Brazil’s proposed transfer pricing legislation has U.S. foreign tax credit implications
The Brazilian government on 9 December 2022 published draft legislation to align its transfer pricing rules with the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations. This potential change in Brazilian transfer pricing policies could have significant consequences from a U.S. international tax and transfer pricing perspective.
Proposed transfer pricing legislation
In a significant realignment of Brazil’s existing transfer pricing regime, Provisional Measure (MP) No. 1.152/2022 mirrors the OECD transfer pricing guidelines and introduces the arm’s length principle to Brazil’s transfer pricing regime. In addition to calling for the adoption of the arm’s length principle (without any destination-based criterion), the proposed legislation incorporates transfer pricing concepts such as the delineation of intercompany transactions, comparability analyses and selection of the most appropriate method. The legislation also introduces traditional transaction methods and transactional profits methods.
Covered intercompany transactions would include those that involve tangible property, intangible property, services, insurance, cost sharing, business restructurings and financial transactions (such as centralised treasury management, guarantee fees and debt). The legislation would introduce the concepts of DEMPE (development, enhancement, maintenance, protection and exploitation) functions and hard-to-value intangible property.
Under the proposed legislation, transfer pricing documentation would be required for penalty protection. The proposed documentation requirements go beyond the OECD transfer pricing guidelines and would require more taxpayer information than the OECD local file guidance. The proposed legislation would impose penalties for failure to prepare complete transfer pricing documentation or to provide it upon request by the Brazilian tax authorities.
The proposed legislation differs from the OECD transfer pricing guidelines in several significant aspects:
- Brazil is a major player in the global commodities market, and the proposed legislation provides special treatment for commodities, including broadening the definition of commodity, expressing a preference for the comparable uncontrolled price (CUP) method and providing specific rules on the timing of transactions. The draft legislation also would require commodity importers and exporters to register transfer pricing information with the tax authorities.
- Transfer pricing adjustments may be performed spontaneously during the year or at the end of the calendar year. However, adjustments would not be allowed to reduce the basis for calculating taxes or increase the value of a tax loss, which may lead to controversies in the event of a residual profit split loss.
- Remuneration for a financial guarantee would be determined based on the benefit obtained by the borrower resulting from the implicit support of the corporate group, and could not exceed 50% of this benefit amount. Furthermore, no remuneration for a financial guarantee would be allowed if the guarantee is deemed to be a shareholder activity.
- Limitations on the interest rates charged on intercompany debt
- If the borrower does not have the financial capacity to assume the risks of the transaction or does not exercise control over the economically significant risks of the transaction, the interest rate would be the risk-free rate of return determined by a government bond.
- If the borrower has the financial capacity or exercises control over the economically significant risks of the transaction, the interest rate would be the risk-adjusted return determined by a government bond plus a premium that reflects the risk assumed by the lender.
The provisional rules need to be enacted into law in Brazil within 120 days from the date of publication. Given the lengthy process Brazil and the OECD have followed to get to this point, and the current favourable environment, the proposed rules are expected to be enacted. If the proposed legislation becomes law, Brazilian taxpayers would have the option to adopt the new rules for the 2023 tax year, but the new regime would be mandatory for 2024.
U.S. foreign tax credit implications
On 28 December 2021, the U.S. Department of the Treasury and the Internal Revenue Service released final regulations related to the foreign tax credit (FTC) for publication in the Federal Register (for prior coverage, see the article in the February 2022 issue of Corporate Tax News). As part of the regulations, jurisdictional nexus was replaced with a new attribution requirement and incorporated into the existing net gain requirement for determining whether a foreign tax is creditable in the U.S. A foreign tax will be creditable only if this attribution requirement is met (among other elements of the net gain requirement), and the determination is made based on whether the taxpayer is considered a resident or nonresident of the jurisdiction imposing the foreign tax.
For foreign tax imposed on residents of a jurisdiction, the 2021 FTC regulations provide that a foreign tax will meet the attribution requirement only if the jurisdiction’s profit allocation rules are consistent with the arm’s length principle (OECD’s Transfer Pricing Guidelines or Internal Revenue Code section 482). Specifically, related party allocation of income, deductions, etc. must be determined under the arm’s length principle without taking into account, as a significant factor, any destination-based criterion (such as the location of customers or users). For tax years beginning after 28 December 2021, the new stringent standard may result in foreign taxes paid in jurisdictions that do not follow the arm’s length principle not being creditable in the U.S. One jurisdiction of concern is Brazil.
The draft legislation released by the Brazilian government aligning the country’s transfer pricing rules with the OECD’s arm’s length standard (not taking into account any destinated-based criterion) is welcome news for U.S. multinational taxpayers. As mentioned above, if the proposed legislation becomes law, local taxpayers will have the option to adopt the new rules for the 2023 tax year. From an FTC creditability perspective, the U.S. Treasury has not released guidance as to whether that will be enough to allow Brazilian foreign taxes to meet the attribution requirement for tax year 2023 (assuming taxpayers choose to adopt the new rules) or whether the attribution requirement can be met only once the new transfer pricing rules become mandatory in tax year 2024. However, pending the issuance of regulations by the Brazilian government, the proposed transfer pricing rules, if enacted, would be expected to go a long way toward meeting the attribution requirement and, ultimately, restoring the creditability of Brazilian foreign taxes paid by residents, subject to the remaining net gain requirement elements being met.
The U.S. transfer pricing and FTC rules are highly complex. Although Brazil’s proposed legislation is not yet final, the new rules are likely to be implemented. U.S. multinationals should begin considering the potential impact and actions needed for tax year 2023 and beyond.