Globalising the transfer pricing landscape

In 2017, Rio de Janeiro hosted the Congress of the International Fiscal Association (IFA), where its second subject was titled "The future of transfer pricing (TP)". In the modern times of BEPS and the ongoing discussion regarding the role of the OECD in coordinating international tax rules, the time of the topic could not have been more apt.

In the same year, Brazil formally requested its ascension to the OECD. It is common belief that the Brazilian TP regime deviates quite extensively from the OECD TP guidelines and that it may lead to double taxation. Thus, questions have arisen over whether it will be necessary for the country's policymakers to review the existing regime and align it to the OECD's standards. But why?

Recently, the National Confederation of Industry (CNI) issued a report demonstrating the reasons why the Brazilian economy is one of the most closed economies worldwide. One of the main reasons for the closure is the complete inability of the country to be integrated into global supply chains, unless the country is the supplier of the commodity or the consumer of the final goods. Besides the logistics, customs and labour complications of the country are plausible reasons for the apparent failure is the nature of the TP rules.

The Brazilian TP rules date back to 1996 and were introduced as an anti-avoidance mechanism, supposedly inspired by the arm's-length principle, as the explanatory statement of the TP law (Law No. 9,430/1996) had stated at its origins. However, the general Brazilian policy approach has always been one of simplicity and enforceability – even if it would risk having double (or under) taxation. Courts have recognised this in several occasions, and the fixed margins methodology was seen as a measure of guaranteeing revenue collection, without spending much on public resources and training.

This position of the country is also reinforced by the absence of paragraph 2 of Article 9 of the OECD Model Convention in the treaties negotiated by Brazil, making it clear that the country will not accept correlative adjustments. However, more recently, Brazil has introduced a mutual agreement procedure (MAP) regulation (as regulated by Normative Instruction No. 1,846/2018) that suggests it is supposed to fix double tax issues arising with treaty partners. Since 2016, the year that the new regulation was introduced, there has been no news of a MAP concluded, so there are still doubts on the effectiveness of the instrument.

Recently, the OECD and the Brazilian tax authorities issued a joint study summarising its findings when comparing the Brazilian TP regime and the OECD TP Guidelines. The comprehensive study pointed out several differences that should be reconciled before Brazil's adherence to the international organisation. Therefore, the aim of this text will be to point out the most relevant differences for international groups, as well as to explain the existing regime.

According to the Brazilian TP legislation, except for transactions with the commodities listed in Normative Instruction No. 1,312/2012, the taxpayer is free to choose one of the following methods to test the inter-company transaction.

These are the TP methods that can be used for importation:

• Independent comparable price (PIC): the PIC is closest to the comparable uncontrolled price (CUP) method foreseen in the guidelines, although the concept of similarity severely limits its utilisation;

• Resale price method (PRL): the PRL is, by far, the most commonly used method in Brazil regarding importations because it does not need to rely on documentation from entities other than the tested party in Brazil. It is defined as the weighted arithmetic mean of the resale prices of services, goods or rights, calculated in accordance with a formula that compares the percentage of the imported good, service or right in the cost of the good sold, and apply such percentage to sales price. This result will inform for how much the imported good, service or right was 'resold' and, if one removes the 'expected profit margin', which can be of 20%, 30% or 40% depending on the sector, this will give the parameter price to be compared with the actual price; and

• Production cost plus profit (CPL) this method is defined by the weighted average production cost of goods, services or rights, identical or similar, added by taxes and fees charged at the country of production, plus a 20% profit margin on top.

Similarly, there are three commonly used TP methods:

• Exportation sales price (PVEx): this method is the PIC equivalent for exportations, but the comparison shall be made considering only the Brazilian company as the tested party (sales made by the Brazilian company to unrelated parties), or another Brazilian unrelated exporter selling similar or identical products;

• The acquisition cost plus taxes and profit method (CAP) is the most commonly used method for export revenues. It basically relies on the arithmetic mean of the acquisition or production of exported goods, services or rights, added by a 15% profit margin; and

• Retail or wholesale price method (PVA/PVV): The PVA/PVV method is defined as the arithmetic mean of goods, rights or services, identical or similar, at the country of destination, excluding taxes added to the price, and a profit margin of 15% (wholesale) or 30% (retail).

It is important to note that in Brazil, there is no 'basket approach', so the taxpayer must follow the same method for each product, not being able to offset adjustments between different products. On the other hand, the taxpayer will be able to pick the method with the lesser adjustment, provided that there is documentation available to support it.

In Brazil, commodity transactions follow the methods inspired in the OECD 'sixth-method', but of course with some deviations. There are two methods for commodities testing: the price under quotation in importations (PCI) and the price under quotation on exports (PECEX). They both rely on comparable data necessarily generated at commodities and futures exchange markets, and adjustments regarding quantity, purity, among other matters, can be made. However, as the OECD report points out in its assessment, "such adjustments are limited to those specified by the legislation and make no consideration of the functional analysis according to the OECD Guidelines".

In the royalties and intellectual property (IP) legislation, the country has its own set of rules that date back to the 1950s (in terms of deductibility), and a unique approach to TP matters: outbound royalties are excluded from the TP legislation, and there is very limited guidance to inbound royalty payments or transfer of IP.

As for royalty payments, there is an objective reason why the legislation excludes such payments from the TP legislation. First, the remittance for payments are subject to the registration of the contracts with the Brazilian Central Bank and the Patent and Trademark Office (INPI). Secondly, the deductibility is limited to the percentages set forth in Ordinance No. 436/1958 from the Ministry of Finance, which determines the maximum royalty percentages for trademarks and know-how payments for several sectors. Practically speaking, the percentages remain unchanged since 1958, and the remittance is also limited, clearly resulting in double taxation or, in some cases, opportunity for avoidance (if an arm's-length rate is lower than the percentage preconised in the ordinance).

On the other hand, the country seems to ignore the fact that IP can be generated in Brazil, especially after the recent bolsters to the IP tax incentives made available in the country (Law No. 11,196/05, or 'lei do bem'), as it is still possible to transfer IP overseas at a cost plus 15%, and still be compliant with the CAP method. In this case, a relevant technology enables the foreign related party to earn a considerable profit and there are no existing instruments for the Brazilian authorities to claim a commensurate with income royalty fee, for instance.

It is very difficult, also, to test transactions with intangibles in general, as the Brazilian methods do not offer any room for a profit split or a transaction net margin method (TNMM). This normally impacts the way that multinational groups are structured, forcing them to set up distribution entities in Brazil, most of the time 'itemising' the intangible, instead of simply sharing the profitability between the entity that develops the IP, and the entity that commercialises it.

Brazil does not have a specific methodology to test intercompany services – and it should fall inside the same bucket as any other operation. On the other side, the OECD recognises the necessity to remunerate group companies that develop as a part of the production process, or even low-value functions, so this is clearly a gap in the TP legislation.

Since 2012, Brazil has been issuing private letter rulings (solução de consulta or solução de divergência), in which they recognise the possibility of a Brazilian company engaging in cost sharing (CSA) or cost-contribution agreements (CCA). To some extent, the tax authorities understand that costs or expenses paid in the context of a CSA or a CCA relate to a reimbursement, and if paid with no mark-up should not be subject to a withholding tax, nor to the TP rules. Deductibility is also allowed. However, more recent private letter rulings have contradicted the previous, making the scenario unclear.

Recently, the Brazilian courts have decided in favour of taxpayers, and that remittances in the context of a CSA or a CCA would be made without the income withholding tax.

In the OECD's joint report with the Receita Federal do Brasil (RFB), the Brazilian authorities recognise the necessity of specific and clear legislation to resolve the disputes arising in this context.

Brazil also provides for a very unique approach regarding financial transactions. Until 2012, there was no obligation for an inter-company loan to be tested. In that year, Brazil introduced the parameters for testing the interest rates, being Brazilian sovereign bonds market rates in US$ (for predetermined rates in US$ loans), in Reais (for predetermined rates in Reais loans), or the 6-month London Interbank Offered Rate (LIBOR) in all the other cases. A fixed 3.5% spread shall be added for outbound interest payments, and in the case of inbound interest revenues, a minimum of 2.5% spread shall be added to the benchmark rates.

The country also possesses thin-capitalisation rules, with a debt-to-equity ratio of 2:1 (0.3:1 for tax havens and privileged tax regimes).

There are no specific rules for special financial operations, like captive insurance, guarantee fees (although we believe the PIC method could be used), cash pooling and hedging transactions.

As we could see, the Brazilian methodologies provide for certainty with fixed margins and the freedom of choice of the method. However, they still provide little room to maneuver when it comes to double taxation, or even regarding the economic essence of the operations. Brazil has recognised that its rules will require a deep review if the country wishes to adhere to the OECD, but, more importantly, the country seems to begin to understand that the existing set of TP rules are a hindrance against the global integration of the country.

If the current political regime continues, it will be a matter of 'when', and not 'if' the country will join the OECD, so one can realistically expect changes in the TP regime in the near future. So be prepared.

Francisco Lisboa Moreira

Partner Bocater Camargo Costa e Silva Rodrigues Advogados Tel: +55 11 2198 2800 fmoreira@bocater.com.br Francisco Lisboa Moreira is a transfer pricing partner at Bocater Camargo Costa e Silva Rodrigues Advogados. He has more than 18 years of experience, including eight years working for KPMG and 10 years as a tax partner at a series of reputable law firms. He has wide experience in the tax structuring of corporate transactions and reorganisations, tax planning and the international taxation of individuals and corporations. He is currently undertaking a LLM at the University of São Paulo, and holds a LLM in international tax from New York University. He has previously been the Brazilian branch reporter for the Regional Congress of the IFA LATAM, which took place in Peru in 2016, where he addressed a topic on the influence of the BEPS plan on the transfer pricing rules in Latin America.

Felipe Thé Freire

Associate Bocater Camargo Costa e Silva Rodrigues Advogados Tel: +55 21 3861 5800 ffreire@bocater.com.br Felipe Thé Freire is an associate at Bocater Camargo Costa e Silva Rodrigues Advogados. He has completed a bachelor's degree at the Federal University of Rio Grande do Norte and a LLM in tax law at São Paulo's Getulio Vargas Foundation. He is currently also pursuing a LLM at the University of Amsterdam. Prior to joining the firm as an associate, he worked at a Big Four firm in their tax audit and consulting team, and focused on financial and capital markets.