APAs and the new transfer pricing rules: the end of litigation, or just the beginning?

An inevitable subject in nine out of ten discussions about international tax law in Brazil concerns the work the country has done and must continue to do to adjust its transfer pricing rules, which are necessary for receiving the green light to join the Organization for Economic Cooperation and Development (OECD).

While the modernization of such rules is not the only recommendation for joining the OECD, it is the most notable requirement – after all, Brazil is a country that has established its own specific rules on the subject. These new rules had an important role when created in 1996 – they improved the surveillance of international trade and financial relations, raising the efforts to prevent disguised profit-sharing between local companies and those of the same group abroad. These rules have also allowed the Brazilian IRS (RFB) to train agents and a special department to analyze these issues – the Special Office for International Affairs (Deain).

Despite the significant (r)evolution they represented, the 1996 rules differed from the global model, particularly in regard to the implementation of fixed margins as a calculation standard. Margins of 20% and 60% for the method of resale price less profit (PRL), 20% for the production cost plus profit (CPL) method, or 15% for the acquisition or production cost plus taxes and profit (CAP) method did not represent the reality taxpayers faced. While the rules favored legal certainty and facilitated the inspection process, they did not resemble market practices, therefore breaching the golden rule: the arm’s length principle.

The rules also raised generic questions involving how the PRL method was calculated: would the repackaging of imported products be treated as industrialization, thus with a 60% margin? Or would it be subject to a 20% margin? The courts have discussed whether the standard price should consider the FOB price rather than the CIF price for calculating the PRL method with a 20% margin.

Furthermore, over time, the RFB commenced another discussion on whether a more restrictive interpretation of calculating the PRL method using a 60% margin than the one provided for by law should be applied. A normative instruction was published that introduced a different calculation method and turned this issue into a commodity by flooding the courts with tax delinquency notices worth millions of Brazilian Reais. The RFB did a good job of convincing the administrative courts that this supposedly mistaken stance had, in fact, been correct.

These are what we might call standard discussions, which became more relevant to the RFB’s agents and taxpayers than other conceptual distortions in the legislation (although not less important). This resulted in less oversight for the latter, and, therefore, they received less attention in court: why would a distributor be considered a related party in Brazil or abroad merely because it has a commercial relationship, when there is no interest in transferring profits in the absence of any corporate relationship? Why is the “export” of rights subject to the transfer pricing rules while the “import” remains subject to the objective limitations set in 1964? Why does the deduction of interest on financial transactions from abroad to Brazil consider all types of transactions, while the taxation of minimum income on transactions in the opposite direction only accounts for loan transactions?

In 2012, transfer pricing rules were so out of touch with reality that Brazil amended its legislation to include market demands (such as methods for trading with commodities) or even adjust some of the aforementioned distortions, though the amendments did not address the core of the issue. It was more of a home renovation rather than a move to a new address.

For taxpayers, the amount of tax delinquency notices under review in the courts shows the importance the tax authorities place on the issue, yet at the same time, they reflect the lack of quality discussion: a considerable part of the disputes involving this matter with the Administrative Council of Tax Appeals (CARF) during the last twenty years refer to the standard discussions (especially those related to the illegality of the Tax Authorities’ view in calculating the PRL60 method), in a clear demonstration of the commoditization of this discussion. This pattern also has also been observed in the judicial courts, although to a lesser extent than in the administrative courts.

Transfer pricing, in essence, is not really a subject for discussion in the courts in any country where it applies: it depends on analysis that includes financial adjustments and statistical comparisons – and none of this is something that can or should be revised and/or adequately questioned by CARF advisers or federal judges, who, of course, have no proper training for this. The fact that decisions on independent comparative pricing (PIC) and Export Selling Price (PVEx) methods depend on reports prepared by third parties, accounting or financial experts, clearly demonstrates this problem.

So far, the discussions only feed back into the different views between the RFB and taxpayers – both in the structure of the legislation and in the analysis of the procedures by way of enforcement.

The new rules the RFB presented throughout 2022 have attempted to change this tradition by introducing the concept of Advance Pricing Agreements (APAs), which allow the taxpayers to reach an agreement with the RFB on the prices charged on certain products, services or rights during a given period.

APAs are, in fact, a positive paradigm shift where everybody wins: they provide predictability and an excellent opportunity for mutual cooperation. They reduce the distance between both sides, allowing both the taxpayers and tax authorities to see opposing perspectives as the parameters to be used are being established – rather than subsequently, as is the case today. For the RFB specifically, APAs also allow the tax authority’s auditors to better understand the arm’s length principle for each sector and even to focus resources on sectors with a higher risk profile. Inspections, in this case, would be restricted to checking for compliance with the APAs.

The APAs are particularly interesting because the RFB can either enter into them with taxpayers (unilaterally), or include tax authorities and related parties from Brazil or countries with which the transaction under analysis is being conducted (bilaterally or multilaterally), in which case the commercial cycle is completed without double taxation.

Therefore, a greater number of signed APAs will lead to a lower volume of court cases and, consequently, fewer contingencies.

They are the key to a new level of legal certainty and certainty in foreign investments.

This is the example set by the United States, whose taxpayers filed 2,936 requests for APAs between 1991 and 2021. In 2021, 16 unilateral, 121 bilateral, and 8 multilateral APAs were presented – a total of 150 APAs. As reported by the US Internal Revenue Service (IRS),1 unilateral APAs in the United States are being completed within an average of 24 months and bilateral APAs in an average of 52 months, with 90% of them approved between five and 15 years (in some cases, they are retroactively effective). Litigation on the matter is irrelevant, considering the scope of commercial operations.

European countries have even more impressive numbers. 1,487 APAs were requested in 2019 alone, with 1,136 being approved (among countries both inside and outside of the European Commission).2 As the average negotiation term ranges from 26 to 46 months, the analysis conducted is actually effective.

These numbers are still far from the reality in Latin America, where almost no APAs have been signed. However, Chile stands as an exception, as its tax authorities have begun to grant them in the last year, signaling to foreign investors that the country does indeed apply internationally expected standards and is willing to ensure foreign investments are secure.

Brazil has the potential to go down a different path from most other Latin American countries and follow in the footsteps of the US or Europe. This is expected to happen as APAs become even more necessary due to the new rules, which are primarily based on the arm’s length principle. Consequently, the parties will encounter more subjective elements (often seen as the downside of new legislation). Two examples where such subjectivity would create significant potential for litigation include the new adjustments to be considered in financial transactions, as well as the long-desired removal of fixed margins in transactions with tangible and intangible assets. Moreover, the inclusion of transactions with intangibles in the transfer pricing rules tends to increase the scope of the discussions.

And there is more to this. If the 1996 rules introduced only primary adjustments (non-deductibility of excessive costs or expenses or taxation of minimum income) as a consequence of the undue transfer of profits abroad, the new rules also present secondary adjustments: any sums of money viewed as such will be considered as granted loans, repatriated capital, or distributed profits or dividends (as the case may be), and subject to the corresponding tax treatment. The lack of an APA would thus have doubly perverse effects.

Bearing this in mind, the issue here is the expectation that in Brazil, APAs will not remain just a good idea. Given our history, this possibility is not absurd – Ordinance No. 222, published in 2008, allowed tax authorities to change fixed margins for certain taxpayers when requested, though it was never put into practice. The Mutual Agreement Procedures (MAPs), more recent instruments, still remain largely unused in practice – and, even so, there is very little transparency from the RFB in regard to the results.

The hope, therefore, is that Brazil will follow the Chilean example and that in the future, the level of efficiency in approving APAs will match what is seen in the United States. Less taxpayer money would be spent on these discussions in court, and the RFB would be able to direct its punitive efforts toward transactions that really matter. Finally, taxpayers would have the adequate legal certainty they deserve to bolster their investments in Brazil.

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1. Available at: https://www.irs.gov/pub/irs-drop/a-22-07.pdf. Viewed on: October 3, 2022.

2. Available at: https://ec.europa.eu/taxation_customs/system/files/2021-04/apas_2019.docx.pdf. Viewed on October 3, 2022.