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Questions raised over Brazil’s transfer pricing rules

Twelve years after Brazil introduced transfer pricing laws and enacted the arm’s-length standard, Luiz Felipe Ferraz and Alexandre de S Almeida of Demarest e Almeida Advogados in Brazil assess whether the standard is being adhered to and what the future holds for transfer pricing in Brazil

In the past decades, a number of non-OECD states have implemented or are in the process of implementing transfer pricing policies based on the OECD guidelines. The new policies show that non-OECD tax authorities attempt to observe their economic realities to make adjustments to the methods and frameworks recommended by the OECD. Deviations may not be convenient to a certain extent but confirm the arm’s length standard is such a broad concept that can be interpreted and implemented in a variety of ways.

According to a report issued by the UNCTAD (United Nations Conference on Trade and Development) in 1995, the legal frameworks used by non-OECD countries did not deal adequately with transfer pricing. The report indicated that the pressing issues were the lack of comparable uncontrolled transactions and evidence on profitability available to tax administrators, lack of administrative and financial resources, and costs with time-consuming cases of litigation.

The truth is that the OECD guidelines may impose challenges. This is due to the subjective characteristics of the traditional transactional methods and the increasing complexity of intercompany transactions. The transactional profit methods came as an alternative but are somewhat arbitrary with a formulary bias. In 1979, the OECD concluded that profit-based methods lacked connection with economic data and turned a blind eye on particular aspects of local companies and businesses.

In other words, the features of the available arm's length methods somewhat contribute to high costs with compliance, audits and litigation. As in the case of the profit-based methods and sourcing rules with apportionment criteria for profits, countries seek alternatives to allocate income. Switzerland, an OECD member, was said to follow the OECD guidelines when in 2004 the OECD criticised the country's administrative tax practices based on a cost-plus-5% method, and the 50/50 and the 80/20 apportionment methods. The methods were linked to a fixed cost-plus mark-up or a fixed percentage of deduction, and provided the Swiss authorities with speed to establish the appropriate tax base. The OECD would have concluded they were not compatible with the arm's length standard, as these rules were unrelated to the use of any form of comparables. In 2005 Switzerland made the necessary corrections.

Truth of the matter, the success of a given State has to be compared with the effort involved and the capacity of implementing useful frameworks. In considering the enactment of a transfer pricing policy in 1997, the Brazilian tax authorities appeared to have weighted these aspects and the challenges associated with the adoption of the OECD methods and how effective they could be to enforce the arm's length standard.

In terms of policy for income allocation, it is possible to identify the comparable uncontrolled price (CUP) method that fully expresses the arm’s length standard at one side. The other traditional transactional methods are placed to its right. At the opposite side there is the typical formulary apportionment method that states the unitary business principle derived from the theory of integration. This method allocates profits on a consolidated basis according to factors of production. In between there is a variety of methods which may be closer to one of the sides according to their characteristics. The formulary profit-based methods are examples of hybrid methods based on factors of production and close to the so-called formulary apportionment method.

The Brazilian tax authorities may have sought to minimise such issues by designing a system they understood could bring simplicity, speed, and more certainty; however they considered important to adjust the OECD policy to the reality of their administration.

The solution came in the form of strictly tax-related provisions based on the equivalent methods of the OECD traditional transactional methods combined with fixed mark-ups. The gross margins are statutory and aim at hypothetically matching uncontrolled prices. Providing evidence to the contrary was supposed to be a task for taxpayers and the gross margins should not be viewed as arbitrary. It is said that mark-ups do not eliminate the arm's length content of the traditional transactional methods. They should be able to preserve the comparability aspect derived from the separate accounting principle to a much greater extent than the profit-based methods did.

The use of mark-ups was discussed in a report the OECD issued in 1979. It recognised the use of fixed margins could represent a benefit to tax administrations and taxpayers if it reduced litigation. They could be arbitrary if not adjusted pursuant to the variable circumstances associated with certain industries. The Brazilian tax authorities seem to follow the analysis to a certain extent. The existence of an option in the legislation, they believe, turns the fixed margins more into a reference for the market. In practice, it is unknown whether any company has attempted to dispute the mark-ups, however the alternative is available under the legislation. In the event taxpayers do not agree with a negative answer from the tax authorities, they have legal routes to continue with the discussion.

Aware of the elements and contradictions of OECD traditional and non-traditional methods, the Brazilian tax authorities appear to believe they have an argument to affirm its policy provides the tools to fairly implement the arm’s length standard in contrast with other methodologies such as the profit-based methods based on formulary apportionment.

Under the Brazilian system, taxpayers are required to elect one method to determine the appropriate intercompany price of goods, services, and rights acquired or sold abroad. Taxpayers must apply the same method for each product or type of transaction consistently throughout the respective fiscal year. Brazil chose not to impose the OECD best method rule to give flexibility to taxpayers that need to support their choices. If studies and documents do not sustain the choice, the tax authorities could establish another method or a new calculation on an arbitrary basis and in accordance with what would be more convenient to the government in terms of adjustments of the taxable income.

Another key feature of the Brazilian transfer pricing legislation is the use of safe harbours. As in the case of the mark-ups, safe harbours are simplified methods that guarantee taxpayers its prices will be accepted by the tax administration if they comply with certain parameters. Safe harbours can fix minimum limits in certain transactions in which the tax administration is keen not to intervene. The OECD does not recommend safe harbours as they are said to be arbitrary, but confirmed the obvious advantages related to reduction of costs and litigation. The Brazilian authorities certainly evaluated that drawbacks derived from safe harbours could be offset by the simplicity of compliance and relief from administrative burden on the tax authorities.

In Brazil, the uses of safe harbours take place in certain circumstances. For export transactions a safe harbour rule applies and a taxpayer is deemed to have an appropriate price provided that the average export sales price is at least 90% of the average domestic sales price charged by the taxpayer or by other export companies relating to identical or similar transactions. Another safe harbour applies where a taxpayer can demonstrate either that its export revenues are less than 5% of total revenues or net income from export sales is at least 5% of export revenues.

The rules make the system flexible and lower costs to both businesses and the government with respect to implementation and audits. The methods are fairly objective and establish the appropriate transfer price by suggesting maximum price ceilings for deductible expenses and minimum gross income floors. The methods focus on seeking a comparison and reconstruction of prices and give less importance to the analysis of profit margins in the case of CPM and RPM.

The arm’s length standard may be implemented through methods that give emphasis on parameters which are similar or somewhat different from those defined as acceptable by the OECD. The application of an arm's length method involves an initial search for comparable uncontrolled transactions. If the Brazilian CUP cannot be used, other allocation techniques could be compatible with the arm's length standard so long as their ultimate objective is to determine the amount of income that the corporation would have earned had it been independent. This is the case of the other two methods provided by the Brazilian legislation just like their OECD equivalents.

In sum, the transfer pricing regime in Brazil is still in the process of adjustments. The Brazilian tax authorities still evaluate what is more convenient in terms of efficiency. Two suggestions for improvement would be a more flexible approach in regard to the fixed mark-ups and defined rules and a special and speedy administrative process to analyze and grant different mark-ups according to the needs of the businesses.

Fixed gross margins impact the tax position of companies. The requirement for high mark-ups may subject importers to having their profits established at a rate higher than that of the market. The risk is that taxes could be imposed on equity depending on the circumstances. In addition, business strategies and market conditions may require different margins.

Brazilian policymakers could take into account the use of different profit margins for each industry or for important products traded in Brazil to recognise particularities that are disregarded. Even if companies can request a change, the burden could be reduced if the government showed flexibility to establish more reasonable parameters. If margins appointing the annual average profitability of transactions per industry could be determined as a reference, adjustments on individual comparisons of prices per product should not be necessary provided that taxpayers reached the average margin of the industry. The government should also review the arguments of taxpayers that cannot comply with the average of the industry and evaluate if the arguments for a change of the mark-up are reasonable. This would have to be done on a case-by-case basis just like now, however today there is a single mark-up for all industries.

The government could then pay attention to the process on how companies could request rulings for different mark-ups. A more clear set of rules on this would be advisable. The process of decision should be transparent and there should be more dialogue between the authorities and businesses. This is an important aspect to characterise the system as arm's length.

It may be said that the Brazilian transfer pricing policy has good and bad aspects, which is not different from the situation found in the policies administered by OECD member countries. It has the advantage of being a simple system based on the use of arm's length methods. The approach with fixed mark-ups is viewed as just another form to establish arm's length methods to implement the standard. The Brazilian methods may result in little consideration to economic data as in the case of profit-based methods, but may allow the government to benefit resident companies or stimulate MNCs to bring the production to the country.

Some of the methods do have a basic formulary aspect which aims at indicating the market mark-up. This should place them together with those empirical methods in between the formulary apportionment and the CUP. As the formulas are not based on factors of production, which is the case of the formulary apportionment and some of profit split methods, the Brazilian RPM and CPM should be viewed as closer to the CUP method and the other OECD traditional transactional methods. This interpretation would ratify the understanding of the Brazilian tax authorities that the Brazilian transfer pricing policy does comply with the arm's length standard and that its methods are arm’s length with the necessary frameworks to implement the standard in Brazil.

There is no international rule that limits the procedure under which a method can be implemented to achieve the standard. Brazil should certainly be concerned with key features of the standard and ensure they are reflected within the terms of its policy. The history of article. 9 of the OECD model would have a lot to reveal on what can be and cannot be done in terms of acceptable methods. The Brazilian arm’s length methods should fully comply with the spirit of article 9.


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