Brazil's International Tax Reform: What Took So Long?
After enduring criticism from trading partners for decades and five years of joint technical work with the OECD, Brazil has finally taken its first formal step toward harmonizing its heterodox transfer pricing regime with multilateral standards — a move widely cited as a prerequisite for OECD accession. But the December 2022 release of Provisional Measure No. 1,152, as significant as it is, raises an important question: What took so long?
The divergence between Brazil's intercompany pricing regime and a transfer pricing system based on the arm's-length principle — the standard for allocating income among associated enterprises, which is endorsed in nearly every bilateral tax treaty and by the OECD's influential transfer pricing guidelines — has long made Brazil something of a rogue state in multilateral tax affairs. Under the OECD-endorsed transfer pricing standards, income and costs are split among associated enterprises by hypothesizing that the entities are unrelated parties transacting on arm's-length terms. Using the most appropriate pricing method under the circumstances, based on the OECD transfer pricing guidelines' method-selection criteria, these transactions are given an arm's-length price. The income and costs associated with paying this arm's-length price are intended to leave the parties with their appropriate share of groupwide profit or loss.
This is not at all how Brazil's intercompany pricing rules worked before January 1 of this year. Although the OECD has graciously characterized the system — enacted in 1996 — as loosely based on the OECD's 1979 report on transfer pricing, the difference between the 1996 regime and evolving OECD standards has expanded at relativistic speed in the years since.
Instead of following anything like the OECD's most-appropriate-method rule, Brazilian taxpayers were free to use any one of the methods made available for the relevant category of transaction. Rather than allowing taxpayers to use unspecified methods — methods not specifically recognized by the OECD transfer pricing guidelines — in appropriate circumstances, taxpayers were bound to use one of the methods stipulated by Brazilian law.
Unlike the OECD guidelines, which are theoretically indifferent to the directional flow of goods, Brazilian law offered different methods depending on whether the controlled transaction involved imports or exports. And when taxpayers applied the Brazilian methods that loosely correspond to the resale-price method or cost-plus method, the gross margin or markup was based on some legally stipulated percentage instead of comparables data. The Brazilian system also had few, if any, provisions that specifically dealt with intangible transfers, intragroup services, or cost-contribution arrangements. In their place, Brazil relied on a series of arbitrary fixed caps and general deductibility principles.
According to a joint report prepared by the OECD and Brazil's tax administration in 2019, Brazil's system was too harsh and too lenient at the same time. It frequently led to double taxation in some cases while doing little to prevent taxpayers' base-eroding tax planning strategies in others. The administrative benefits often attributed to Brazil's use of fixed margins and arbitrary deductibility caps did nothing to ease coordination problems with Brazilian trading partners or promote tax certainty for multinational taxpayers.
Growing recognition of these problems, along with the pressure tied to OECD accession, led Brazil and the OECD to embark on an alignment project in early 2018. After nearly five years of periodic press releases and progress reports, Brazil's president issued a provisional measure that faithfully reproduces the key principles contained in the OECD transfer pricing guidelines — including guidance on hard-to-value intangibles and financial transactions.
But five years is a long time to write something that reads like an abridged Portuguese version of OECD transfer pricing guidelines. The "gradual alignment" approach endorsed by Brazil and the OECD contemplated a transitional period over which the new rules would be introduced, but it did not suggest waiting five years before even beginning the phase-in period. And the provisional measure is, as the name suggests, provisional. The OECD-modeled regime is elective for taxpayers in 2023, but congressional approval will be necessary for it to become mandatory in 2024. So even this belated alignment could in theory be transitory.
Many factors could be responsible for the timing, including possible obstacles or delays associated with Brazil's rulemaking procedures, the need to train tax enforcement personnel, or distractions created by more pressing government matters. It's also possible that the January 2022 U.S. foreign tax credit regulations that seemingly single out Brazil for the denial of credits (specifically on the basis of non-adoption of the arm's-length principle) or a desire to join the multilateral consensus while the work on pillar 1 is still underway gave Brazil new motivation to complete the project. Regardless, Brazil's transition will not be truly complete until the measure is approved by Brazil's Congress, a development that cannot come too soon for taxpayers and Brazil's trading partners.