Since 1997, transactions between Brazilian and foreign companies have been subject to controversial legislation. In September this year, that legislation changed, meaning businesses looking to make deals in the area might need to catch up
Brazil does not follow the Organisation for Economic Cooperation and Development’s (OECD) guidelines. Brazilian transfer pricing legislation sets out specific methods for pricing of transactions between Brazilian and foreign affiliates. These methods vary in accordance with the nature of the transaction under analysis (i.e. import or export transactions). Local transfer pricing methods establish maximum price ceilings for deductible cost associated with intercompany inbound transactions and minimum income floors for intercompany outbound transactions.
The legislation first came into effect on January 1, 1997 and has always been a source of controversy. It has recently been through significant changes, which were introduced by law 12,715/2012 published on September 18, 2012. Although law 12,715/2012 applies to fiscal years starting on or after January 1, 2013, taxpayers can opt to apply the rules from fiscal year 2012. Highlights of the new Brazilian transfer pricing legislation include changes to the resale price minus profit method (PRL), which are outlined below.
The PRL has been the most frequently used method to determine the reasonableness of the price paid by a Brazilian taxpayer in inbound intercompany transactions. It takes into account certain statutory gross profit margins, which vary depending on the use of the imported products, services, or rights. The statutory gross profit margins in old rules were 60 percent for imported items used by the importer in the production process and 20 percent in all other cases in which the imported items are not used in the production process, regardless of the industry of the taxpayer. Law 12,715/2012 introduces the following changes to the application of the PRL method:
- New gross profit margins: New gross profit margins will apply, depending on the taxpayer’s industry sector or the activities for which the imported products, services, or rights are used. One of the major differences between the MP 563/2012 and Law 12,715/2012 regards to the exclusion of the word “manufacturing” from the description of several of the relevant industry sectors and activities for which the new gross profit margins should apply. Law 12,715/2012 clearly expands the scope for certain gross margins to extend their application, and is no longer limited to manufacturing activities.
- Freight and insurance, and import tax costs: One of the most controversial issues raised with regard to import transactions is the treatment of freight and insurance costs and its impact on the Brazilian import tax cost for purposes of comparison with the price calculated using the PRL method. From an economic perspective, payments to third parties do not generate a transfer of profits to related parties and, therefore, should not be subject to the transfer pricing rules. Law 12,715/2012 now provides that, unless paid to related parties, freight and insurance expenses as well as the import tax and other customs costs incurred by the local importer should not be taken into account when determining the price that is subject to assessment under the Brazilian transfer pricing rules.
- PRL calculation formula: Law 12,715/2012 also introduces changes to the PRL formula. The parameter price, which continues to have as its starting point a sale transaction entered into by the Brazilian taxpayer, must take into account the ratio of the products, services, or rights imported from related parties to the total costs of the products, services, or rights sold by the Brazilian taxpayer. For practical purposes, this change expands the approach the Brazilian tax authorities have been requiring taxpayers to apply when applying the ‘PRL 60’ method. Stated differently, and disregarding the new gross profit margins, the PRL formula provided by Law 12,715/2012 is essentially the same as the one Brazilian tax authorities were imposing on taxpayers when applying the old PRL 60 percent method for goods, services, or rights applied in the production process since 2003 (i.e. under Normative Instruction 242/2002). The table below compares the old and new PRL formulas. Please note that for purpose of this article the old PRL formula (left side of the table below) corresponds to the formula provided by Normative Instruction 243/2002. The PRL method has been a source of controversy and various interpretations for that method exist, some of which, depending of the facts and circumstances, can be more beneficial than the new PRL formula provided by Law 12,715/2012.
- Changes to the comparable uncontrolled price method (PIC): The PIC is defined as the weighted average of the uncontrolled prices of similar goods, services, or rights as calculated in the Brazilian market or in other countries, for purchase or sales transactions carried out under similar circumstances. Law 12,715/2012 provides that the application of the PIC method in cases in which the taxpayer applies the method based on uncontrolled import transactions should take into account similar uncontrolled transactions with a volume representing at least five percent of the total import amount from related parties. Law 12,715/2012 did not set a threshold where the PIC method is applied solely based on comparable transactions entered by parties other than the Brazilian importer. Law 12,715/2012 also provides that the PIC method should be applied based on transactions entered during the same fiscal year as that is under analysis. When transactions entered during the same period are not available, the taxpayer can rely on transactions entered into in the prior year, as long as they make adjustments to the price of such transactions to account for foreign exchange rate fluctuations.
- New transfer pricing methods for commodities: Law 12,715/2012 introduces two additional transfer pricing methods to the existing Brazilian methods: the stock exchange import price and stock exchange export price for inbound and outbound transactions in commodities, respectively. Under the additional methods, the basis for comparison is the average stock exchange price for the relevant items adjusted for any applicable upward or downward spreads. The stock price that should be used corresponds to the average price on the date of the transaction. In cases in which no stock price exists for the relevant date, the analysis should be based on the average stock price for the most recent date before the transaction date. For commodity products not negotiated in stock exchanges, the law 12,715/2012 also allows for the use of prices obtained from reputable international sector institutions. The new transfer pricing methods must be applied in intercompany transactions involving commodities. In other words, taxpayers would no longer be allowed to apply any of the remaining methods to assess the reasonableness of their transfer prices.
- Inbound and outbound loan transactions: Taxpayers have long argued that interest paid on intercompany loan transactions is not subject to the Brazilian transfer pricing legislation if the loans are registered with the Brazilian central bank. Law 12,715/2012 specifically provides that interest expense paid to related parties will not be deductible if above the six-month London Interbank Offered Rate, plus a three percent annual spread. Please note the Brazilian Minister of Finance has the authority to change the base rate. In practical terms, the new provision indicates that interest expense above such a threshold will be taxed at the applicable corporate income tax rate.
Unfortunately, the changes introduced by Law 12,715/2012 do little to align the Brazilian transfer pricing legislation with the international norm. They continue to lack the economic rationale provided under the OECD guidelines. Nevertheless, these are significant and will affect the transfer pricing tax burden of all multinational companies in Brazil, which are generally subject to a significant level of scrutiny by the Brazilian Revenue Services. The proactive development of an efficient transfer pricing policy is key to mitigating any double taxation issues. This process usually includes:
- Working to develop an intercompany transaction inventory;
- Assessing the more appropriate method to document intercompany transactions based on facts and circumstances;
- Assessing the possibility of managing intercompany prices within the fiscal year in order to either mitigate or zero any Brazilian transfer pricing adjustments;
- Assessing whether the relevant intercompany transactions are memorialised in intercompany agreements; and
- Preparing transfer pricing analyses and reports documenting all the relevant intercompany transactions.