Brazil’s isolated approach to the arm’s-length principle

In February 2018, a joint project carried out by Brazil´s tax authority (Receita Federal do Brasil – RFB) and the OECD officials began with a clear focus on undertaking a deep analysis of the Brazilian legislation on international tax and transfer pricing (TP) applicable rules. Its focus was to detail the steps for the country to proceed with its accession to the organisation.

After a thorough examination, the project was concluded in July 2019. At that time, the OECD drafted a report suggesting that Brazil adopts the arm’s-length principle as a parameter for TP rules.

It implied that legislation on topics including prevention of double taxation, intangibles, intra-group services, cost contribution agreements, attribution of profits to permanent establishments, financial transactions and other specific types of transactions should be reviewed. At that time, there was a lot of discussion on a possible ‘partial’ alignment, which raised concerns by the Brazilian academic community, as well as tax practitioners.

The OECD’s and RFB’s apparent conflicting positions have later evolved. In that sense, parties put together an official joint-report entitled “Transfer Pricing in Brazil: Towards Convergence with the OECD Standard”, establishing clearly that the adoption of the arm’s-length principle in Brazil would not mean full alignment with existing OECD Transfer Pricing Guidelines (TPG), but rather a consideration of the principle as general guidance for legislation and regulations that might be enacted or amended in the future.

A public consultation on safe harbours for TP has been concluded by the RFB and a new report with its conclusions is expected to be released soon.

It is a relatively accepted idea that Brazil places arm’s-length as a ‘standard’ for evaluating ability to pay and equality between taxpayers, rather than a ‘principle’ that must be followed by the legislator when introducing applicable rules for determining the taxable income. This discussion is extremely important, as Brazil remains an outsider in a globalised international tax world, remaining the only major economy to follow such an approach.

This idea ends up reflecting on the application of the TP rules and controls, as internally it is not perceived as an unsurmountable principle, but rather as a standard to be followed when determining the income between related parties under the auspices of the equality and ability to pay. It became clear over the years that arm’s-length is a concept that is foreign to the Brazilian legal system.

It is vital, therefore, to comprehend fully the discussion to better understand the rationale under the Brazilian legal and tax system. From a constitutional standpoint, rules should respect the ability to pay principle while still operating with a mechanism that provides for alignment of prices with market practices. However, such rules must also be practical and objective, as the policy consideration has always been to privilege methodologies that are simple and provide for legal certainty – even if at risk of giving rise to double taxation.

Considering this policy consideration, it is easier to understand why Brazilian tax authorities consider the current methodology already meets and is aligned with the arm’s-length standard. As mentioned in the Final Report of Actions 8–10 (Aligning Transfer Pricing Outcomes with Value Creation), the position of the country at the time was that:

• Fixed margins were aligned with industry practices;

• Current methodology was in line with the arm’s-length standard; and

• Whenever treaties signed by Brazil contain Article 9, paragraph 1 of the OECD Model, Brazil grants access to mutual agreement procedures (MAP), in line with BEPS Action Plan 14, which would allow for disputes regarding TP to be solved.

An OECD-trained TP professional would clearly disagree, as Brazil’s fixed margins approach and the existence of maximum royalty rates for deduction and payment to related parties abroad are clear examples – in our view – of deviations from the spirit of the arm’s-length principle.

It is interesting noting that the current CARF’s position (Federal Administrative Appeals Council) is that, even if the Brazilian approach may create room for abuse, transactions meeting the objective fixed rates must be deemed compliant with the Brazilian TP rules.

This position arises from jurisprudence established many years ago following the ‘Marcopolo’ cases (CARF Decisions 1402-00.752 (calendar years 2000 and 2001), 1402-00.753 (calendar year 2003) and 1402-00.754 (calendar years 2004–2008), all dated August 30 2011., especially the Marcopolo II case. In that precedent, judges concluded that, although Marcopolo foreign sales entities did not perform functions other than sales and contract functions, the cost-plus method was met (cost plus 15%), a level of profitability compliant with the Brazilian TP rule, which should be sufficient for it to be held legal/valid.

In addition, it is worth mentioning that in several situations taxpayers attempted to make use of the OECD TPG approach to TP, sustaining that the Brazilian rules could not supersede a treaty provision (Article 9 of the Model Convention). The court, however, denied those attempts and taxpayers were not successful.

All of Brazil’s 33 double tax treaties in force contain Article 9-1 of the OECD Model Convention. However, none of them contains Article 9-2 (correlative adjustments). This is one of the major reasons why the Brazilian system, from a logic point of view, is still disconnected from systems around the globe.

Brazil expressed its position in the final report on BEPS Actions 8–10, stating that tax treaties contain Article 9, paragraph 1 of the OECD and UN Model Tax Convention and a case of double taxation arises, this is captured by this treaty provision and Brazil will provide access to MAP, in line with the minimum standard of Action 14.

Everyone agrees that the idea that Brazil’s TP rules are aligned with the arm’s-length principle would only be true if its fixed margins could be adjusted according to the economic reality of a taxpayer. But this has not been the case, at least not in practice.

The OECD–RFB report explains that there is a mechanism that would, in theory, allow for a formal request to reevaluate fixed margins. According to Ordinance 222/2008, a formal request can be made by an entity representing an economic/professional group on a national level. There is no time limit, however, for tax authorities to provide an answer and, if granted, taxpayers would need at least two years for the changed margin to be effective.

The request must provide sufficient economic evidence that the margin should be different than the standard one to be aligned with the economic reality of the transaction and/or industry. According to the report, nonetheless, requests of that nature were never successful due to lack of proper supporting documentation.

The OECD–RFB report presented observations on what most taxpayers already sensed: current Brazilian methods do not follow the arm’s-length principle and this results in failure to prevent BEPS. In addition, this position increases the risk of double taxation.

We agree with the report’s conclusion that the Brazilian methodology may facilitate compliance with tax legislation, as few resources are needed to apply the predetermined margins, but we also acknowledge, as the report does, that Brazil leaves untaxed revenues generated by the exploitation of very lucrative ‘value creation activities’ that occur within the country’s territory.

The final two issues pointed out by the report relates to tax compliance and tax certainty. From a compliance perspective, although it removes the judgment aspect of reporting economic transactions, they also require an item-by-item calculation and misses out what could be a basket approach to further ease such ancillary obligations. The tax certainty issue is also mentioned, from the taxpayers’ perspective, as they will have certainty regarding their adjustment, but cannot rely on it to assure that their adjustment was aligned with the arm’s-length.

It seems clear that some convergence by Brazil with the longstanding arm’s-length principle would be very much welcome, as the country’s current isolated approach not only prevents Brazil from further integrating to the international community (e.g. accession the OECD) and engaging in important trade.

In addition to this, because fixed margins may be – under certain circumstances – disconnected with the reality of some industries and transactions, they might be abused by taxpayers willing to, while still complying with the objective rules, artificially shift profits to lower taxing jurisdictions, which certainly it is not within the legislation’s goal and policy consideration.

However, the extent of the convergence must be carefully assessed. We concur with the suggestion made by the OECD–RFB report that this convergence should not mean an abandonment of current Brazilian rules, for many reasons.

While the OECD TPG are well-established and widely accepted around the globe, which could arguably bring more legal certainty, it may end up making attribution of profits in Brazil a lot more complex, what is especially worrisome to developing countries lacking the structure necessary to deal with such complexity. The outcome of its full application in Brazil could be the opposite, bringing more uncertainty to a tax system that already has it in abundance. The RFB will need to train multiple tax inspectors to be able to review transactions under the arm’s-length principle.

In this sense, an intermediate solution could greatly benefit the Brazilian tax system. A possible approach towards this idea could be to make possible, in practice, for taxpayers and tax authorities to argue that given fixed margins are in disconnect with economic reality and out of touch with OECD TPG and build the case for a different transfer price (i.e. possibility of rebuttal). Even though this is, in theory, possible (see Ordinance 222/2008), reality shows that it has been nearly impossible to successfully file for this.

Another possibility could be to allow for the arm’s-length principle as provided by the OECD TGP to apply automatically only to industries that are internationally very similar, due to global uniform regulatory frameworks (e.g. financial sectors).

While it is recognised that the Brazilian tax system should allow for more uniformity with approaches used by other countries, especially the OECD TPG, the fact that its fixed margins have now been in place for a long time, providing for compliance simplicity and the legal certainty inherit to it must not be ignored. The solution, as mentioned, should be somewhere in the middle of the road.

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Francisco Lisboa Moreira

Partner Bocater Camargo Costa e Silva Rodrigues Advogados T: +55 11 2198 2800 E: fmoreira@bocater.com.br Francisco Lisboa Moreira is a TP 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. Francisco has wide experience in the tax structuring of corporate transactions and reorganisations, tax planning and the international taxation of individuals and corporations. Francisco is currently undertaking a master’s degree in tax law at the University of São Paulo.

Alexandre Luiz Moraes do Rêgo Monteiro

Partner Bocater Camargo Costa e Silva Rodrigues Advogados T: +55 11 2198 2800 E: amonteiro@bocater.com.br Alexandre Luiz Moraes do Rêgo Monteiro is a partner at Bocater Camargo Costa e Silva Rodrigues Advogados. Alexandre has been practicing tax law for more than 10 years. He has experience in litigation (administrative and judicial, drafting legal opinions, inbound and outbound investments and private wealth management. Alexandre holds a master’s degree in international taxation from New York University.

Felipe Thé Freire

Associate Bocater Camargo Costa e Silva Rodrigues Advogados T: +55 11 2198 2800 E: ffreire@bocater.com.br Felipe Thé Freire is an associate at Bocater Camargo Costa e Silva Rodrigues Advogados. Prior to joining the firm as an associate, he worked at a Big Four firm in their tax audit and consulting team. Felipe is an experienced tax advisor who advises on tax law, capital markets and pension funds. Felipe holds a bachelor’s degree at the Federal University of Rio Grande do Norte, a LLM in tax law at São Paulo’s Getulio Vargas Foundation and an advanced LLM in international and European tax law at the University of Amsterdam/International Bureau of Fiscal Documentation – IBFD.