Preparing for 2024: Navigating Brazil's pivotal shift to the Arm's Length Principle - key considerations and next steps
Brazil, the largest economy in South America, has taken a significant step in its tax policy. Brazil has enacted a law (Law 14,596/23) that transitions the country towards the Arm’s Length Principle (ALP). This change underscores Brazil’s commitment to aligning its taxation policies to global standards. While this development is promising for the national economy, fostering an environment that encourages international trade and investment, the transition towards the ALP represents a significant change. It may come with several challenges, given the distinct characteristics of Brazil’s tax system.
This pivotal shift will significantly impact multinational companies operating in Brazil and marks a watershed moment in Brazil's taxation history. With less than six months left until this new legislation takes effect, it is crucial for multinationals to take immediate and actionable steps to ensure readiness by the mandatory deadline of 1 January 2024 (but with an early adoption available for calendar year 2023).
What has Changed
Brazil’s transfer pricing (TP) framework was established by Law 9,430/1996 (the “current system”) and has remained largely unchanged for more than 25 years until the end of 2022, when Provisional Measure 1,152/2022 was enacted, which was converted into Law 14,596on 14 June 2023, establishing a new TP system in line with the ALP of OECD TP Guidelines for Multinational Enterprises and Tax Administrations.
While the current system is relatively simple, more objective by relying on pre-fixed margins and with limited methods, it has become outdated and is unable to address problems of double taxation and tax base erosion resulting from the mismatch between the local TP rules and the rules applied internationally.
Below is a table with a summary of the main differences between the current rules and the new rules:
New ALP-based TP Rules (Law 14,596/23)
Current TP Rules (Law 9,430/96)
|Covered Transactions: Any commercial or financial transaction between related parties or with third parties in a country with favored taxation (i.e., income tax lower than 17%).
|Covered Transactions: Import and export of goods, rights and services between related parties or with third parties in a country with favored taxation.
|Benchmark price: Based on comparability studies and functional analysis – Arm's Length Principle (ALP).
|Benchmark price: Determined by methods generally based on fixed profit margins.
|Pros: Contributory capacity, better suited to combat double taxation.
|Pros: Practicality, tax certainty and less tax litigation.
|Cons: Complexity, subjectivity, potential increase in tax litigation.
|Cons: Asymmetry with international rules creates double taxation and double non-taxation (BEPS), US foreign tax credit restrictions.
|Treatment of Intangibles: Royalties are subject to ALP.
|Treatment of Intangibles: Treatment of Intangibles: Scope doesn’t include passive royalties.
|Financial Operations: Loans, guarantees, cash pooling, insurance, etc.
|Financial Operations: Only loans and advances.
|Choice of Method: Obligation to choose the “most appropriate method” (the one that conveys the most reliable results for the situation under analysis). Hierarchy of methods: PIC (CUP) preferred when can be reliably applied.
|Choice of Method: Taxpayer may choose the most beneficial method for them.
Detailed guidelines on the practical implementation of the ALP are expected to be released this summer (July – August), offering further clarification on the treatment of new transactions.
Even as Brazil makes strides towards joining the OECD, it is essential to recognize that the country’s unique tax landscape may pose challenges in incorporating local operations into the global transfer pricing model due to the following reasons:
- Customs and Tax Interaction: Brazil has a unique structure that places customs and federal tax authorities in close interaction (as they are part of the same governmental agency, the Federal Revenue Service - RFB), offering a unique visibility into cross-border operations.
- Unique Indirect Taxes: Brazil has a multitude of unique indirect taxes on cross-border transactions, particularly on importation of services and rights (licenses), which could impact the local operating model and transfer pricing policy design.
- Lack of Local Comparables: A lack of local comparable data may pose a challenge in applying the ALP, making it necessary for Brazilian tax authorities and taxpayers to invest time and resources in benchmarking studies to bridge this gap.
- Tax Litigation “Culture”: despite recent new legislation allowing tax authorities to enter into settlements to resolve pending tax litigations, tax agents usually issue tax assessments charging very high penalties (standard is 75%) plus interest, which must be resolved in the administrative appeals and/or judicial court systems. Accordingly, even with robust TP documentation, there is a risk of tax litigation.
Transition Roadmap and Recommendations
To navigate this pivotal shift successfully, multinationals are encouraged to take the following steps:
- Gather Facts: Understand the specifics of Brazil’s operations, including a detailed understanding of functions, assets and risks of local entities, and how the shift to ALP may impact your operations.
- Assess and Design a Transfer Pricing Model: Map the new transactions and evaluate how Brazil’s operations align with your global transfer pricing model. Make necessary adjustments that account for unique factors such as customs and indirect taxes.
- Embrace a Bespoke Strategy: Refrain from applying a generic approach. In light of Brazil’s distinct tax environment, ensure that local specifics are accounted for in the transfer pricing policy.
- Defend Your Technical Position Vigilantly: As local authorities adapt to the new guidelines, there might be a period of adjustment. Hence, once you have made a thorough fact-finding to accurately delineate the controlled transactions and have gathered robust supporting documentation, defending your technical position becomes crucial during this transition phase.
- Pursue Tax Certainty: Consider the possibility of Advance Pricing Arrangements (APAs) to establish tax certainty, especially in complex interplay with customs and indirect taxes, minimizing the risk of ending up in tax litigation.
Brazil’s decision to adopt the ALP represents a significant transformation in the country's taxation landscape. While the shift will undoubtedly come with challenges, it also presents an opportunity for businesses to align their operations more closely with global tax standards. We recommend to pro-actively assess the impacts of these changes on your operations and take necessary steps to mitigate transfer pricing risks and enhance tax certainty.