How will Brazil’s move for OECD membership affect its tax policies?
Gustavo Carmona Sanches
Executive Director, International Tax Services
Ernst & Young Assessoria Empresarial Ltda
+55 11 2573 5523 (office)
+55 11 995 023 726 (mobile)
On 29 May 2017, the Brazilian Government formally applied to become a full member of the Organisation for Economic Co-operation and Development (OECD). The move is part of the Brazilian Government’s wider plan to attract foreign investors as the country emerges from one of its worst recessions on record. If the application is approved, Brazil would be the largest emerging economy in the OECD and the third Latin American country to join (after Mexico and Chile), as well as the first of the BRICS (Brazil, Russia, India, China and South Africa) to become an OECD member.
Brazil has had a working relationship with the OECD since the early 1990s, and this has intensified since 2009 as the agendas of the G20 (of which Brazil is a member) and the OECD have become more closely aligned. However, the road to full membership could present some challenges, not least because Brazil’s positions on certain tax policy issues diverge significantly from those of the OECD and its 35 member countries.
Below is a high-level overview of Brazil’s current relationship with the OECD, how its tax policies differ from OECD members, whether Brazil will need to revise those policies in order to accede to the OECD, and the next steps in its path to full membership.
Brazil’s current relationship with the OECD
Brazil’s collaboration with the OECD started in 1994, when it joined the OECD’s Steel Committee, and gradually deepened. In 2007, Brazil and four other large emerging economies (China, India, Indonesia and South Africa) became “Key Partners” of the OECD, a status that enables those countries to participate in the work of the OECD’s substantive bodies, with a view to possible full membership. Today, Brazil participates in numerous OECD committees and working parties, including as an Associate of the Inclusive Framework on Base Erosion and Profit Shifting (BEPS) and as a member of the Global Forum on Exchange of Information and Transparency for Tax Purposes. In addition, Brazil has become an adherent to 31 OECD legal instruments, including the Convention on Mutual Administrative Assistance in Tax Matters.
Why has Brazil applied for full membership?
In the past, Brazil’s decision-makers chose not to pursue full membership, as such a move would require the Government to make changes to domestic legislation in a number of areas, particularly in tax. However, with Brazil struggling to overcome a series of political crises and recover from a record-setting two-year recession, the centrist, pro-business government of President Michel Temer (who assumed office in August 2016 following the impeachment and removal from office of Dilma Rousseff on charges of manipulating the federal budget) is putting in place measures to attract foreign investment and boost growth. Applying for full membership to the OECD sends a strong signal that Brazil is seeking market-friendly policies.
What are the major differences between Brazil’s tax policies and those of OECD member countries?
Brazil’s transfer pricing policies are a key area of divergence. Brazil does not apply the arm’s length standard for calculating transfer prices, as set out in the OECD’s Transfer Pricing Guidelines. Instead, it applies a formulary approach, with non-rebuttable fixed profit margins that are subtracted or added to the outcome of uncontrolled transactions (practiced price). The application of predetermined profit margins can, in some cases, lead to over- or under-taxation of transactions because the mark-up required by the Brazilian rules may be higher or lower than the profit actually derived by the taxpayer. The other country involved in the transaction may not make a corresponding adjustment when the profit allocated to the company located in Brazil does not reflect the arm’s length standard (as prescribed by the OECD Transfer Pricing Guidelines).
Brazil’s tax legislation, meanwhile, does not expressly provide for the elimination of double taxation arising from transfer pricing adjustments, and its double taxation treaties do not adopt the corresponding adjustment provisions under Article 9(2) of the OECD Model Tax Convention (OECD Model). Seeking double taxation relief through a treaty’s mutual agreement procedure (MAP), if a treaty exists, generally has not been feasible, as Brazil to date has not resolved any treaty disputes via MAP (recent changes to Brazil’s MAP practice are noted below). Multinational enterprises (MNEs) operating in Brazil have, to some extent, come to accept transfer pricing adjustments as a cost of doing business in Brazil – a solution that comes at the expense of reducing profit margins and reducing Brazil’s competitiveness as a manufacturing location.
Brazil’s treaty practice of applying withholding tax on payments remitted abroad for technical services – regardless of whether a permanent establishment (PE) exists – also departs from OECD norms. Taxpayers have long challenged Brazil’s position, arguing that service payments should fall within the definition of business profits as established by Article 7 of the OECD Model, which limits source taxation to business profits made in direct connection with a PE. For many years, the Brazilian tax authorities asserted that income related to technical services that did not involve a transfer of technology should be treated as “other income” under Article 21 of its tax treaties (which provides for withholding at source), rather than as “business profits” under Article 7, on the grounds that payments for technical services are classified under Brazil’s domestic legislation as “revenue” and not as “profit” (it should be noted that Brazil’s domestic legislation does not expressly define the term PE).
Brazil’s Federal Supreme Court rejected the tax authorities’ position in a 17 May 2012 decision (REsp 1161467/RS) involving an interpretation of the Brazil-Canada tax treaty. The court held that the treaty definition of business profits is broader than the domestic definition of taxable income and, therefore, Article 7 applied to payments remitted abroad for technical services performed without any transfer of technology.
Following that decision, the Brazilian tax authorities abandoned its “other income” position in an Interpretive Declaratory Act issued in June 2014. However, the government stated that if technical services are included in the definition of “royalties” for treaty purposes (whether a transfer of technology is involved or not), then the royalty provisions of Article 12 (which permits withholding at source) are to apply, rather than Article 7. Moreover, the tax authorities adopted a very broad concept of "technical services," stating that such services cover any activity in which the service provider needs "skills, technique and training." In effect, Brazil preserved its right to tax fees for technical services (as well as administrative and similar services) at source. This unilateral approach to changing the application of tax treaties is not in line with the principles set forth in the Vienna Convention on the Law of Treaties (Vienna Convention), to which Brazil is a party.
Brazil’s position on MAP was, until recently, another area of divergence. Although its tax treaties contain MAP provisions, Brazil historically ignored requests to resolve treaty disputes via MAP (as part of its BEPS commitments, Brazil last year published guidelines under which taxpayers can request that MAP be invoked; see below). Brazil’s position was one of the reasons that Germany decided, in 2005, to terminate its tax treaty with Brazil.
Will Brazil need to change its tax policies if it joins the OECD?
In principle, the OECD would require Brazil to start accepting the arm’s length standard, or, at least, accept the arm’s length standard when compelled to do so under a treaty MAP provision. This would likely require Brazil to adopt the arm’s length standard in its domestic legislation. However, this could be a difficult step for Brazil to take, as it would require the Brazilian tax authorities to deal with the subjectivity that the arm’s length standard entails, rather than the formulary approach that Brazil currently uses. A potential alternative would be for Brazil to maintain its current transfer pricing legislation but use a different approach within the context of double tax treaty situations. One possibility would be to accept different profit margins (in effect, move to a rebuttable margin system), when doing so would result in a transfer price aligned with that under the arm’s length standard.
Regarding the taxation of technical services, Brazil would, in principle, need to start following the Vienna Convention and accept the proper use of Article 7, which would limit Brazil’s ability to classify such services as royalties under Article 12. However, it is important to note that Brazil is currently renegotiating nearly 10 tax treaties. Brazil intends to include in those treaties the broader definition of royalties, which would cover fees from technical, administrative and similar services. Under this definition, such services are those whose execution depends on specialized technical knowledge, as well as administrative assistance or consultancy activities carried out by independent professionals, employees or automated structures with clear-cut technological content.
Accordingly, to the extent its tax treaties are amended as a result of bilateral negotiations to include the broader definition of royalties, Brazil would be permitted to levy tax at source on service fee remittances under those amended treaties. Nonetheless, with regard to its remaining tax treaties, Brazil would be required to change its position and follow the Vienna Convention by respecting the narrower definition of royalties (which would mean accepting the application of Article 7 and the limitation of a country’s power to levy tax at source on the remittances of service fees).
What is Brazil’s position on the OECD’s BEPS recommendations? Would it need to change its position if it joins the OECD?
As a member of the G20, Brazil has committed to implementing the BEPS minimum standards, i.e., those pertaining to Actions 5 (Harmful Tax Practices), 6 (Treaty Shopping), 13 (Country-by-Country Reporting) and 14 (Dispute Resolution). Accordingly, Brazil would not need to change its approach if it becomes a full OECD member, as OECD and G20 members are legally required only to implement the four minimum standards and are not legally obligated to implement measures categorized as common approaches or best practices.
It should be noted that while Brazil is permitted to maintain its current practice against corresponding transfer pricing adjustments, as the provision of corresponding adjustments is only a best practice and not a requirement under Action 14, it will nevertheless be obligated to provide access to MAP in transfer pricing cases, as that is required by the minimum standard under Action 14. Indeed, Brazil has formally committed, as noted in the Final BEPS Report on Actions 8-10 (Transfer Pricing), to grant access to MAP to resolve cases of double taxation arising from the fact that Brazil does not adopt the arm’s length standard. As part of its commitment to implementing Action 14, Brazil’s tax authorities in November 2016 published a Normative Instruction (NI 1,669/16), which provides guidance on the requirements and criteria for taxpayers to invoke MAP under a relevant tax treaty.1
In this sense, and within the context of the BEPS peer review and monitoring process, Brazil’s MAP practices will be subject to peer review in December 2018. It is therefore expected that Brazil will want to demonstrate a change in behavior – not only to demonstrate it is compliant with BEPS, but also that it is moving toward a more OECD-compliant approach to dispute resolution.
The Brazilian tax authorities have said they have no current plans to sign the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent BEPS (MLI). The MLI is a mechanism created under Action 15 to enable interested countries to swiftly amend their existing bilateral tax treaties in line with the treaty measures recommended under the BEPS project. For now, it appears that Brazil will continue amending its 32 tax treaties on a bilateral basis. In fact, on 21 July 2017, Argentina and Brazil signed a protocol amending their 1980 tax treaty, incorporating several BEPS recommended measures that would typically be covered by the MLI.
What are the next steps?
According to the OECD’s Framework for the Consideration of Prospective Members (Framework), upon receiving a request for membership from a Key Partner, the OECD Secretary-General will prepare for the OECD Council’s consideration a proposal inviting the Key Partner to enter into accession discussions and develop an accession roadmap. The Council (the OECD’s decision-making body comprising one representative per member country, plus a representative from the European Commission) will determine whether to open membership discussions based on the Key Partner’s willingness, preparedness and ability to adopt OECD practices, policies and standards.
Annex I of the Framework sets out the criteria on which the Council bases its decision whether to open accession discussions. That includes the prospective member’s “state of readiness” in a number of areas, such as economic and public governance; how its policies, laws, regulations and practices are aligned with the measures and practices required by OECD legal instruments; the prospective member’s position regarding the OECD’s fundamental values as expressed in the OECD’s vision statement; and its political commitment to the OECD’s membership obligations.
If the Council agrees to open accession discussions, the Secretary-General will prepare an accession roadmap for adoption by the Council. The roadmap details the conditions, criteria and process for accession, including the in-depth reviews that must be carried out by various OECD technical committees. Once the technical reviews have been completed, the Secretary-General will present to the Council the technical committees’ formal opinions, a final statement from the prospective member and a general report on the accession process with a recommendation. The Council’s decision to extend membership must be unanimous.
In light of the significant changes to Brazilian tax policy that could arise if Brazil becomes a member of the OECD, MNEs should closely monitor the accession process. It is expected that Brazil will have to change its positions on transfer pricing and the taxation of service fees as minimum conditions to joining the OECD.
It would be surprising if Brazil does not succeed in its application for OECD membership, given its status as a Key Partner and its active participation in joint G20/OECD initiatives, including the BEPS project. As a G20 member, there will likely be strong political pressure to approve Brazil for OECD membership. In tax matters, having Brazil join the OECD would be beneficial for all parties involved – OECD members could learn from Brazil’s experiences in tax administration, particularly its technical prowess in advancing tax digitalization, while Brazil could draw on OECD standards and practices in building a path for sustainable and inclusive development.
Even if Brazil does not become an OECD member, taxpayers should expect to see changes to Brazil’s MAP practices as a result of the BEPS initiative. Given Brazil’s commitment under Action 14 to resolving treaty disputes by mutual agreement, an opportunity exists for MNEs to start applying for MAP prior to the peer review of Brazil that is scheduled to begin in December 2018.
1 See EY Global Tax Alert, “Brazil publishes Normative Instruction on mutual agreement procedures under tax treaties,” dated 8 December 2016.