The arm's length principle in Brazil: A first glance to domestic publicly traded companies as potential comparables

Through the publication of Provisional Measure (PM) No. 1,152/22 just before the end of 2022, the Brazilian income tax system is on the verge of finally adopting the arm's length standard for intercompany dealings.

This new body of rules, which, if converted into law by 1 June 2023, will likely become effective as of 1 January 2024 for taxpayers who don't voluntarily opt in the new system in fiscal year 2023, is mostly aligned with OECD's transfer pricing guidelines.

The measure has in general been well received by multinational companies doing business in Brazil. However, a direct extrapolation of their current transfer pricing policies and procedures cannot be taken for granted. Taxpayers are expected to face some practical challenges when adapting their Brazilian operations into their global transfer pricing models and procedures.

One of these challenges revolves around whether domestic companies, as opposed to foreign ones which is a standard practice across Latin America, could be more suitable to test the compliance with the arm's length principle under profit-based methods. Through an analysis of the number and observed profit margins of Brazilian publicly traded companies in different industries, we offer below a first glance of this particular issue.

In depth

While specific guidelines regarding the procedures to apply the transfer pricing methods are not included in the PM and may eventually be part of the implementing regulations, it is to be expected that the Brazilian tax authorities will prefer to use information from domestic comparable companies when taxpayers apply profit-based transfer pricing methods and select a Brazilian taxpayer as tested party.

Regardless of whether the expected implementing regulations will be as specific to cover this particular issue of domestic comparables, this preference will likely be observed in practice once the first transfer pricing audits under the new system start being conducted by the Brazilian tax authorities.

Unlike other Latin American jurisdictions, Brazil has a large and mature stock market (B3) hosting the largest number of publicly traded companies (300+) in the region, doubling the number of companies in the second and third largest stock markets in the region (Chile and Mexico). Thus, the Brazilian stock market represents a valuable source of information that other Latin American countries lack, and this could give room for a number Brazilian publicly traded companies to be used as appropriate comparables to test arm's length standard, provided that they satisfy the comparability factors duly acknowledged in the PM.

In this context, it is imperative for taxpayers and practitioners to get a sense of the industry sectors that might have a significant number of companies in order to provide a statistically reliable sample (and thus mitigating the need to use foreign comparable companies) and to consider the level and ranges of profitability that these companies report. With this in mind, we performed a high-level review of the publicly listed companies, with the following findings:

• There currently are 346 publicly listed companies in Brazil, and 338 of them have financial information available for the 2020-2021 period.
• Of these 338 companies, around 247 are the parent company of a multinational group, and the rest are subsidiaries of a group or company.
• The breakdown of these companies, per division of industrial activity, is detailed in the following table. The majority of these companies operate in three industry sectors: manufacturing (30%), finance (20%), and electric gas and sanitary services (19.5%).

By breaking the companies down further by subdivision and calculating the 2020-2021 average Return on Sales (ratio of operating margin to net sales) for those subdivisions reporting more than five companies, the following findings were obtained:

• There is a significant number of companies in different sectors across the Brazilian economy that might translate into statistically significant samples, provided that comparability requirements are met after further analysis on a case-by-case basis.
• Most sectors show healthy profits in the period of analysis, with some exceptions such as the Construction.
• The companies with the highest margins are in the Mining, Finance, and Agriculture, Forestry and Fishing sectors.
• Several sectors show operating losses in the lower end of the range, such as Transportation Equipment, Miscellaneous Retail, Insurance Carriers and Business Services.
• Within the Manufacturing sector, there are significant variations in profitability across sub-divisions. For example, the median Return on Sales of the Transportation Equipment subdivision is 4.4%, while that of the Primary Metals Industry subdivision is 16.4%.

The significant number of publicly traded companies in the Brazilian stock market makes it advisable for companies implementing transfer pricing policies based on profit-based methods to assess whether publicly traded domestic companies meet the comparability requirements for the transaction under analysis in such a way that they reduce the need to use foreign comparable companies whose financial information would typically require several comparability adjustments.

While the figures above provide a preliminary indication of the levels and ranges of profit margins that publicly traded Brazilian companies report in different sectors, they should not be a reference to set up intercompany prices in Brazil without further analysis on a case-by-case basis.