Brazil set to align its transfer pricing rules with international standards

In a promising development for multinational groups with existing operations in Brazil, or considering new investments in Brazil, it appears that the long-standing differences between the Brazilian transfer pricing rules and international standards are to be resolved. Following a meeting on 12 April 2022 between the OECD and the Brazilian federal finance authorities, the parties announced that Brazil intends to adopt a new transfer pricing framework fully aligned with the OECD Transfer Pricing Guidelines. No date for implementation has yet been announced but it is unlikely that changes will take effect as early as this year. Whilst this is welcome news, UK headquartered groups are unlikely to see the full benefits of transfer pricing rules harmonisation until a UK-Brazil double tax agreement (DTA) is agreed which comprehensively addresses the double taxation risks in relation to cross-border payments for services.

What changes can we expect to see?

The announcement that Brazil’s new transfer pricing framework will be aligned with the OECD Transfer Pricing Guidelines implies some significant changes to the existing Brazilian transfer pricing rules, including:

• The full application of the arm’s length principle to all types of business transactions, both inbound and outbound;
• Accurate delineation of the controlled transaction by an analysis of functions, assets and risks;
• Assessment of arm’s length pricing by the methods described in the OECD Guidelines, with comparability to uncontrolled transactions considered against the OECD’s comparability factors;
• Entitlement to intangible-related returns based on the distribution of development, enhancement, maintenance, protection and exploitation (DEMPE) functions;
• Rules on intercompany services to include the question of an economic or commercial benefit, the concept of shareholder activities, duplicative services and direct or indirect charging, with simplified analysis for low value-adding services;
• The application of Chapters IX and X of the OECD Guidelines to business restructurings and financing transactions, respectively;
• A requirement for transfer pricing documentation in line with the Base Erosion and Profit Shifting (BEPS) ‘Action 13’ recommendations: Master File and Local Files to complement the existing requirement for Country-by-Country Reporting; and
• The potential for Advance Pricing Agreements, subject to the necessary capacity building.

Whilst multinationals will welcome full adoption of the OECD rules, in the short term there are likely to be additional costs and resource implications of complying with the new requirements. Groups will need to transition from the current transfer pricing system in Brazil, which is largely based around the resale price method and cost plus method, but uses pre-fixed margins rather than comparables. Challenges can be expected in switching to approaches based on benchmarking net margins and contribution analysis based profit splits which will be unfamiliar to the tax authorities.

Implementation timetable

The Brazilian Government has stated that a legislative proposal will be submitted to Congress at an “appropriate moment”. It is unlikely the changes will take effect as early as this year as 2022 is an election year in Brazil and constitutional limitations mean that tax law changes usually enter into force in the following year.

A UK-Brazil DTA?

The absence of a DTA with Brazil remains the most significant gap in the UK’s DTA network. The main barriers to starting formal negotiations on a DTA agreement with Brazil have been the proper application of Article 9 of the OECD Model Treaty (transactions between associated enterprises and the arm’s length principle) and the taxation of services.

HMRC have received feedback for a number of years that the cost of implementing arm’s length charges for management services and use of intellectual property between a UK group company and its Brazilian subsidiary is prohibitive and it is more cost effective for the UK company to make a one-sided transfer pricing adjustment to impute income in its corporation tax return. This creates economic double taxation and results in excess cash being trapped in Brazil and potentially subject to further taxes on repatriation. As a result, a UK-Brazil DTA, which comprehensively addresses the double taxation risks in relation to cross-border payments for services, will be key to UK headquartered groups seeing the full benefits of the transfer pricing rules harmonisation.

The prospects are improving, and it is clear that there is political will for a UK-Brazil treaty. However, before formal negotiations can start there has to be a realistic prospect of being able to agree a treaty and reaching a mutually acceptable position on the taxation of services remains a major obstacle and may be complicated by wider considerations arising from ‘most favoured nation’ clauses in other treaties entered into by Brazil.

Brazil may also want to see how the OECD BEPS 2.0 international taxation reforms play out, in particular ‘Pillar One’ (the reallocation of some taxing rights over profits of the largest and most profitable groups to market jurisdictions). Brazil is a large market jurisdiction, so likely to receive substantial reallocations, whilst conversely its largest domestic groups are in the extractive and financial services sectors, for which exemptions from Pillar One are planned.

Regarding the source taxation of fees for technical services, in our experience, a large part of the problem lies in the fact that the Brazilian tax deducted from service fees is not creditable in the UK if the work is carried out in the UK and the income therefore arises in the UK rather than Brazil. If a deduction is available in Brazil for arm’s length charges based on the OECD Transfer Pricing Guidelines and the treaty clearly defines what services are subject to withholding tax (WHT) and includes the usual wording in the ‘Elimination of Double Taxation’ article ensuring that income subject to withholding in one Contracting State in line with the treaty is regarded as sourced in that State for the ‘Elimination of Double Taxation’ article, this issue should be removed.

This will still, however, leave another issue. Brazilian WHT is levied on the gross service fee, whereas, assuming the income is trading income in the UK, the credit is in any event limited to the profit that the UK service provider makes on the transaction.

In practice, a treaty setting a fixed rate of WHT on services is probably the best that can be managed, and companies will have to continue to live with the choice of either suffering some double taxation on the service fees or not charging for the services and paying UK tax on the basis of a transfer pricing adjustment.

For further information please contact:

• Phil Roper