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Transfer pricing compliance: effects of the changes in law and of the economic scenario

Clarissa Giannetti Machado, Trench Rossi Watanabe, Brazil Thiago Del Bel, Trench Rossi Watanabe, Brazil

For the last years, Brazilian taxpayers have been experiencing difficulties concerning the transfer pricing compliance, either because of the recent amendments to the legislation – some of them "inspired" by the tax transparency of the OECD's project on base erosion and profit shifting (the so-called BEPS) – or due to the impacts of the economic crisis that Brazil has been facing and the more recently depreciation of local currency.

As known, Brazil does not follow the arm's-length principle that is internationally established in the OECD Transfer Pricing Guidelines. Historically, the Brazilian transfer pricing legislation provides rules and methods to determine maximum amounts of deductible expenses and minimum amounts of taxable income for Brazilian entities engaged in transactions with foreign related parties, parties domiciled in low tax jurisdictions or parties subject to privileged tax regimes. Such methods are based on statutory (minimum or maximum) profit margins. The result from any chosen Brazilian transfer pricing method is deemed the "Brazilian arm's-length price", but it is not a specific price ("market price"), but rather a minimum or maximum threshold.

On January 1st, 2013, the first "best method rule" was introduced in the Brazilian tax legislation, specifically applicable in case of import and export of commodities subject to transfer pricing control. The methods are named Exchange Import Price Method (PCI) and Exchange Export Price Method (PECEX). In general terms, the "Brazilian arm's-length price" under these methods is the market price of the relevant commodities that are traded in internationally recognized future and exchange markets. Whenever a Brazilian party imports or exports commodities from/to a foreign related party (or a party domiciled in a low tax jurisdiction or subject to a privileged tax regime), the above methods must be adopted.

The introduction of the "best method rule" for commodities shows that, even though Brazil does not follow the OECD Transfer Pricing Guidelines, there is an "indirect" influence of the BEPS initiative to Brazilian transfer pricing rules. In the world of transparency there are more and more limitations in connection with the allocation of profits and expenses among companies domiciled in different jurisdictions.

Specifically in case of Brazil, the taxpayers have been experiencing difficulties in complying with the "best method rule" for commodities due to the "definition" of commodities as provided in the legislation and the poor rules for adjustment purposes. For purposes of Brazilian transfer pricing compliance, commodities are any products negotiated in futures and exchange markets listed in the legislation, or any products listed in the legislation and that, cumulatively, are subject to public prices in exchange markets or in internationally recognized sectorial research institutions also listed in the legislation. In terms of calculation of the deemed arm's length price, the legislation does not provide the necessary flexibility and a complete set of rules to allow the taxpayer perform the necessary adjustments to accommodate differences between the products and other market conditions.

Another relevant amendment to the legislation, also introduced in 2013 but that has been triggering relevant tax effects during this year, relates to cross-border loans and financial transactions subject to Brazilian transfer pricing scrutiny. The interest rates set forth in the legislation as to determine the maximum amount of deductible expenses and the minimum amount of taxable income were significantly changed and are now based not only on the London Interbank Offered Rates (LIBOR), but also on the interest rates paid by the sovereign bonds of the Federal Republic of Brazil issued in the foreign market, plus a spread based on the market average defined by the Minister of Finance. Whether the taxpayer needs to apply the LIBOR or the interest of Brazilian sovereign bonds depends on the currency and on the type of interest rate (pre-fixed or post-fixed interest rate) established for the specific loan/financial transaction. With the increase of the interest rate in the market, the maximum deductible interest provided in the legislation (in case the Brazilian taxpayer is the debtor) has became too low, when compared with the market conditions. Accordingly, it has resulted in double taxation as the foreign lender has been required to recorded for tax purposes abroad an interest rate higher than the one deductible in Brazil.

The economic challenges that Brazil currently faces are also creating impacts to the transfer pricing compliance, mainly for import transactions because of the recently high appreciation of the United States Dollar (USD) and other foreign currencies when compared with the Brazilian Real (BRL). As mentioned, the Brazilian transfer pricing legislation provides rules and methods to determine maximum amounts of deductible expenses and minimum amounts of taxable income, the so-called "Brazilian arm's-length price". The high appreciation of the USD are affecting the compliance with the "Brazilian arm's-length price" determined according to the so-called Comparable Uncontrolled Price Method (CUP) and the Resale Price Less Profit Method (RPM), which are the most common methods elected on import transactions.

Under the CUP method, the "Brazilian arm's length price" for imports is determined based on the arithmetical average of sales price of goods, services or rights, either identical or similar, prevailing in the Brazilian or foreign markets, in transactions of purchases and sales, under similar payment conditions. The CUP rules only allows exchange variation adjustments in case the taxpayer has to use comparable transactions occurred in the previous calendar-year (if no comparable transactions were available during the same calendar-year). There is no authorization relating to exchange variation adjustments for comparable transactions occurred during the same calendar-year as the transactions subject to transfer pricing control.

Under the RPM method, the "Brazilian arm's length price" for imports is determined based on the arithmetical average of resale prices of goods (in Brazil) less unconditional discounts granted, taxes and contributions imposed on sales, commissions and brokerage fees paid, and a profit margin of 20%, 30% or 40% based on the economic sector of the legal entity subject to transfer pricing control. The "Brazilian arm's length price" under the RPM is calculated considering the participation of the costs of imported goods, services or rights in relation to the total cost of the goods, services or rights commercialized in Brazil. Accordingly, the appreciation of the USD tends to increase the cost of the imported goods, services or rights, as there will be an increase of the imported price (if we consider the same price in foreign currency) when converted into local currency. Therefore, if the resale price remains the same (in BRL), the profit margin of the Brazilian entity tends to decrease, making the compliance with the "Brazilian arm's length price" more difficult.

Finally, it is being noticed a recent increase in the number of transfer pricing audits carried out by Brazilian tax authorities. In this context, it is recommended that taxpayers are prepared to support the compliance with the Brazilian transfer pricing rules, taking into account the practical difficulties outlined above.