The management of tax consequences associated with intercompany transactions entered by Brazilian taxpayers has been challenging since Brazil implemented local transfer pricing rules through the enactment of law 9,430/96, in force as of January 1, 2007. The law was later modified by law 9,959/00. The challenges associated with the enactment of Laws 9,430/96 and 9,959/00 have been escalating gradually, as never seen in the Brazilian tax environment. These are mostly connected with the publication of Normative Instruction (IN) 243/02 by the Brazilian Revenue Services. The application of IN 243/02 generally results in significant transfer pricing adjustments, which, no rarely are higher than the taxpayer’s operating profits for the taxable year under analysis. In practical terms, these tax adjustments are add-backs to the Brazilian income tax and social contribution tax bases (taxed at 34 percent).

Aiming to tax the income of Brazilian taxpayers on a global basis, the implementation of the Brazilian transfer pricing legislation was an important step in modernising Brazilian tax rules and regulations for cross-border transactions. This modernisation process started with the enactment of Law 9,249/95, which implemented the taxation of income earned abroad starting January 1, 2006, and was subsequently complemented with the enactment of Laws 9,430/96 and 9,959/00, which established transfer pricing methods and formulas, including the definition of statutory minimum gross margins to be earned by Brazilian taxpayers in connection with their intercompany transactions, as well as providing general guidelines to be followed by Brazilian taxpayers when applying the local transfer pricing rules.

The main purpose of the Brazilian transfer pricing legislation is protecting the Brazilian taxable basis from the transfer of results outside of Brazil before they were effectively taxed. This transfer of results may occur through inbound and outbound intercompany transactions performed at more advantageous prices that do not conform to those of similar transactions under similar circumstances entered by independent parties – arm’s-length principle.

OECD principles
In theory, Brazil chose to follow the transfer pricing principles set forth in the Organisation for Economic Cooperation and Development Guidelines (OECD Guidelines).

However, in practical terms, the methods prescribed under the Brazilian transfer pricing legislation have little resemblance to those under the OECD guidelines. It relates to their names only. The Brazilian transfer pricing methods are called Comparable Uncontrolled Price (PIC), Export Transaction Sales Price (PVex), Resale Price Minus Profit Margin (PRL), Wholesale Price in the Country of Destination (PVA), Retail Price in the Country of Destination (PVV), and cost plus profit margin methods for import and export transactions (CPL and CAP, respectively).

The Brazilian transfer pricing legislation focuses heavily on inbound transactions (i.e. import transactions). The most adopted transfer pricing method to assess the reasonableness of the prices paid in intercompany import transactions is the PRL method. Although the application of the PRL method is generally not beneficial to taxpayers (to extend it usually results in transfer pricing adjustments), this method is the most applied due to difficulties in obtaining production costs information for the imported products from the original foreign manufacturer (as required under the CPL method) or identifying comparable uncontrolled transactions allowing for the application of the PIC method. The starting point for the application of the PRL method is the third-party sales information performed by the Brazilian taxpayer itself. This information is generally available in taxpayers books and records. For these reasons, most tax practitioners understand the application of the Brazilian transfer pricing legislation is mostly based on the application of the PRL method. There is significant controversy regarding to the application of the PRL method. In general, it is defined as the arithmetic mean of the resale price for goods, services or rights, less: (i) unconditional discounts granted; (ii) taxes and contributions levied on the sales; (iii) commission and brokerage fees paid; and, (iv) a profit margin of: (a) sixty percent, calculated on the resale price after deduction of amounts referred to in preceding items and the value added in the country, in the case of goods utilised in the production process; (b) twenty percent, calculated on the resale price, in all other hypothesis.

Since its enactment, the Brazilian transfer pricing legislation has successfully achieved its indirect goals of increasing tax revenue, mostly in respect to intercompany import transactions.  This is due to the lack of economic reasoning behind the methods prescribed by the Brazilian transfer pricing legislation, which fail to follow the internationally adopted principles associated with pricing, identification of comparable uncontrolled transactions, and levels of profitability.

Based on the above, the differences between the Brazilian transfer pricing legislation and the OECD guidelines start by disregarding market prices as reference to the identification of a potential transfer of profits abroad to extend such an analysis is based on statutory gross profit margins that have no economic rational supporting their application and end at the courts where taxpayers pursue the application of the more beneficial PRL formula defined by Law than the one innovated and defined by IN 243/02. In practical terms thissignificantly increases taxpayers’ transfer pricing adjustments, which clearly disrespects the hierarchical principle whereby a law is superior to an administrative act and, consequently, the Brazilian Constitution.

As a result from the differences between the PRL formula prescribed by Law 9,959/00 and the one under IN 243/02, transfer pricing adjustments and income tax and social contribution tax bases have increased exponentially.

Transfer pricing audits by the Brazilian Revenue Services are based on the PRL formula prescribed by IN 243/02. In instances where taxpayers have followed the formula prescribed by Law 9,959/00, transfer pricing assessments can result in multimillion dollar adjustments to the income tax and social contribution tax basis. Over the period of 2002 to 2007, Deloitte conducted an independent analysis of the gross profit margins earned in several Brazilian and foreign industries. Deloitte’s independent analysis was unable to identify any industry segment earning gross margins of 60 percent or higher.

There are enough elements for taxpayers to defend themselves from the never-ending appetite for tax income of the Brazilian Revenue Services and defend the correct application of the PRL formula prescribed by law 9,959/00 while rejecting the modification of such formula that has been imposed by a mere administrative instruction, which requires taxpayers to either earn arbitrary and unreasonable gross margins in the sale of products containing components imported from related parties or face significant transfer pricing adjustments, which can be compared to confiscation of capital income instead of taxation of income generated by taxpayers.

Interpreting PRL
The disputes for the correct application of the PRL formula as defined by Law 9,959/00 in connection with the use of more reasonable gross profit margins create uncertainties in tax practitioners and taxpayers, which already take on several business risks.

The uncertainties created by the different interpretations of the PRL formula (i.e., Law 9,959/00 vs. IN 243/02), in connection with multimillion dollar transfer pricing adjustments imposed by the Brazilian Revenue Services, many of which, taxpayers are unable to afford, have resulted in several costly court litigations which have been dragging on for years before decisions are taken.

Assuming the principles provided by the Brazilian Constitution and tax code would prevail, taxpayers can rest assured the legality principle whereby an IN cannot state differently from the law it is supposed to regulate. Taxpayers will then be successful in not suffering unreasonable impositions from the Brazilian Revenue Services.

However, even if taxpayers are successful, in the end the entire tax system loses to a certain extent. Taxpayers would have incurred unnecessary time and costs in connection with tax litigations that could have been avoided in case the Brazilian Revenue Services had reason before enacting IN 243/02, the government for creating a fictitious expectation of tax income, the courts for being involved in litigations that should not have existed, and individual taxpayers that have to take more money out of their pockets when purchasing products containing imported components simply to cover expensive transfer pricing-related costs and legal expenses.

Brazil is certainly a prosperous market with a developing economy. However, uncertainties and threats created by taxing authorities, who should foster economic growth and a more friendly business environment, may discourage companies, investors, and potential entrepreneurs to do business in Brazil, which in turn would reduce Brazil’s current growth levels.

For more information Email: fmatos@deloitte.com; atinoco@deloitte.com