It’s been a very eventful start to the year for Brazil: a new president, a new cabinet, and a whole new set of transfer pricing rules. Brazilians are in for a wild roller coaster ride.
On December 28, 2022, in his final days in office, former Brazilian President Jair Bolsonaro signed Provisional Measure (“PM”) No. 1,152/2022, introducing new Transfer Pricing rules in Brazil in alignment with the OECD Guidelines and Transfer Pricing Framework (“OECD TPG”). This was approved by the House of Representatives on March 30, 2023, with some key amendments.
A PM is a type of Decree with legal status that must be approved by the House of Representatives and the Federal Senate within 60 calendar days from publication (extendable by another 60 calendar days) to be enacted as Law, being subject to regulation by the Federal Revenue Office (“RFB”). The PM will now be discussed and voted on by the Federal Senate.
Up until the issuance of PM 1,152/2022, the Brazilian Transfer Pricing approach was unique in determining (i) a maximum deductible price for imports and (ii) a minimum taxable price for exports. The legislative intent behind this policy dates to the nineties, aiming to prevent base erosion due to increasing inbound capital flows and to secure a baseline tax revenue for the growing exports of goods and services.
As a result, this approach did not require elaborate pricing comparisons, functional analysis, or risk analysis. Furthermore, it provided Brazilian taxpayers the freedom to choose among traditional transactional methods, as transactional profits methods are absent. This transfer pricing regime applies only to certain transactions, such as tangible assets, services, and loans, and outbound royalty payments are subject to a deductibility cap.
Given its particular legal framework, Brazil’s transfer pricing didn’t really intend to accurately determine the price of transnational operations between related parties for tax purposes based on what independent parties would have agreed in comparable circumstances. The main argument in favor of these rules is that they provide a greater degree of certainty and simplicity, but this may also result in outcomes misaligned with the arm’s length principle, which is generally adopted by OECD members.
Beyond misalignments that may generate potential double taxation or even double non-taxation, both undesirable outcomes from the taxpayer and tax administration perspectives, these rules also negatively affect Brazil’s ability to expand trade and attract inbound investment.
In this context, the new PM introduces several provisions amending the Corporate Income Tax (“IRPJ”) and Social Contribution on Net Profits (“CSLL”) legislation aiming to better adapt these taxes to OECD standards. For the first time, it makes clear reference to the arm’s length principle, even though it does not specifically mention the OECD Guidelines. It also brings a broader definition of related parties and covers all types of intercompany transactions, including services, tangible property, intangible property, cost contribution arrangements, business restructurings, insurance, and financial transactions.
Moreover, while the PM revokes the deductibility limits for royalties (a longstanding prohibition that greatly restricted transactions involving certain types of intangibles), it also provides that no tax deduction for royalties or technical assistance payments will be allowed intwo situations: (i) when the amount deducted in Brazil is not treated as taxable income at the beneficiary level (e.g., when the deduction of such amount in Brazil results in double non-taxation); or (ii) when paid to beneficiaries located in low tax jurisdictions or in preferential tax regimes. The latter was removed in the text approved by the House of Representatives so that the deductibility of royalties involving those transactions must follow the arm’s length principle.
Since Brazil is a major player in the global commodities market, the PM also sets forth a special treatment for commodities, including broadening the definition of ‘commodities’ to generally include physical products or byproducts for which unrelated parties use quoted prices as a reference to establish prices in comparable transactions, thus abandoning the previous definition which relied on a closed, exhaustive list of goods classified as commodities. Under the new regime, specific methods for commodities have been revoked, expressing a preference for the comparable uncontrolled price (“CUP”) method.
With respect to the application of the CUP method to commodities, the wording of the PM approved by the House of Representatives extended the list of reliable comparables – which was previously restricted to public prices – to include the use of internal comparables.
To apply the arm’s length principle, the controlled transaction must be conducted consistent with the analysis of the facts and circumstances of the transaction and evidence of the effective conduct of the parties, and a comparability analysis must be performed vis-a-vis unrelated parties’ transactions. The PM also implements the concepts of DEMPE (development, enhancement, maintenance, protection, and exploitation) functions and hard-to-value intangible property.
With the new PM, taxpayers will no longer be free to choose the applicable transfer pricing method. Instead, they must apply the most appropriate method taking into consideration the terms and conditions that would be established between unrelated parties in a comparable transaction. However, the CUP method is preferred whenever reliable information is available.
On February 24, 2023, Normative Instruction (“IN”, functionally similar to treasury regulations in the United States.) No. 2.132 was published by the RFB, aiming to regulate transfer pricing adjustments. According to this IN, when the terms and conditions set forth in the controlled transaction deviate from those that would be established between unrelated parties in comparable transactions, a Brazilian legal entity will be required to spontaneously proceed with a primary upward adjustment, which involves calculating the appropriate result (including taxable amount and/or disallowing an expense deduction) to correct its taxable base. In case the adjustment is not performed spontaneously, tax authorities will have the authority to carry it out ex officio.
On the other hand, primary downward adjustments – whose aim is to reduce basis by computing an expense deduction, increasing a tax loss, and/or excluding a taxable amount – would not be allowed. This may lead to disputes in the event of a residual profit/loss split.
However, the good news is that the taxpayer can perform retrospective compensatory adjustments until the end of the calendar year to adjust the operating margin to the level consistent with the arm’s length principle through the issuance of debit or credit notes without the need of prior approval by the RFB.
Additionally, it is important to highlight that the IN states that those compensatory adjustments may not automatically trigger adjustments to the bases of other taxes and duties, including those applicable to the importation of goods and services (withholding income taxes, VAT, customs duties, etc.).
There was a provision in the PM introducing secondary adjustments to resolve discrepancies derived from primary upward adjustments (made spontaneously by the taxpayers or ex officio by the tax authorities), which refer to an amount transferred to a related party in excess of what is allowed under transfer pricing rules. This amount would be treated as a loan granted by the Brazilian legal entity, which should be remunerated at a rate of 12% per annum. This rate could be reduced to zero if the amount was repaid within 90 days.
However, the provisions related to the secondary adjustments were removed by the House under the argument that they are detrimental to the taxpayer because they establish a presumed fixed rate of interest, which is not in line with the arm’s length standard.
The new TP rules will be in force as of January 2024, but taxpayers may opt to apply them in 2023. Multinationals that have a higher fixed margin than their real markup or that pay a significant amount of royalties abroad (now fully deductible) might have the incentive to early adopt the new TP rules. The recently issued IN also regulated the form and timing to be observed by taxpayers who desire to adopt the new rules in the current year. They must complete and submit a form along with an electronic administrative proceeding request through the e-CAC platform by September 30, 2023. If the option is exercised, it will be irreversible.
If the taxpayer fails to comply with the new transfer pricing requirements, penalties may be applied, ranging from BRL 20,000 (USD 4,000) up to BRL 5,000,000 (USD 1,000,000).
Another important change is the possibility of entering into Advance Pricing Agreements (APAs) with the RFB, which were not available under the previous regime. Through APAs, taxpayers may establish which transfer pricing methodology should be applied to their particular transactions in advance and in agreement with the tax authorities. The APA procedure will be consistent with international practices.
Despite its meritorious effort to modernize Brazilian TP rules by aiming to mirror OECD standards, the practical challenges that the taxpayers will have to address cannot be understated. Not to mention that the PM will still be extensively debated by Congress and amendments are expected before it becomes Law.
It is widely known that one of the main reasons for introducing new transfer pricing rules and making adjustments in the royalty and technical assistance deductibility rules in Brazil was the change to the U.S. tax policy introduced on December 28, 2021, which disallowed foreign tax credits in regard to income tax paid or withheld by Brazilian taxpayers, mainly due to the deviation of the Brazilian transfer pricing system from the arm’s length principle.
The 2021 FTC regulations provided that foreign taxes paid abroad would be creditable only if the jurisdiction’s profit allocation rules were consistent with the arm’s length principle, disregarding the use of source-based criteria (such as the location of customers or residence of the payor).
On November 18, 2022, the U.S. Treasury and the IRS released proposed regulations that loosened the requirements of the current foreign tax credits, allowing some level of deduction disallowance or justification for a disallowance based on policy considerations that reflect the same policy choices made in analogous U.S. rules. In this sense, the fact that the PM provided no tax deduction for royalties or technical assistance payments in case of double non-taxation may be favorably assessed by the U.S. Treasury.
However, it is still not clear whether the proposed new transfer pricing rules will be enough for the United States to allow its residents to take foreign tax credits on taxes paid in Brazil since that country, as well as many developing countries, have source rules which attribute the power to tax to the jurisdiction where the payor resides, which are often contrary to U.S. source rules.
If the PM is enacted as Law, Brazil will be making a giant leap in the right direction. However, there are several challenges and technical issues that will have to be faced by taxpayers and tax authorities to have the new system up and running in line with international standards and practices. It remains to be seen whether this change will have a measurable impact on trade and foreign direct investment, particularly as regards the updated foreign tax credit regulations in the United States.