The State Of The Arm’s Length Standard In Brazil
Brazilian Transfer Pricing: Some History And Context. Does Fixed Margin Make Sense?
Coming into force January 1997 following the enactment of Law 9.430/96, Brazilian Transfer Pricing (TP) rules have been enacted departed from OECD’s standards. Despite the fact OECD’s Transfer Pricing Guidelines largely relies on the Arm’s Length Standard (ALS), Brazil decided to put in place methods based on fixed margins (Cost Plus and Resale Price, to name a couple).
Not following the OECD and its economic analysis based on risks and functions might have been the right choice at the time. Brazil is a huge country and had big gaps in terms of knowledge and Information access between its regions and people. Further, its tax inspectors were not necessarily required to obtain specialized education in tax and the Judiciary (where ultimately TP cases would be tried) did not have specialized tax courts (where the same judge, despite its competence, would rule cases ranging from indigenous disputes to complex cross-border tax cases). These marks have historically been recognized and remain partially true these days.
Brought into perspective, Brazil Legislators implicitly recognized that fixed margins would provide the necessary certainty as to results given the unique facts of the country. ALS, on the other hand, was viewed by the policymakers as potentially bringing more harm than good. In essence, fixed margins are simpler to regulate, follow and to inspect.
Brazil is the world’s 8th largest economy and despite the fact that 90% of the GDP is located in the Southeast region, the continental size of the country cannot be disregarded. Differently from most OECD countries, the efforts in connection to inspecting TP in such a huge and diverse country would likely result in very different outcomes. This variance is speculated as to why other BRICS are careful in fully adopting OECD’s standards.
Institutional speed and effectiveness might also have been causes of concern adopting a full ALS model. To that effect, TP rules have been in place for over twenty years and, to date, only three cases have been tried in Courts.
The adoption of fixed margins seems to have made sense in the past and is not likely to drastically change in a near future given the current environment in Brazil. Still, TP is evolving in Brazil and so are some of the issues outlined above. This evolution seems to be going in the right direction, as ALS is more and more permeating the methods prescribed by law. In that sense, Law 12.715/12 materially overhauled the TP legislation in relation to commodities, where fixed margins are no longer used as parameter but rather the market (Stock Markets, Futures etc.) adjusted to the specificities of that a given transaction. This new rule, by the way, is pretty close to the outcome suggested by BEPS’ Action 10.
Oil & Gas: An Arm’s Length Standard Evolution In The Upstream Business
Along with a new Upstream regime brought by Law 12.351/10, that is, the Production Sharing Contract (PSC) Law, Brazil seems to be moving towards an ALS direction. PSCs differ from the previous Upstream regime in place in the country where Concessions were issued to companies willing to explore pristine areas seeking oil at a high risk but with high rewards in return: as much oil as they could find.
In very simple terms, in a PSC the government trusts a given area is promising oil-wise and offers the venue to the market hoping to form a partnership with Contractors specializing in exploring and producing oil in exchange for a share in the oil to be produced. Exploratory risks and production costs lie with the Contractor, who will seek refund in kind (Cost Oil) in addition to the share agreed with the government.
The importance of the ALS in the new PSC regime then resides in the Cost Oil element described above. Prior to receiving the Cost Oil in return for its investments, Contractors must provide the government with evidence that the expenditures have been made reasonably. Such a scrutiny, when it comes to costs stemming from related party contracts executed in this context, is to be made in light of the ALS to prevent Contractors from artificially controlling prices in both ends of the transaction. As a result, the TP rules applied to the PSC as a mechanism to control Cost Oil rely primarily on the ALS rather than on the fixed margins generically prescribed elsewhere.
Although seen as an important evolution, the PSC rules described above are not in fact too distant from the Law 9.430/96 mens legis. Despite the fact such a law inaugurated TP in Brazil with a very strong fixed margin bias, it is always important to note that the ALS has been appointed as a guiding principle in the justification that informed the Federal Legislature and Administration to approve the TP bill into Law 9.430/96.
Closing Words
This paper has sought to provide an angle of the ALS situation in Brazil and how it is evolving, especially in connection to the Oil & Gas business, where the international nature of activities require specific measures to ensure TP is properly applied.
Brazilian TP practices are evolving and closing the ALS gaps along the way as seen above. Still, there is much to be done and work must go on to prevent double taxation stemming from different TP rules in different jurisdictions.
Despite the differences between the local methods in comparison to OECD’s, it is highly recommended that companies seek to mitigate the gaps between Brazilian and international TP practices to enable businesses to thrive and taxes to be equitable.
