Il Blog di Marco Piazza

Il Punto di Luiz Felipe Centeno Ferraz e Rafhael Romero Bentos 

It has been historically repeated over more than two decades that the current Brazilian tax rules applicable to transfer pricing have been recognized as a set of outlier provisions for not adopting the standards provided by the Organisation for Economic Co-Operation and Development (OECD).

This mantra tends to change in the near future: as Brazil has requested ascension to integrate this organization as a permanent member, embracing such model might arise as a key requirement for a positive outcome. In this context, the OECD and the Brazilian Internal Revenue (RFB) Service recently launched a report stating the need of further developments in the local legislation – the “Transfer pricing in Brazil – Towards convergence with the OECD standards”.

Unlike other jurisdictions, Brazil has adopted a system based on a formulaic approach with fixed income margins as percentages established by legislation rather than applying the widely accepted arm’s length principle (ALP), taxpayers have discretion to select their applicable methods and some specific safe harbours are provided.

Inspired on the OECD 1979 report, the domestic rules were established in 1996 and have not observed subsequent amendments on the OECD Guidelines. Those in favour of this system defend that it brings simplicity with clear and defined rules, not imposing comprehensive comparability of transactions amidst related parties, ease compliance for taxpayers and less administration costs for tax authorities. This system is beset of practicality, predictability and tax certainty from a domestic point of view, with no large number of tax disputes with the Courts.

Detractors, on the other hand, describe relevant disadvantages arising from this method. The lack of international alignment and discrepancies between the local provisions with foreign methods generate double taxation for some enterprises or double non-taxation for others, result in less revenue for Brazil due to facilities to tax bases allocation throughout this misalignment, and a significant level of tax uncertainty for taxpayers in cross-border transactions. It has been argued, therefore, that fixed margins ignore the comparability common method, drifting apart from the economic reality of each sector and transaction.

In light of this context, the aforementioned study aimed at analysing pros and cons of the current transfer pricing rules, which led to the understanding that Brazil must adopt domestically the OECD standards as the main criteria involving transactions between related parties. While the report acknowledges the benefits of the Brazilian system, it highlights that those rules fail in attending the main goals of transfer pricing, such as avoiding double (non) taxation and allocating the appropriate tax base in each jurisdiction.

This is because the formulaic method would be strictly rigid and substantiated in unclear criteria. The freedom of choosing methods in general results in reduced tax burden, once taxpayers might adopt the most tax efficient one in detriment of the method that best favours the ALP. Lastly, ‘safe harbour’ provisions on exports would produce inappropriate outcomes and concerns regarding the appropriateness of profitability.

The joint project also outlined a relevant number of weaknesses and divergences in the Brazilian rules. For instance, an absence of a true ALP into the domestic law, the absence of a profit split method, the non-ALP outcomes deriving from the fixed margin approach, the absence of comparability analysis and an absence of special considerations for intangibles, financial transactions, and business restructuring – in addition to the existence of limited requirements regarding documents, issues related to nexus rules and the non-existence of specific dispute resolution mechanisms.

Further detailed examination also pointed out other negative aspects of the existing framework. In order to prevent double taxation, transfer pricing rules intend to mirror tax effects in both jurisdiction in which the transaction takes place by providing specific comparability to relief the ultimately tax burden. In cases involving the ALP and fixed margins, this divergence results in double taxation. Such misalignment with international rules, therefore, arguably leaves room for manipulation of profit allocation and cross-border tax arbitrage, in which the appropriate tax base may not rightly be attributed in each country.

The project finally stated that simplicity is relative, given that important features of transfer pricing are not addressed on the existing system, such as intra-group transactions, structures involving intangibles, and reduced standards of comparability. Lastly, the alleged tax certainty might be identified solely from the domestic perspective as international taxpayers face evident uncertainty due to the contrary treatments over the same transaction (fixed margins versus ALP).

This context of advantages and disadvantages led the OECD and the RFB to conclude that an entire convergence of the Brazilian rules towards the international standards is greatly recommended. Arguments in favour of this integral alignment defend that a new system will eliminate the current double taxation, prevent profit shifting, increase certainty from an international view, integrate Brazil to global chains and boost external investments and, finally, positively impact the expected joining of the country to the OECD. It was suggested that this process could be paved by steps – by moving the fixed margins to a safe harbour and then closer to the ALP to better reflect economic reality of transactions – but the desirable trend is an immediate conversion when the time comes.

At this point, part of the tax community still discusses to what extent this convergence is desirable. Lots of criticism have shed lights on the OECD standards for imposing significant compliance costs, ignoring synergies within economic groups and for being time-consuming. Some alternatives to the ALP have been approached as a form to address the current challenges under this system, then expecting Brazil to adapt domestic rules to a relatively unstable model might be unproductive.

Changing local rules will have a relevant cost. The report did aimed at disclosing the OECD conclusions; thus, it is naturally not clear as to procedures to implement the proposed updates, difficulties that will emerge in convincing the private sector – which may bear higher costs in attending complexities under the new system – and the National Congress that, ultimately, will approve amendments on the legislation (political barrier).

Another relevant consequence of this adjustment is related to tax disputes in transfer pricing. While Brazil stands out as an outlier in terms of high volume of disputes, fortunately this is quite uncommon under the formula system for being predictable and rigid. However, it certainly will change due to the complexities generated from the adoption of ALP as stated by the OECD.

Despite the potential downsides, we believe the benefits will outweigh damages. OECD’s recommendation is out and clear and, if Brazil intends to become a permanent member of this elite group of countries, the current transfer pricing system in place for over twenty years must be updated. Positive outcomes of this alignment will be extremely favourable to Brazil as turning out this large economy in a more integrated jurisdiction, while fostering external Investments.

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