution activities, commodity trading involves more than just distribution activities of buying from, and selling commodities to, related parties. Commodity trading involves sourcing, gathering market intelligence, managing logistics, determining sales and marketing strategy, blending, warehousing, and financial management, among others.

• When the entity carries out business activities that assume the risks, bearing the financial consequences thereof, the assessment of the operating margin may prevent the entity from receiving upside benefits and incurring downside costs.

• If the entity performs a complex functional analysis, it may be difficult to identify reliable comparables or may entail numerous or substantial adjustments of the comparables.

Given these considerations, it is unlikely that the operating margin assessment under the MLT method is adequate.

Its application can, however, be considered in cases with limited buying and selling activities and risks, providing a practical solution to otherwise unsolvable transfer pricing issues, when used sensibly and with appropriate adjustments.

Another PLI applied in the evaluation of the MLT method is the ratio between gross profit and operating expenses, called the Berry ratio.

The application of the Berry ratio, however, may be compromised in cases where the following circumstances are present in a transaction:

• The taxpayer does not perform any value-added functions other than distribution of the products distributed;

• The value of the functions performed by the taxpayer is not affected by the value of the products distributed;

• There is a direct link between operating expenses and gross profits; or

• The taxpayer does not use any intangibles in the transaction.

Essentially, the Berry ratio is based on the presumption that the value of the functions performed is proportional to operating expenses rather than sales. The rate may be appropriate in a situation where the entity purchases commodities from related parties to resell them to other related parties in a back-to-back transaction and takes interim ownership of the asset but does not assume any risk or perform any value-added functions related to the commodity that extend beyond the commodity distribution.

Although the new Brazilian transfer pricing legislation has introduced fairer rules in line with international standards, the evaluation of the method to be applied is complex and, therefore, the lack of specific guidelines on commodity operations generates uncertainties among companies operating in the sector.

To promote effective implementation of transfer pricing legislation in Brazil, it is essential that tax authorities provide clear guidance on how companies should price commodity transactions, which should include:

• The development of sector guidance – tax authorities can collaborate with experts in the commodities sector to develop guidance that takes into account the unique characteristics of these transactions;

• Public consultation – opening a public consultation process to receive inputs from companies and tax experts can help to identify key challenges and develop appropriate solutions; and

• International cooperation – Brazil may seek cooperation with other countries to share best practices and experiences in the taxation of commodity operations.

It is noticeable, therefore, that Law 14,596/23 comprises only basic guidelines for the evaluation of these transactions and that there are still questions that need to be clarified, especially regarding the application and choice of methods, origin of information, and realistically available options.

In view of the matters presented here, the author concludes that this law is only the first stage in the construction of the new transfer pricing legislation in Brazil. In addition to the law governing the subject, it is expected that regulatory instructions and other acts may bring greater definition on the matter, as well as formal and informal interactions of companies with the authorities, among which an advance tax ruling request with the Special Secretariat of the Federal Revenue Service stands out.

Given the complexity, importance, and impact of decisions related to transfer pricing for commodity transactions, it is recommended that taxpayers consider seeking guidance from the Brazilian Federal Revenue Service.

In this regard, prior consultation can provide clarity and legal certainty by promoting a transparent and accountable approach to transfer pricing for commodity transactions with respect to various aspects related to the selection of comparable transactions and appropriate comparability adjustments, the determination of comparability factors considered significant to the circumstances of the case, and the determination of critical assumptions regarding future transactions, among other elements that must be included in a proper transfer pricing analysis.

Notwithstanding, taxpayers should be aware that the ruling may be revoked, with retroactive effect, in the event that it has been based on false, misleading, or omitted information. Therefore, it is essential to make the enquiries carefully and accurately.

Regarding the practical issues underlying requests for a ruling, the new legislation already provides for the possibility of requesting one from the Federal Revenue Service, which will include an analysis of the criteria established as to:

• The selection and application of the most appropriate method and financial indicator;

• The selection of comparable transactions and comparability adjustments;

• A determination of comparability factors considered significant for the circumstances of the case; and

• A determination of critical assumptions regarding future transactions.

The ruling shall be valid for up to four years and may be extended by two years, subject to approval by the competent authority.

Although consultation with the tax authorities is an option offered to the taxpayer, it is necessary to assess whether the present moment is the most appropriate, since these authorities are still essentially involved in preparing the supplementary legislation that will govern this and other pending issues.

The guidance that may be appropriate at this time for the taxpayer is to wait for the new publications and, if these are not sufficient, then the proper ruling should be made to obtain clarifications on the aspects that may still be obscure to the situation of the entity.

The other option available to taxpayers that have questions about the choice of method, and the aspects inherent in its application, would be to adopt the one considered the most reasonable in their understanding, based on their facts and supporting documentation, and, concomitantly, monitor the positions of the Federal Revenue Service for any future corrections and/or adjustments.

Finally, it should be noted that both options have advantages and disadvantages that should be carefully assessed by taxpayers seeking an appropriate evaluation of their transfer pricing practices, depending on their risk profile and patience to obtain a formal position from the tax authorities. This is the beginning of a new era for Brazilian taxation, and, like any drastic change, it will require effort and resilience to be shown by companies, with no room for complacency.