News › Weekly Alert Article
Transfer pricing rules
Summary of the main aspects of the transfer pricing rules in Brazil (June 2006).
Up to December 31, 1996, the transfer pricing rules in Brazil, with related parties, were restricted to import rules (for import duty purposes) and to the distribution of profits (for income tax purposes). The understanding and the use of these rules were subjective and became incompatible with the current Brazilian reality regarding the growth of foreign investment, mainly due to the process of privatization.
Transfer pricing rules in Brazil were introduced by Law No. 9,430 of December 27, 1996, effective as of January 1, 1997. Law No. 9,430/96 introduced the concept of transfer pricing control for purposes of taxation in transactions between related parties or with parties domiciled in tax havens (which for Brazilian tax purposes is a jurisdiction in which income and gains are tax free or subject to taxes levied at a maximum rate lower than 20%), establishing minimum prices for export transactions, maximum prices for import transactions and maximum deductible amounts of interest. It is important to note that these issues are of a tax nature, not of an exchange nature.
Brazil is not a member of the OECD, but the explanatory notes to Law No. 9,430/96 mention OECD rules as one of the sources that inspired this Brazilian Law. Nevertheless, the Brazilian Law has been criticized for failing to respect international treaties signed by Brazil and for not following OECD recommendations. As Brazil is not a member country of the OECD, it is not required to follow OECD recommendations. However, many of the conventions to avoid double taxation, to which Brazil is a signatory, follow the OECD model, creating conflicts in the transfer pricing rules.
The principal difference is that Brazilian legislation does not adopt the "arm's length principle", but instead establishes maximum prices that will be accepted as deductible in importation transactions, and minimum profit levels in the case of exportation. The Brazilian legislator thus opted for formulas as the means to avoiding subjectivity in evaluating transfer prices.
The other transfer pricing methods established under the Brazilian legislation are given names that are similar to those provided for in the OECD model convention, but the Brazilian methods differ significantly from the OECD methods. Professor Ricardo Mariz, for example, has commented on the differences between the price comparison method established under Brazilian legislation and the method adopted in the OECD's recommendations:
"Although the disparities between Law 9430/96 and the "arm's length" principle are many, it is enough to mention that under the Brazilian Law, the reference for comparison purposes is the average market price throughout the entire base period, which can be, and normally is, different from the market price on a given date. In effect, when one refers to an average, one is referring to a number of prices that produce an arithmetical average value, which means that the average is different from all, or almost all, the individual values that compose the average.
Now, a price that is absolutely compatible with the price prevailing in the market on the date of the transaction can easily be incompatible with the average price over the period, and so trigger tax consequences. Thus, a company could carry out controlled transactions at a certain time during the comparison period, at prices strictly within the market at the relevant time, but those prices might well differ from the average over the period, because of seasonal variations typical of the market."
The Brazilian transfer pricing rules provide for three methods to determine maximum deductible expenses, costs and charges in connection with imported goods and services in transactions with a related party or a party located in a tax haven.
The three methods are the following:
- Independent Compared Prices ("PIC");
- Resale Price less Mark-up ("PRL"); and
- Production Cost plus Mark-up ("CPL").
If the effective price charged in an import transaction is higher than the highest transfer price calculated according to one or more of the three methods above, the difference between the effective price and the transfer price is non-deductible for income tax purposes.
For exports, Brazilian taxpayers are subject to transfer pricing if the average sales price is lower than 90% of the average sales price carried out with unrelated parties in the Brazilian market. In this case, the export income will be adjusted according to one of the following methods:
- Average Price of Export Sales ("PVEX");
- Wholesale Price in the Destination Country Less Profits ("PVA");
- Retail Price in the Destination Country Less Profits ("PVV"); and
- Production Cost Plus Profits Method ("CAP").
In the case of export transactions, if the effective price charged is less than the lowest transfer price calculated according to one or more of the four methods described above, the difference between the effective price and the transfer price will be considered to be taxable income.
For the purposes of transfer pricing controls, Brazilian law considers the following to be related parties of a company established in Brazil:
- The foreign parent company
- A foreign branch;
- A foreign company or non-resident individual directly or indirectly holding a stock participation of sufficient level to make them a related or controlling party, as defined in Brazilian Corporation Law.
The following situations shall similarly constitute a relationship for the purposes of liability to transfer pricing control.
- When the foreign and Brazilian companies have the same shareholders or the same management or at least 10% of the shares of both companies are the property of the same company or individual.
- When the non-resident company or individual and the Brazilian company together hold stocks in a third company at a level which characterizes them as related or controlling parties in accordance with the above mentioned Brazilian Corporate Law.
- When the foreign company is defined as a related or controlling party in accordance with the Brazilian Corporation Law (Art. 243, BB 1 and 2).
- When the foreign company or individual is associated with the Brazilian company in any form of condominium, consortium or partnership.
- When the non-resident individual is a relative to the third degree or is the spouse (legally or by common law) of any director or directly or indirectly controlling partner or quota holder.
- When the foreign company or individual holds exclusive writ to sell and purchase the goods produced or commercialized or services rendered by the Brazilian company.
- When the non-resident or company grants exclusive writ to the Brazilian company to sell or purchase its goods or services.
In addition to the rules applicable to transactions between related parties, the transfer pricing regulations set forth that such rules also apply to international transactions carried out with a person or legal entity, whether related or not, located in the so-called low tax jurisdictions. For transfer pricing purposes, a low tax jurisdiction is deemed to be the country that taxes income at a maximum rate below twenty percent (20%). Based on the regulations relating to Transfer Pricing and to the incidence of income tax on revenues of beneficiaries resident or domiciled in low tax jurisdictions, as from January 1, 2000, the following countries are considered as tax havens by the Brazilian Internal Revenue Department: American Virgin Islands, Andorra, Anguilla, Antigua, Dutch Antilles, Aruba, Bahamas, Bahrain, Barbados, Barbuda, Belize, Bermuda, British Virgin Islands, Campione D'Italia, Channel Islands (Alderney, Guernsey, Jersey and Sark), Cayman Islands, Cook Islands, Costa Rica, Cyprus, Djibouti, Dominica, Gibraltar, Granada, Hong Kong, Labuan, Lebanon, Liberia, Liechtenstein, Luxembourg (with respect to the holdings regulated by Law No. 31, of 1929), Macau, Madeira Island, Isle of Man, Maldivas, Marshall Islands, Mauricio Islands, Malta, Montserrat, Monaco, Nauru, Niemi, Niue Islands, Panama, Santa Lucia, San Marino, Saint Kitts and Nevis, Saint Vincent, Seychelles, Singapore, Vanuatu, Samoa Island, Sultanate of Omar, Tonga, Turks and Caicos Islands, United Arab Emirates.
The methods applicable in import transactions can be explained as following:
- PIC: comparison between the import price and price adopted (i) by the exporter abroad, in transactions with non-related parties; (ii) by the importer in Brazil in transactions with other non-related suppliers; and (iii) in transactions between other non-related suppliers and buyers. Such comparisons must use transactions with the same payment conditions and terms. Other adjustments allowed for by the Brazilian legislation are on brokerage fees, interest included in price, freight and insurance, among others. This method is defined as the arithmetical average of sales price of goods, services or rights, be they identical or similar, prevailing in the Brazilian or foreign markets, on transactions of purchases and sales, under similar payment conditions. In other words, the taxpayer shall compare costs, expenses and charges of goods, services or rights acquired from a related party, over a given period of time, with such an arithmetical average. If the costs, expenses and charges incurred by the taxpayer exceed the arithmetical average, the exceeding amount shall then be added back as taxable income. Moreover, with respect to the arithmetical average, only transactions carried out between unrelated purchasers and sellers will be taken into consideration for purposes to calculate such an average.
- PRL: resale price used by the Brazilian importer less (i) unconditional discounts; (ii) taxes included in the price; (iii) brokerage fees; and (iv) 20% of the mark-up or, in case of imported goods used in the production process of the importer (for instance, raw material), 60% of the mark-up. Other matters may be taken into account, such as payment conditions, quantity, etc. As a general rule, it is only possible to use the PRL method when the product imported is intended for direct resale. The regulations accept profit margins other than those set forth in the specific methods, provided the taxpayer proves they are based on publications, surveys or reports prepared by foreign governments, foreign tax authorities, or companies or institutes of well-known technical standing.
- CPL: the average production cost of identical or similar goods in the exporter's jurisdiction, plus (i) taxes and duties charged by such jurisdiction in export transactions; and (ii) profit margin of 20% on the evaluated cost. Note that the federal authorities require a very detailed report, containing the amount of each item included in the cost.
The methods applicable in export transactions can be explained as following:
- PVEX: This method is defined as the arithmetical average of export prices adopted by the taxpayer or another exporter of goods, services or rights, either identical or similar, with unrelated parties, during the same corporate income taxation period and under similar payment conditions. If the taxpayer does not export goods, services or rights to unrelated parties, the tax authorities may compare the taxpayer's export prices with those adopted by third parties that export identical or similar goods, services or rights. The concept of "similar goods" for exports is the same as in the case of imports.
- PVA: The second method for exports to a related party is the wholesale price in the destination country less profit method, defined as the arithmetical average of sales of identical or similar goods on the wholesale market in the country of destination, with similar payment conditions, after deducting (i) the taxes computed in the sales price, charged in that country, and (ii) a profit margin of 15% over the wholesale price
- PVV: This method is similar to the preceding method, except for the fact that it is based on the retail price instead of the wholesale price. It is defined as the arithmetical average price of identical or similar goods on the retail market in the country of destination, with similar payment conditions, after deducting (i) the taxes computed in the sales price, charged in that country, and (ii) a profit margin of 30% over the wholesale price.
- CAP: This is an authentic cost plus method. The method requires the Brazilian Seller to recognize a profit margin of at least 15% (plus the costs incurred) for income tax purposes. It is defined as the arithmetical average of the acquisition or production costs of the goods, services or rights exported, including the taxes levied on exports in Brazil and a profit margin of 15% over the sum of costs and taxes. Pursuant to the regulations, the amounts paid by the foreign entity as freight and insurance are included in determining the acquisition costs for the purposes of this method.
According to current legislation, the taxpayer is not required to comply with one of the transfer pricing methods if it is able to evidence that the average sales price of goods, services and rights in cross-border controlled transactions is at least 90% of the average sales price in contemporaneous uncontrolled transactions carried out in the Brazilian market.
Treasury Ruling no. 243/02 sets out two unclear provisions, which some have interpreted as "safe harbour" situations. The first provides that a taxpayer which has a net profit originating from export sales to related parties, before income tax and the 12% social contribution on adjusted income and an amount of at least 5% over such sales, can demonstrate its compliance to the transfer pricing rules only by submitting the documents for the transactions with related parties. The second imposes the same requirement on taxpayers which show net export revenues originating from transactions with related parties equal to or less than 5% of its total net revenues.
Such situations do not characterize true "safe harbours", particularly because the tax authorities have the power to reject the amount of revenues recognized by the taxpayer. Nevertheless, it is important to note that these provisions only apply to export sales of goods, services or rights. They do not apply to taxpayers importing goods, services or rights from foreign related parties.
Note that the 5% net profit must be calculated based on the annual average profit of the current year and the two precedent years. The applicability of this safe harbour is extremely controversial because the applicable regulation does not state how the calculation should be made. In order to determine the annual average profit there are three different calculations:
(i) Percentage of each of the three years (most conservative);
(ii) Sum of the percentages obtained in each year (Arithmetical average)
(iii) Weighted average of the three years, i.e., (i) multiplying the percentage obtained in each year by the respective export revenue, (ii) adding the three results and (iii) dividing the amount determined in item "ii" by the total amount of export revenues for the three years.
Also in connection with transfer pricing, Law No. 9,430/96 sets forth the minimum (taxable) and maximum (deductible) interest rates charged in inter-company loans falling outside the Central Bank of Brazil's jurisdiction: LIBOR for six months plus 3%. Brazilian borrowers can only deduct a maximum interest rate of LIBOR plus 3% paid to a non-resident related party, while Brazilian lenders must recognize as taxable income, at least, the same interest, in loans extended to foreign related parties.
When arising from a contract which is not registered with the Brazilian Central Bank, this rule can be avoided giving proof that the interest used is based on market interest rates.
Application for Lower Profit Margins
On April 30, 1997, the Ministry of Finance issued Ordinance no. 95/97, which permits taxpayers to apply for a change in the profit margins set out in the transfer pricing regulations. The Ordinance only provides for general rules and does not specify how taxpayers should proceed. The proper regulations to change profit margins for transfer pricing purposes are set out in Treasury Ruling no. 243/02. The Treasury Ruling states that changes in profit margins can be requested by either the tax authorities or taxpayers. Although not clear, this provision would also, in theory, permit the tax authorities to increase profit margin percentages.
To change profit margins, the taxpayer must file an application with the Treasury and provide certain documents. The Treasury Ruling also requires that the taxpayer indicate the term within which the new profit margin will be adopted. The reason for this provision is unclear, particularly because the taxpayer has the opportunity to change transfer pricing methods at the beginning of each fiscal year (in Brazil, January 1st). When the application is filed, the Treasury analyses the proposed profit margin, the term within which it will apply and the documents the taxpayer has presented. The Ruling authorizes the Treasury to request further information and documents, if necessary.
If the Treasury does not accept the profit margin proposed, it notifies the taxpayer. No appeal is available. If the Treasury accepts the profit margin and the terms, the application is sent to the Ministry of Finance who notifies the taxpayer by means of an Ordinance. If the Treasury accepts the profit margin but does not accept the terms, it proposes new terms that the taxpayer must follow. Again, no appeal is available.