By Marcelo Natale, Carlos Ayub, Fernando Matos, and Alexandro Tinoco

As part of long-awaited initiatives to stimulate gross domestic product growth, the Brazilian Executive on April 3 published Provisional Measure (PM) 563/2012, which included relevant changes to the country’s transfer pricing rules. PM 563/2012 has now been converted into law 12,715/2012, published on September 18, 2012. Law 12,715/2012 is significantly similar to PM 563/2012, which amended the transfer pricing rules applicable to importation of goods, services, and rights, set new profit margins for certain sectors, and created two new transfer pricing methods. Although law 12,715/2012 applies to fiscal years starting on or after January 1, 2013, taxpayers may opt to apply the rules from fiscal year 2012.

Highlights of the new Brazilian transfer pricing legislation include the following:

Changes to the resale price minus profit method (PRL): The PRL historically has been the most frequently used method to determine the deductible amount associated with an inbound intercompany transaction entered into by a Brazilian taxpayer. The PRL method takes into account certain statutory gross profit margins, which vary depending on the use of the imported products, services, or rights. The statutory gross profit margins in the old rules were 60 percent for inbound transactions entered into by the Brazilian taxpayer as an input to its production process and 20 percent in all other cases in which the inbound transaction is not used in the production process, but rather transferred/resold to an unrelated party, regardless of the taxpayer’s industry.

Law 12,715/2012 introduces the following changes to the application of the PRL method:

• New gross profit margins: New gross profit margins will apply, depending on the taxpayer’s industry sector or the activities for which the inbound products, services, or rights are used. One of the major differences between PM 563/2012 and Law 12,715/2012 involves the exclusion of the word “manufacturing” from the description of several of the relevant industry sectors and activities for which the new gross profit margins should apply. Law 12,715/2012 clearly expands the scope of certain gross margins to extend their application to taxpayers in a given sector, irrespective of their involvement with manufacturing activities. Table 1 below compares the language to describe the gross profit categories between the original PM 563/2012 and Law 12,715/2012:

• Gross Profit Margin	Sector or activity under PM 563/2012	Sector or activity under Law 12,715/2012
  40%	Manufacturing of pharmachemicals and pharmaceuticals	Pharmachemicals and pharmaceuticals products
  	Manufacturing of tobacco-related products	Tobacco-related products
  	Manufacturing of optics, photography, and cinematographic equipment and instruments	Optics, photography, and cinematographic equipment and instruments
  	Sale of medical and dentistry-related machinery and equipment	Medical and dentistry-related machinery and equipment
  	Extraction of oil and natural gas	Extraction of oil and natural gas
  30%	Manufacturing of chemical products	Chemical products
  	Manufacturing of glass and glassrelated products	Glass and glass-related products
  	Manufacturing of cellulose, paper, and paper products	Cellulose, paper, and paper products
  	Metallurgy	Metallurgy
  20%	All other sectors	All other sectors

• Freight and insurance and import tax costs: One of the most controversial issues with regard to import transactions is the treatment of freight and insurance costs and its impact on the Brazilian import tax cost for purposes of comparison with the price calculated using the PRL method. From an economic perspective, payments to third parties do not generate a transfer of profits to related parties and therefore should not be subject to the transfer pricing rules. Law 12,715/2012 now provides that, unless paid to related parties, freight and insurance expenses, as well as the import tax and other customs costs incurred by the local importer, should not be considered in the determination of the transaction price taken into account by the Brazilian transfer pricing rules.
• PRL calculation formula: Law 12,715/2012 introduces a change to the PRL formula to the effect that the parameter price (which continues to have as its starting point a sale transaction entered into by the Brazilian taxpayer) must take into account the ratio of the products, services, or rights purchased from foreign related parties in the total cost of a given product, service, or right sold by the Brazilian taxpayer. This change enacts into law a calculation procedure that resembles the Brazilian tax authorities’ regulations “PRL 60” method. Stated differently, and disregarding the new gross profit margins, the PRL formula provided by Law 12,715/2012 resembles calculation procedures the Brazilian tax authorities were imposing on taxpayers when applying the old PRL 60 percent method for goods, services, or rights applied in the production process since 2003 (i.e., under Normative Instruction 243/2002).
• Table 2 below compares the old and new PRL formulas. Please note that for purposes of this article the “old” PRL formula (i.e., on the left side of the table below) corresponds to the formula provided by Normative Instruction 243/2002. The PRL method has been a source of controversy, and various interpretations of that method exist, some of which, depending of the facts and circumstances, can be more beneficial than the new PRL formula provided by Law 12,715/2012.

• Old PRL formula/a	$	New PRL formula/c	$
  (A) Imported component CIF+II/b	50.00	(A) Imported component FOB/d	40.00
  (B) Cost of goods sold	80.00	(B) Cost of goods sold	80.00
  (C) Net sales	100.00	(C) Net sales	100.00
  (D) Ratio (A/B)	62.50%	(D) Ratio (A/B)	50.00%
  (E) Base for PRL (C*D)	62.50	(E) Base for PRL (C*D)	50.00
  (F) PRL margin (E*60%)	37.50	(F) PRL margin (E*20%)	10.00
  (G) PRL price (E-F)	25.00	(G) PRL price (E-F)	40.00
  (H) Transfer pricing adjustment (A-G)	25.00	(H) Transfer pricing adjustment (A-G)	0.00

  Notes:
  /a – For tangible products applied in the manufacturing process, based on IN 243/2002.
  /b – Old regulations require taxpayers to base the analysis on the cost plus insurance and freight (CIF), plus import tax prices for the purchased products.
  /c – The new regulations make no distinction between manufacturing or resale. Gross profit margins should vary depending on taxpayers' industry sector. For "all other sectors," for instance, the gross profit margin under the PRL should be 20 percent. Depending on the taxpayer’s sector or activity, higher gross profit margins apply (please refer to Table 1 above).
  /d – The new regulations allow taxpayers to base the analysis on the freight on board (FOB) prices for the purchased products.
  

• Changes to the comparable uncontrolled price method (PIC): The PIC is defined as the weighted average of the uncontrolled prices of similar goods, services, or rights as calculated in the Brazilian market or in other countries, for purchase or sales transactions carried out under similar circumstances. Law 12,715/2012 provides that the application of the PIC method requires comparable transactions representing at least 5 percent of the importation cost of the tested transaction in cases in which the taxpayer substantiates its transfer prices with internal comparables (that is, transactions entered into by the Brazilian taxpayer with unrelated parties). Law 12,715/2012 did not set a threshold when the PIC method is applied solely based on comparable transactions entered into by parties other than the Brazilian taxpayer. Law 12,715/2012 also provides that the PIC method should be substantiated by transactions entered into during the same fiscal year as those under test. When transactions entered into during the same period are not available, the taxpayer can rely on transactions entered into in the prior year, as long as they make adjustments to the price of such transactions to account for foreign exchange rate fluctuations.
• New transfer pricing methods for commodities: Law 12,715/2012 introduces two additional transfer pricing methods to the existing Brazilian methods: the commodity exchange import price and the commodity exchange export price for inbound and outbound transactions with commodities, respectively. Under the additional methods, the basis for comparison is the average commodity exchange price for the relevant items adjusted for upward or downward spreads. The commodity exchange price that should be used corresponds to the average price on the date of the transaction. In cases in which no commodity exchange price exists for the relevant date, the analysis should be based on the average commodity exchange price for the most recent date before the transaction date. For commodity products not negotiated in commodity exchanges, Law 12,715/2012 also allows the use of prices obtained from reputable institutions, to be identified in tax authorities’ regulations. The new transfer pricing methods must be applied in intercompany transactions involving commodities. In other words, taxpayers would no longer be allowed to apply any of the remaining methods to assess the reasonableness of their transfer prices.
• Inbound and outbound loan transactions: the law in effect provides that taxpayers are not subject to the Brazilian transfer pricing legislation if the loans are registered with the Brazilian central bank. Law 12,715/2012 specifically provides that interest expense paid to related parties will not be deductible if above the six-month London Interbank Offered Rate for dollar denominated loans, plus a 3 percent annual spread. The Brazilian Minister of Finance has the authority to change the spread rate. In practical terms, the new provision means that interest charges above such a threshold will not be deductible for corporate income tax purposes.
• Limitation on ability to change transfer pricing method: Currently, domestic companies conduct an annual transfer pricing analysis and include the results on specific forms filed with the Brazilian income tax return. After tax authority’s regulation and effective from fiscal year 2012, a taxpayer cannot change a previously chosen transfer pricing method once the Brazilian tax authorities initiate an audit. If the authorities conclude that the method originally chosen by the taxpayer should be disqualified, the taxpayer will be granted an additional 30-day period to prepare a new transfer pricing analysis that can be based on any of the other available methods.

Brazil's transfer pricing rules have been a source of controversy since they entered into effect. Unfortunately, the changes introduced by Law 12,715/2012 do little to align Brazilian transfer pricing legislation with international norms. The rules continue to lack the economic rationale provided under the U.S. transfer pricing regulations and the Organization for Economic Cooperation and Development (OECD) transfer pricing guidelines. Nevertheless, the changes are significant and will impact the majority of multinational companies in Brazil.