The impact of OECD membership on TP in Brazil
Carlos Ayub of Deloitte Brazil discusses how planned accession to the OECD will affect transfer pricing (TP) in Brazil, and also provides an update on the consequences of discontinuing the Libor rate.
Since the early 1990s, Brazil has held the status of key partner of the OECD. This means that Brazil has an important role to play in different aspects of this organisation – adopting its instruments, being part of the OECD’s statistical reports and peer reviews on specific industries, and being invited to attend all meetings with ministers of member countries.
As a key partner, Brazil is already part of working groups that share relevant information on economic policy, trade, environment, science, and technology and education. However, Brazil intends to develop the key partner status and become a member country.
As part of the current government’s growth programme, which started with ex-President Michel Temer in 2017, Brazil is seeking to obtain economic benefits that can only be achieved by becoming a full member of the OECD. These include increased credibility with international investors and the possibility of raising funds abroad at lower interest rates.
OECD approves Brazil’s request
The great news is that after almost five years of talks and exchanges of information, on January 25 2022 the OECD finally approved Brazil’s request to begin negotiations to become an OECD member, along with five other countries that filed the same application (Argentina, Peru, Romania, Bulgaria and Croatia).
Brazil has been striving to meet the necessary requirements for accession to the OECD since it submitted its formal candidacy to become a member in 2017, especially with regard to compliance with legal instruments. The legal instruments consist of a set of comprehensive standards approved by the OECD Council.
Brazil has been striving to meet the necessary requirements for accession to the O ECD since 2017.
These standards aim to standardise certain behaviours, national policies, and information exchanges on a variety of topics, such as the environment, economy, taxation, trade, governance, education and employment.
So far, Brazil has transposed 112 of the 257 legal instruments required to join the OECD, making Brazil the country that complies with the most requirements among the current candidates.
It is worth recalling that, at the tax level, Brazil’s accession as a member of the OECD should bring to light some key discussions, in particular on TP rules. These were the subject of an extensive evaluation by a special study group at the OECD, which concluded that Brazilian rules are not consistent with the arm’s-length principle and must be aligned with international TP guidelines.
Besides the TP rules, there are other tax aspects that include intercompany transactions and result in great constraints regarding the justification and documentation of transactions. An example is transactions that involve the payment of royalties by Brazilian entities to related parties abroad. The domestic laws and regulations impose extremely onerous deductibility restrictions that are often far removed from the reality of the international market, invariably resulting in double taxation.
Whether due to criticism coming from different parties, overall management difficulties, or even the requirements of the accession process, local tax authorities acknowledge that changes to the TP rules in Brazil are necessary and urgent. There is a consensus that the rules should be changed to harmonise them with international practices.
Urgent need to change TP legislation
The OECD’s requirement for alignment with its rules makes the need to change the Brazilian TP legislation more urgent. For this reason, discussions between Brazilian tax authorities and the OECD have been constant, and several actions towards alignment have already been taken. Among the steps that still need to be taken, the most significant are:
The Brazilian government needs to respond to the letter sent by the organisation and commit to the OECD values and standards, as reflected in the OECD 60th Anniversary Declaration and the Ministerial Council Statement adopted in 2021;
From the positive response, the OECD will prepare a roadmap identifying the committees, policies, laws and regulations in Brazil that will be assessed;
The OECD assessment process will imply changes in local laws, regulations, policies, and practices to align Brazil’s legal framework with the organisation’s best practices;
Once all the technical committees have completed their reviews, a final decision will have to be made, by unanimous vote of the OECD Council;
After the Accession Agreement is signed, the Brazilian Congress will review it for approval; and
Finally, the President of the Republic will enact the Agreement and Brazil, from then on, will become a member of the OECD.
It is worth repeating that it is believed that Brazilian TP reform does not necessarily depend on Brazil becoming a member of the OECD. But this reform is essential for Brazil to become a member.
Therefore, the deadline for this change is slightly earlier than the deadline for becoming a member of the OECD, which is from two to five years, according to estimates released after the first meetings between government authorities and the OECD.
On March 14, the Minister of Foreign Affairs, Carlos França, publicly stated his estimate that the process for Brazil to join the OECD would take at least two years from that date.
França said: “We are moving at a fast pace to join the Organisation within a shorter period of time. It should take two years; I don’t believe we can complete the process before two years.”
Nevertheless, on March 28 the Minister of Finance, Paulo Guedes, went on an official visit to France and Spain to meet with investors and the General Secretary of the OECD, Mathias Cormann, among other authorities.
Guedes’ first official appointment was with the Director of the OECD’s Centre for Tax Policy and Administration, Pascal Saint-Amans, and the Deputy Director of the OECD’s Directorate of Financial and Corporate Affairs, Antônio Gomes.
In this meeting, Guedes discussed the reforms proposed by the Brazilian government to simplify the tax system and bring the country closer to OECD standards. On this occasion, the directors recognised the advances underway in Brazil and acknowledged the support of the Brazilian authorities in the TP project between the Brazilian tax authority (IRS) and the OECD.
Two weeks later, on April 14, another virtual and public event titled “A New Transfer Pricing System for Brazil – For Integration into Global Value Chains and Development” was held in Brazil. This included the Minister Paulo Guedes and the Director of the OECD Centre for Tax Policy and Administration Pascal Saint-Amans.
Other people attending included Melanie Hopkins, UK acting ambassador, British Embassy Brasilia; Julio Cesar Vieira Gomes, special-secretary of the Federal Revenue of Brazil; Sandro de Vargas Serpa, deputy special secretary of the Federal Revenue of Brazil; Claudia Pimentel, co-ordinator general for taxation, Secretariat of the Federal Revenue of Brazil; and Tomas Balco, senior tax adviser at the OECD Centre for Tax Policy and Administration.
During this meeting the presenters explained the key features of Brazil’s new TP system, including technical aspects, and provided updates on the status of the work and the next steps.
The OECD assessment process will imply changes in local laws, regulations, policies, and practices.
The event could be described as a high-level meeting, during which the Brazil-OECD project team unveiled the key features of Brazil’s new TP system that clearly address the issues identified and support the fiscal and development objectives of Brazil.
In a final important remark during the event, Sandro Serpa affirmed that “this is a government project”, which will be discussed with the affected industry sectors and will be, in due course, submitted to all the stages required by the Brazilian National Congress.
The Transfer Pricing remodelling discussions has gained even more strength since the Foreign Tax Credit rules has grown in US, impacting substantially the cross-border transactions performed between Brazil and United States.
These new exigencies have speed up the Brazilian tax authorities’ movements and has included frequent previous discussions with civil society before them enact a draft of the Bill, which shall be concluded until July 2022.
It is believed that this movement towards the OECD will remain unchanged, whether the current government remains in office for the next four years or if another president is elected who has the same economic agenda.
Since 2020, the Financial Conduct Authority (FCA) has said that Libor, which is one of the main market indicators, will be wound down in 2022.
For several years Libor has been the most important benchmark rate in the global market of floating interest rates, used as a basis for various types of transactions such as fixed income, derivatives, and credit facilities, and there would be much to discuss about it.
However, this article will focus on the impacts of this decision on TP studies of Brazilian entities and the effects on their related companies abroad.
In Brazil, Libor is used as a benchmark rate in some cases where the local TP rules require it, such as:
Benchmarking loan agreements that entail variable interest payments or, in the case of fixed interest payments, with currencies other than the US dollar or the Brazilian real, between related parties;
Adjustments to the payment deadlines to apply the comparable independent prices (PIC) method, when it is shown that an entity does not have an internal interest policy used for this purpose; and
Determining the interest that must be deducted from sales prices in the domestic market for calculating the resale price less markup (PRL) method.
Both for the adjustment to present value of the sale price in the domestic market using the PRL method and for the purposes of applying the PIC method, the benchmark rate used is US dollar, six-month Libor. The exception is if a Brazilian taxpayer has a clear interest policy applied to instalment sales.
As regards the interest charged on intragroup loans, in cases where a Brazilian taxpayer is either the lender or the borrower, Libor is charged plus a spread determined by Law 9430/96. The rate is 3.5% for expenses (when the Brazilian company borrows money from foreign related parties) and 2.5% for income (when the Brazilian company lends money to foreign related parties).
The Libor rate used must correspond to the functional currency of the loan agreement; if a currency that does not have a corresponding Libor is used, the taxpayer must apply the US dollar Libor.
Timing of discontinuation
According to the FCA, the discontinuation of Libor will take place as follows:
After December 31 2021, all euro Libor and Swiss franc Libor variations, one-week and also two-month US dollar Libor, overnight/spot, one-week, two-week, two-month and 12-month pound sterling Libor, and Japanese yen Libor will cease to be published;
Overnight, one-month, three-month, six-month, and 12-month US dollar Libor will be published until June 30 2023; and
One-month, three-month, and six-month pound sterling Libor and Japanese yen Libor will have their formulation updated and will be published until the end of 2022.
Since the valuations performed using Libor always consider the six-month rate, the use of euro Libor and Swiss franc Libor has been immediately discontinued for current contracts denominated in these currencies.
Contracts with functional currencies in pound sterling and Japanese yen will not be affected until early 2023. Contracts in US dollars, or in any functional currency not corresponding to Libor, will not be affected until early mid-2023.
As for taxpayers with active contracts issued in euros or Swiss francs, it is necessary to amend these contracts by changing the currency to allow the corresponding interest to be calculated and recognised. For these cases, the rate change may increase the interest amount, since both euro Libor and Swiss franc Libor were negative at the end of 2021.
For contracts issued in other currencies, it is possible to keep them unchanged in 2022. However, the winding-up of all Libor rates in 2023 will require an amendment to Law 9430/96, or otherwise the law will be silent on an alternative to evaluate variable interest rates and an increase in legal uncertainty.
In light of the uncertainty created by this lack of provision, Brazilian entities that have loan agreements with their related parties that provide for a negotiation, renegotiation, or novation date after December 31 2021 should revise them. If necessary, they should change the expected interest rates to avoid possible taxable adjustments. The contracts registered with the Central Bank of Brazil signed before this date, in principle, would be exempt from showing the interest rates used under TP rules.
It is worth mentioning that central banks of the various markets have created substitute benchmarks for Libor based on risk-free rates (RFR): overnight rates without a credit risk component. These rates are different from IBORs, which have term structures and a credit risk component. These benchmarks include:
Overnight financing rate (SOFR), from the US;
Sterling overnight index average (SONIA), from the UK;
Euro short-term rate (ESTR), from the European Union; and
Tokyo overnight average rate (TONAR) from Japan.
Even though market experts point out that several countries have used the US rate as a benchmark, for now, any statements about replacing Libor are mere speculation.
Finally, the Brazilian authorities have not yet issued any statement on possible replacements of Libor for TP purposes. Some people conclude that the reason for their silence is to align the current local rules with OECD rules.