Transfer Pricing Reform in Brazil and ‘Options Realistically Available’: New Tax Disputes Ahead?

Law No. 14596/2023 introduced new transfer pricing rules in the Brazilian tax system, in line with the arm’s length standard. The transfer pricing reform is a result of a long project carried out by the Brazilian Federal Revenue Office since 2018, with support from the Organization for Economic Cooperation and Development (OECD) and the United Kingdom (UK), aiming at convergence of Brazil’s transfer pricing rules and the OECD Transfer Pricing Guidelines.

Among the most controversial aspects of the new transfer pricing law is the analysis of ‘options realistically available’ to the parties at the time of the transaction. Article 7, section 1 provides that, in the delineation of the controlled transaction, the ‘options realistically available’ to the parties shall be considered to assess the existence of other options that could have generated more advantageous conditions to any of the parties and that would have been adopted if the transaction had been carried out between unrelated parties, including its non-performance.

On July 3, 2023, the Brazilian Federal Revenue released, for public input, a draft version of the Normative Ruling enacted to regulate the new transfer pricing regime. However, regarding the ‘options realistically available,’ Article 10 of the Normative Ruling only reproduces the wording of the law, without establishing parameters for the replacement or non-recognition of transactions.

Broad discretionary powers

Such a broad discretionary power granted to the tax authority by the new transfer pricing law may give rise to more litigation in Brazil, as it would be able to replace or disregard transactions not based on the existence of a flaw in the legal transaction carried out by the taxpayer, but rather based on other options available to the parties at the time of entering the controlled transaction.

The lack of a general anti-avoidance rule (GAAR) in force, as recognized in 2022 by Brazil’s Supreme Court in the judgment of the Direct Action of Unconstitutionality No. 2446, is a clear evidence of the restrictive approach so far adopted (at the legislative level; Administrative Tax Courts have been applying anti-avoidance doctrines in the analysis of tax planning structures in Brazil, mainly the ‘business purpose test’) in the Brazilian tax system, in which the tax authority was only allowed to disregard or requalify transactions in the case of sham, fraud, or willful misconduct, as set forth Article 149, item VII, of the National Tax Code.

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Under the OECD Transfer Pricing Guidelines (2022, p. 75 (§ 1.140-1.142)), the requalification or non-recognition of a controlled transaction by the tax authority may occur:

  • when the economically relevant characteristics of the transaction, as accurately delineated, are incompatible with the contract signed by related parties; or
  • when the transaction is not commercially rational.

Both situations are considered exceptional by the OECD, according to which the tax authority cannot do so in an arbitrary manner, without solid grounds. It follows that the tax authority cannot requalify transactions that are undertaken by independent parties in comparable situations, because, in these cases, there is no abnormal or irrational element in the transaction.

Need for a holistic assessment

The analysis of the ‘options realistically available’ is a step for the accurate delineation of the transaction and it intends to investigate whether any concrete alternative available offers a more attractive solution for achieving the parties’ business objectives. According to the OECD Transfer Pricing Guidelines (2022, p. 41 (§ 1.38)), independent parties would not undertake a transaction whose effects make them worse off than other feasible options available.

Thus, the analysis of the ‘options realistically available’ depends on a holistic assessment, which considers the two parties of the controlled transaction. Its objective is to verify whether the option chosen by the parties is the most appropriate and attractive to meet their interests and business objectives, in comparison with the other alternatives available at the time of contracting the transaction.

The case of Norway vs. Hess Norge

An example of the issue can be found in the Hess Norge case, judged by the Gulating Court of Appeals in 2017.

In summary, Hess Norge entered into a loan agreement in 2006, in the amount of USD 1.5 billion, with maturity date in 2011, which provided for the payment of interest calculated at the LIBOR rate, plus one percent.

In 2009, almost two years before maturity, the loan agreement was renegotiated, changing the currency from USD to NOK. As a result of the renegotiation, the agreed interest rate was changed to NIBOR for three months, plus 4.5 percent, which led to an increase in the interest rate due by Hess Norge.

When examining the case, the tax authority claimed that independent parties would not have renegotiated their loans before the maturity to increase the interest rate. In its appeal, the taxpayer justified the early renegotiation of the loan agreement as a measure to change the currency of the agreement, proving that it recorded foreign exchange losses from 2006 to 2009, in the amount of NOK 686 million.

In contrast, the increase in the interest rate in the period until the original maturity date resulted in a rise in financial expenses incurred by Hess Norge in the amount of only NOK 262 million, which would demonstrate the economic rationale of the taxpayer’s decision.

The judging panel considered that, for the 2009 tax period, refinancing the loan was not the behavior expected from independent parties, as Hess Norge had to pay significantly higher interest rates and the existence of foreign exchange losses in the past would not imply equivalent losses in the future.

High degree of subjectivity

Regardless of the outcome of the judgment, this case demonstrates the high degree of subjectivity derived from the ‘options realistically available.’ The taxpayers’ objective of mitigating foreign exchange losses in the Hess Norge case seems to be a justifiable, reasonable, and legitimate business decision, even if one considers that it was not the best option available to the taxpayer at the time.

In this respect, a belated analysis of the facts, at the time of the review of the tax assessment notice by a Tax Court, may pose additional difficulties for the retrospective assessment (ex-post evaluation) of the options that the taxpayer had at the time of the transaction.

This high degree of subjectivity in the analysis of ‘options realistically available’ is unsettling, given that this investigation assumes that independent parties act in an economically rational manner and choose the most efficient option, ignoring that there are several behavioral biases that can affect business decisions.

Moreover, the analysis of ‘options realistically available’ replaces the taxpayer’s business wisdom with that of the tax authority, regardless of any flaws in the legal transaction undertaken by the taxpayer.

It is imperative to note that this interference of the tax authority in the taxpayers’ business activities was widely rejected by the administrative case-law in the analysis of the concept of “business expenses” for corporate income tax purposes (Decision No. 9101-001394 of February 17, 2012, of the 1st Panel of the Superior Chamber of Tax Appeals).

Concluding remarks

In my view, the analysis of the ‘options realistically available’ cannot be converted into a requirement for the taxpayer to examine, before taking any business decision, the risk-reward ratio of all options available at the time of transaction, as it could be unfeasible and inhibit business activities.

In addition, the replacement or non-recognition of transactions can only take place in cases where it is impossible to price the actual transaction according to the arm’s length standard and the criteria established by the transfer pricing legislation. Consequently, it is not a tool to increase tax collection or to overcome difficulties in determining the arm’s length price of a controlled transaction.

It implies that tax authority should not resort to the non-recognition of the controlled transaction if there is a way to price the option chosen by the taxpayer in accordance with the arm’s length standard. If it is possible to price it properly, the taxpayer must be taxed in accordance with the actual transaction (not a deemed transaction), because of the principles of legality and legal certainty.

Consequently, the mere observation that third parties would not have carried out the same transaction is not sufficient for that end. After all, there are arrangements that only exist within the same corporate group, such as treasury activities and management fees (one may refer to the OECD Transfer Pricing Guidelines, 2022, p. 75 (§ 1.142)).

Based on the above, it is possible to conclude that Brazil’s new transfer pricing law may give rise to new tax disputes in Brazil, especially if undetermined concepts and legal standards provided for in the new transfer pricing law are used by the tax authority in an open and flexible manner.

Particularly, the analysis of the ‘options realistically available’ cannot be carried out by the tax authority in a random and arbitrary manner, under penalty of being unconstitutional due to:

  • violation of legal certainty, since the taxpayer will not be able to foresee the tax consequences of its legal transactions, given that it could change the outcome of the transfer pricing control in the light of options other than the one chosen by the taxpayer; and
  • breach of tax legality, as the taxable event will not result from the actual transaction (concrete facts), but rather from an adjusted version of the transaction, extracted from the options that supposedly would have been chosen by independent parties in the market.

The article has been written by Ramon Tomazela, Partner, Mariz de Oliveira & Siqueira Campos Advogados. Tomazela is a Ph.D. and a Master in Tax Law from the University of São Paulo., and holds a LL.M. in International Taxation from the Vienna University of Economics and Business.