Tax Management Transfer pricing REPORT D Volume 13 Number 12 Page 701 Wednesday, October 27 2004 lsSN15217760 Analy BRAZIL An Approach to Brazilian Transfer Pricing Practice By Napoleao dagnese and carlos Eduardo ayub Napoleao Dagnese, M.A., is a staff member of the European transfer pricing team at Deloitte Touche in Dusseldorf. Carlos Eduardo Ayub is a senior manager with Deloitte Touche in sao Paulo Since 1997, when Brazil began requiring taxpayers to document transfer prices, regulations prescribing fixed global profit margins have been fuel for ntensive criticism Before the introduction of Brazilian legislation containing transfer pricing rules,compliance with the arms-length principle for related-party transactions was governed through regulations on disguised or hidden distribution of profits. However, no straight disposition applied specifically to cross-border related-party transactions. This was remedied with the enactment of Law 9. 430/96. which covers cross-border transactions even though it reduced the significance of market price comparisons While Brazilian transfer pricing methods have names similar to those used internationally, the only methods that are similar are the comparable uncontrolled price(CUP)methods(there are two in Brazil: one for export and another for import transactions). Evidence of the differences in Brazil's methods include that the law imposed fixed gross profit margins on methods other than CUP for related-party export and import transactions. Several normative sources intending to limit price manipulations followed that 1996 aw,explaining, complementing, and even changing its interpretation and contents However, it is important to understand that although the profit margins are fixed-what could suggest a simplification of the transfer pricing practice- many details must be considered when Brazilian transfer pricing rules are applied because of the complexity of the legislation For example, the rules must be applied to each product, service, or right Subjects, Related Parties Not so controversial as the application of methods is the description of subjects that are focsued on the transfer pricing requirements, although such description may trespass the description of related parties contained in Brazilian tax treaties. The concept of related parties, pessoas vinculadas ncludes entities that are directly or indirectly involved somehow in the transaction. Art. 23 Law 9. 430/96 and art. 2 RI 243/02 describe constellations of interdependence for transfer pricing purposes. The usual direct and indirect relations of capital participation- 10 percent in the other company
Volume 13 Number 12 Wednesday, October 27, 2004 Page 701 ISSN 1521-7760 Analysis BRAZIL An Approach to Brazilian Transfer Pricing Practice By Napoleão Dagnese and Carlos Eduardo Ayub* *Napoleão Dagnese, M.A., is a staff member of the European transfer pricing team at Deloitte & Touche in Düsseldorf. Carlos Eduardo Ayub is a senior manager with Deloitte & Touche in São Paulo. Since 1997, when Brazil began requiring taxpayers to document transfer prices, regulations prescribing fixed global profit margins have been fuel for intensive criticism. Before the introduction of Brazilian legislation containing transfer pricing rules,1 compliance with the arm's-length principle for related-party transactions was governed through regulations on disguised or hidden distribution of profits. However, no straight disposition applied specifically to cross-border related-party transactions. This was remedied with the enactment of Law 9.430/96, which covers cross-border transactions, even though it reduced the significance of market price comparisons.2 While Brazilian transfer pricing methods have names similar to those used internationally, the only methods that are similar are the comparable uncontrolled price (CUP) methods (there are two in Brazil: one for export and another for import transactions). Evidence of the differences in Brazil's methods include that the law imposed fixed gross profit margins on methods other than CUP for related-party export and import transactions. Several normative sources intending to limit price manipulations followed that 1996 law, explaining, complementing, and even changing its interpretation and contents.3 However, it is important to understand that although the profit margins are fixed--what could suggest a simplification of the transfer pricing practice-- many details must be considered when Brazilian transfer pricing rules are applied because of the complexity of the legislation. For example, the rules must be applied to each product, service, or right. Subjects, Related Parties Not so controversial as the application of methods is the description of subjects that are focsued on the transfer pricing requirements, although such description may trespass the description of related parties contained in Brazilian tax treaties. The concept of related parties, pessoas vinculadas, includes entities that are directly or indirectly involved somehow in the transaction. Art. 23 Law 9.430/96 and art. 2 RI 243/02 describe constellations of interdependence for transfer pricing purposes. The usual direct and indirect relations of capital participation--10 percent in the other company--
administrative or equity control, joint administrative or corporate control, as well as joint ventures fall under the definition of related parties Furthermore, the definition of related parties also includes relatives up to the third degree, spouse or common-law spouse of any officer, partner, or dired or indirect controlling shareholder of a company. Brazilian rules further include agents, distributors, or concessionaires when they work exclusively for a company. Moreover, the existence of any relationship with nonresident individuals, or gal entities with respect to purchase and sale operations performed during the calendar year, must be documented and reported annually in the corporate income tax return Besides related parties, Brazilian transfer pricing rules apply to transactions between individuals or legal entities resident or domiciled in Brazil with any individual or legal entity, whether related or unrelated, that resides or is domiciled in countries or territories with favored taxation these are locations that impose no taxation on income, or taxation at a rate of less than 20 percent, or with domestic legislation that allows secrecy about the legal entities capital composition or ownership Methods Even though the motivation behind Law 9. 430/96 was to promulgate Brazilian transfer price rules that would conform with those of Organization for Economic Cooperation and Development countries, in fact, Brazil has hybrid methods that are inspired partially by the oECD guidelines, but otherwise strongly look for a minimum and maximum profit margins, which conflicts with the arms-length principle Determining precise percentages within a limited number of applicable methods, the rules establish exact values of transfer prices to be However, Brazil's approach often results in one of the following e sometimes due to transactions characteristics there is no applicable method the concept of a range of applicable prices is strongly reduced(see elow Price Range) o increased danger of double taxation cases, since a market-based transfer price in an OECD-conforming country rarely will ensure the requested preset margins for the Brazilian company; and e if the real margins are not in accordance with the preset margins, it will lead to an income adjustment that will impose a tax that is not based on profit, but on patrimony, conflicting with constitutional principles of taxation. This problem may theoretically be passed over since margins can be changed, what actually is difficult to occur (see below Change of the Preset Profit Rates Brazilian rules may have been intended to simplify inspections by authorities, to reduce interpretative discussions, and to ensure minimum revenue. However, even if the inspection process is simplified for the tax authority, checking not-so-precise market prices, functions, and risks creates
administrative or equity control, joint administrative or corporate control, as well as joint ventures fall under the definition of related parties. Furthermore, the definition of related parties also includes relatives up to the third degree, spouse or common-law spouse of any officer, partner, or direct or indirect controlling shareholder of a company. Brazilian rules further include agents, distributors, or concessionaires when they work exclusively for a company. Moreover, the existence of any relationship with nonresident individuals, or legal entities with respect to purchase and sale operations performed during the calendar year, must be documented and reported annually in the corporate income tax return. Besides related parties, Brazilian transfer pricing rules apply to transactions between individuals or legal entities resident or domiciled in Brazil with any individual or legal entity, whether related or unrelated, that resides or is domiciled in countries or territories with favored taxation. These are locations that impose no taxation on income, or taxation at a rate of less than 20 percent, or with domestic legislation that allows secrecy about the legal entities' capital composition or ownership.4 Methods Even though the motivation5 behind Law 9.430/96 was to promulgate Brazilian transfer price rules that would conform with those of Organization for Economic Cooperation and Development countries, in fact, Brazil has hybrid methods that are inspired partially by the OECD guidelines, but otherwise strongly look for a minimum and maximum profit margins, which conflicts with the arm's-length principle. Determining precise percentages within a limited number of applicable methods, the rules establish exact values of transfer prices to be observed. However, Brazil's approach often results in one of the following: sometimes due to transactions characteristics there is no applicable method; the concept of a range of applicable prices is strongly reduced (see below Price Range); increased danger of double taxation cases, since a market-based transfer price in an OECD-conforming country rarely will ensure the requested preset margins for the Brazilian company; and if the real margins are not in accordance with the preset margins, it will lead to an income adjustment that will impose a tax that is not based on profit, but on patrimony, conflicting with constitutional principles of taxation. This problem may theoretically be passed over since margins can be changed, what actually is difficult to occur (see below Change of the Preset Profit Rates). Brazilian rules may have been intended to simplify inspections by tax authorities, to reduce interpretative discussions, and to ensure minimum revenue. However, even if the inspection process is simplified for the tax authority, checking not-so-precise market prices, functions, and risks creates
a huge administration procedure for the taxpayer, who must manage the immense volume of transactions. Exacerbating the situation is the fact that Brazil does not allow aggregation of transactions or limit application of its equirements to only the most relevant transactions. Controversies regarding the rules'contents are vivid problems Law 9. 430/97 describes transfer pricing methods, divides transactions into imports and exports, and offers approaches for each. For each approach, the law describes a limited number of methods applicable to each product, service, or right Import Transaction Methods Method of Compared Independent Prices Since no other methods consider the comparison of prices adopted between non-related enterprises, the Method of Compared Independent Prices(PIC) is the only Brazilian method available that applies the arm s -length principle in This method is defined as the arithmetic mean of prices of goods, services and rights equivalent or similar to goods, services and rights selected within the Brazilian market or in other countries in purchase and sale operations under similar payment conditions. The price of imported goods, services, and rights purchased from a related party must be compared with the prices of equivalent or similar goods, services, and rights. This may be done through n internal or through an external comparison Price adjustments to minimize the effects of differences in the business conditions, physical nature and contents on the prices to be compared may be done as long as they are strictly related to e liability for product warranty or for the applicability of the service o liability for promotion of the goods, services, or rights to the public by means of advertising and publicis Q liability for quality control, service, and sanitary standards o agency costs for purchase and sale transactions carried out by unrelated parties, taken into account for the purpose of price freight and insular In this sense, rather than a potentially wide adjustment based on functions
a huge administration procedure for the taxpayer, who must manage the immense volume of transactions. Exacerbating the situation is the fact that Brazil does not allow aggregation of transactions or limit application of its requirements to only the most relevant transactions. Controversies regarding the rules' contents are vivid problems. Law 9.430/97 describes transfer pricing methods, divides transactions into imports and exports, and offers approaches for each. For each approach, the law describes a limited number of methods applicable to each product, service, or right. Import Transaction Methods Method of Compared Independent Prices Since no other methods consider the comparison of prices adopted between non-related enterprises, the Method of Compared Independent Prices (PIC) 6 is the only Brazilian method available that applies the arm's-length principle in import situations. This method is defined as the arithmetic mean of prices of goods, services, and rights equivalent or similar to goods, services and rights selected within the Brazilian market or in other countries in purchase and sale operations under similar payment conditions. The price of imported goods, services, and rights purchased from a related party must be compared with the prices of equivalent or similar goods, services, and rights. This may be done through an internal or through an external comparison. Price adjustments to minimize the effects of differences in the business conditions, physical nature and contents on the prices to be compared may be done as long as they are strictly related to: payment terms; negotiated volumes; liability for product warranty or for the applicability of the service or right; liability for promotion of the goods, services, or rights to the public by means of advertising and publicity; liability for quality control, service, and sanitary standards; agency costs for purchase and sale transactions carried out by unrelated parties, taken into account for the purpose of price comparisons; packaging; and freight and insurance. In this sense, rather than a potentially wide adjustment based on functions
performed and risks assumed, the law confines the spectrum of adjustments but without specifications regarding their applicability. Nevertheless, it remains the nearest method that in fact considers market prices on imports the internationally known CUP method; for example, often no acceptable a Applying this method can lead to the usual problems encountered by usi comparables can be found Resale price Less profit method In view of the fact that the Resale Price Less profit method is the method most often used, and somehow also the most polemic, it requires a more extensive explanation. Although the name of this method is similar to the internationally accepted resale price method, its similarity stops at the moment in which Brazilian legislators required the calculation by product and set a floor for income on imports Initially the legislation requested a general gross profit margin of 20 percent, which was later- restricted to imports to be directly resold. To items to be used in the production process in Brazil, a gross profit margin of 60 percent is Under the terms of the law this method is defined as the arithmetic mean of the resale price for the goods, services, or rights, less e unconditional discounts granted, o taxes and contributions levied on the sales e commission and brokerage fees paid; and 60 percent, calculated on resale price after deducting values referred to in items above and value added in the country, in hypothesis of goods used in oduction process 20 percent, calculated on resale price, in all other hypothe sis. ID The 60 percent margin is imposed on all kinds of industrial sector products, not taking into account different margins for different products. This must be carefully analyzed when formulating marketing and price strategies dealing with baskets of products Definitions of "resale, ""commercialization ""industrialization "and production"generated questions. An often-used example regards the import by pharmaceutical companies of concentrated chemicals, which in Brazil are solely mixed or dissolved in not active substances, or even just repacked in small portions and resold. Administrative decisions- used to consider such chemicals as production of raw-materials, falling under the 60 percent profit margin disposition Contradictory Rules A more intensive controversy arose in 2002, when a regulatory instruction of the Federal Revenue Service completely changed the application of the 60 percent margin of the resale price less method -Other than the law, which required a variable 60 percent margin over the imported items depending on how much value was added in Brazil, the new rule requires that companies engaged in the import of goods used in production processes have an actua
performed and risks assumed, the law confines the spectrum of adjustments but without specifications regarding their applicability. Nevertheless, it remains the nearest method that in fact considers market prices on imports. Applying this method can lead to the usual problems encountered by using the internationally known CUP method; for example, often no acceptable comparables can be found. Resale Price Less Profit Method In view of the fact that the Resale Price Less Profit Method8 is the method most often used, and somehow also the most polemic, it requires a more extensive explanation. Although the name of this method is similar to the internationally accepted resale price method, its similarity stops at the moment in which Brazilian legislators required the calculation by product and set a floor for income on imports. Initially the legislation requested a general gross profit margin of 20 percent, which was later9 restricted to imports to be directly resold. To items to be used in the production process in Brazil, a gross profit margin of 60 percent is imposed. Under the terms of the law, this method is defined as the arithmetic mean of the resale price for the goods, services, or rights, less: unconditional discounts granted; taxes and contributions levied on the sales; commission and brokerage fees paid; and profit margin of: 60 percent, calculated on resale price after deducting values referred to in items above and value added in the country, in hypothesis of goods used in production process; 20 percent, calculated on resale price, in all other hypothesis.10 The 60 percent margin is imposed on all kinds of industrial sector products, not taking into account different margins for different products. This must be carefully analyzed when formulating marketing and price strategies dealing with baskets of products. Definitions of "resale," "commercialization," "industrialization," and "production" generated questions. An often-used example regards the import by pharmaceutical companies of concentrated chemicals, which in Brazil are solely mixed or dissolved in not active substances, or even just repacked in small portions and resold.11 Administrative decisions12 used to consider such chemicals as production of raw-materials, falling under the 60 percent profit margin disposition. Contradictory Rules A more intensive controversy arose in 2002, when a regulatory instruction of the Federal Revenue Service completely changed the application of the 60 percent margin of the resale price less method.13 Other than the law, which required a variable 60 percent margin over the imported items depending on how much value was added in Brazil, the new rule requires that companies engaged in the import of goods used in production processes have an actual
effective gross profit of at least 60 percent on the raw materials participation in the sale price of finished goods. This requirement runs highly over the average gross profit margin effectively achieved by Brazilian companies that mport from related parts, as recently emphasized through specialized research. This interpretation can be better understood through the illustration on this PRL in lay (B)Total Sales Costs of material: RS 35 inished Goods: RS 90 ) Net Sale Price (C)Value Added (E) Profit Margin Bas (B-A) RS 55 D-CK RS &5 (F)Profit Margin PRL in regulation RI 243/02 (B) Total Sales Costs of Material: RS 35 Finished goods: I D) Net Sale Price: (F)Profit Margin ment(AGK If Aso Not in accord with the terms of the law, the new regulation does not take the value added in the country(C, first diagram) into account to compute the gin(F), which is computed dir (E, second diagram), thus representing greater impact on the parameter price (G) Moreover, the parameter price(G)that by law was inversely proportional to the value added in the country(C, first diagram) encourages companies to substitute imports by products manufactured in Brazil. This was left aside by the new instruction. If, however, the apparent intent of the law was to foster manufactured products' nationalization, to enable implementation of new plants, to easy transfer of technologies to Brazil, and to create jobs, the opposite can be said about the tax authorities ruling The prevalence of the law over the administrative ruling seems to be evident, since the first stage is hierarchically higher than the second, i.e., laws of documenting each transaction of each product, as requested by the lak ?g altered only by equally ranke the ruling ' s instruction may cause discomfort to taxpayers. The managem and making strategically attention to avoiding adjustments at the end of the not have the certainty of knowing exactly what revenue authorities want in y fiscal year is already a huge work. In addition, even doing this, taxpayers ma
effective gross profit of at least 60 percent on the raw materials participation in the sale price of finished goods. This requirement runs highly over the average gross profit margin effectively achieved by Brazilian companies that import from related parts, as recently emphasized through specialized research.14 This interpretation can be better understood through the illustration on this page.15 PRL in law PRL in regulation RI 243/02 Not in accord with the terms of the law, the new regulation does not take the value added in the country (C, first diagram) into account to compute the gross profit margin (F), which is computed directly on the prorated sale value (E, second diagram), thus representing greater impact on the parameter price (G). Moreover, the parameter price (G) that by law was inversely proportional to the value added in the country (C, first diagram) encourages companies to substitute imports by products manufactured in Brazil. This was left aside by the new instruction. If, however, the apparent intent of the law was to foster manufactured products' nationalization, to enable implementation of new plants, to easy transfer of technologies to Brazil, and to create jobs, the opposite can be said about the tax authorities' ruling. The prevalence of the law over the administrative ruling seems to be evident, since the first stage is hierarchically higher than the second, i.e., law's dispositions may be altered only by equally ranked instruments.16 Regardless, the ruling's instruction may cause discomfort to taxpayers. The management of documenting each transaction of each product, as requested by the law, and making strategically attention to avoiding adjustments at the end of the fiscal year is already a huge work. In addition, even doing this, taxpayers may not have the certainty of knowing exactly what revenue authorities want in (B) Total Sales Costs of Finished Goods: R$ 90 (A) Cost of Imported Raw Material: R$ 35 (D) Net Sale Price: R$ 140 (F) Profit Margin (Ex60%): R$ 33 (G) Parameter Price (E-F): R$ 22 If A>G, adjustment (A-G); if A<G, no adjustment (C) Percentage of (A) in (B): (B/A) 39% (E) Participation of (A) in the Sale Price: (CxD) R$ 55 (C) Value Added (B-A): R$ 55 (B) Total Sales Costs of Finished Goods: R$ 90 (A) Cost of imported raw material: R$ 35 (D) Net Sale Price: R$ 140 (E) Profit Margin Basis (D-C): R$ 85 (F) Profit Margin (E*60%): R$ 51 (G) Parameter Price (D-F): R$ 89 If A>G, adjustment (A-G); if A<G, no adjustment