Brazil's rising interest rates expose foreign-facing companies

Transfer pricing specialists warn that Brazil's interest rates, which have increased for 12 consecutive months, may limit local firms' ability to deduct taxes from their profits when doing business with foreign corporations.

To fight inflation, the Central Bank of Brazil raised the benchmark interest rate to 13.75 percent on August 3. It then kept that rate unchanged on September 16.

According to Ricardo Bolan, tax partner at the So Paulo legal firm Lefosse Advogados, "When there is an increase in interest rate by the Central Bank, somehow there is an indirect effect on the application of TP rules by Brazilian companies."

The current TP regulations for inter-company finance in Brazil are different from those in other nations that follow OECD guidelines.

The TP regime has not adhered to the arm's-length concept since it took effect in 1997. (ALP). The regulations instead apply to entities in low-tax nations or intercompany loans with interest.

Certain benchmark rates must be taken into account when determining the upper limit on how much may be written off as an expenditure or the revenue ceiling resulting from an intercompany loan or other debt instrument.

The benchmark interest rate for transactions in US dollars with a fixed rate is based on the current market rate of Brazilian government-issued sovereign bonds on a global scale, indexed in US dollars.

Transactions in Brazilian reals that are established at a fixed rate but are indexed in the local currency are subject to the same criteria.

The benchmark rate for transactions involving other currencies is the London Interbank Offered Rate (Libor), and all dollar Libor tenors are scheduled to expire on June 30, 2023.

According to Igor Scarano, TP director at consulting company Kroll in So Paulo, while these regulations dictate the deductibility of the interest on related party loans, the spread decided by the Ministry of Finance must also be taken into account.

"When the Brazilian entity is the borrower, the deductibility ceiling of the expenses should take into consideration the proper interest rate plus a spread of 3.5%," he says.

"When the Brazilian entity is the lender, the floor revenue should take into consideration the proper interest rate plus a spread of 2.5%," he continues.

Companies with offices in Brazil will experience base rate increases differently than businesses in OECD member countries since Brazilian TP regulations diverge substantially from OECD norms.

The impact of the increase in interest rates on inter-company financing, according to Victor Kampel, tax partner at So Paulo law firm Campos Mello Advogados, is particularly pertinent at this time considering how costly borrowing is in Brazil.

The yields will fluctuate along with interest rates. A base rate of 13.75 percent would result in rising yields and falling bond prices. In other words, Brazilian businesses that borrow money from relatives who are not Brazilians may have to pay higher interest rates.

wAccording to Scarano, "whenever the interest rate in Brazil rises, the interest related to the government bonds also rises. This is how it affects the TP environment."

The TP requirements for some inter-company loans, such as the six-months Libor with post-fixed interest rate, may not increase as expected because Brazil does not follow OECD rules.

Brazilian businesses could not completely deduct interest in this situation.

The higher rate will have an impact on businesses conducting inter-company transactions, according to Allan Fallet, partner at the So Paulo legal firm Mauger Muniz Advogados.

"If the domestic market has a high rate today while the market rate of Brazilian sovereign bonds issued in the foreign market for the same term is lower, the Brazilian-resident company that performed the operation through an intra-group transaction with an associated company abroad could only deduct interest expenses up to a lower limit," he continues.

"A Brazilian-resident company without any connection abroad will be able to fully deduct the interest percentage practised in Brazil," the author continues.

According to Fallet, corporations having inter-company operations and a foreign connection will pay a higher tax rate.

Taxpayers may experience a large loss in deductibility due to the extra fixed spread determined by the finance minister, which is frequently at a low figure and far from the market interest rates in Brazil and the ALP.

According to Bolan, the goal would be to have a loan set up in a certain way that would enable the Brazilian firm to deduct as much interest as feasible.

The Central Bank's choices have an impact on these rates, therefore Scarano advises multinationals planning to lend to or borrow from a Brazilian subsidiary using a fixed rate in US dollars or Brazilian reals should additionally verify the appropriate government bond yield.

The limitations for deductibility may increase, according to Dante Zanotti, partner at the So Paulo legal firm Lefosse Advogados, if the relevant condition is the payment of Brazil's sovereign bonds in US dollars or Brazilian reals.

On the other hand, according to Zanotti, "for inter-company cross-border loans denominated in Brazilian reals or US dollars with pre-fixed interest rates, Brazilian companies may actually have more space to fully deduct interest expenses for corporate income tax purposes."

Taxpayers must also take the exchange rate into account even though base rate increases have an impact on bond pricing. Bond rate estimates may be impacted by the fact that bonds or transactions in Brazilian reals will have a greater rate than bonds issued in US dollars.

"Our exchange rate has historically changed a lot. There have been huge variations," Bolan points out. 

"In the past year, the Brazilian real has devaluated a lot compared to other currencies. Higher interest rates on bonds will make them more attractive to investors."

The impact of increasing interest rates on inter-company financing demonstrates once more how difficult it is for tax advisors in Brazil to incorporate economic context into a company's TP analysis due to Brazil's non-alignment with OECD norms.

According to Fallet, the TP system violates a number of constitutional tax principles in Brazil by failing to create a process that compares the parameter price of interest to market realities and by not complying with OECD guidelines.

He continues that this might result in legal action from taxpayers who claim a loss as a result of using these margins.

There is no economic justification, according to Hanna Lauar, tax consulting manager at Belo Horizonte's Azevedo Sette Advogados legal company. This leaves the taxpayer in the dark.

"If Brazil followed OECD rules, the economic purpose of any transaction including loans would fit better – the arm’s length would fit better the economic purpose of transactions. Here we can’t follow the economic rationale," she continues.

"We just have a law and we have to follow that law. It would be better from a non-aggressive tax planning [perspective] and for the taxpayer to consider an interest rate usually considered for a loan," says Lauar.

Brazil declared in April of this year that it will put Chapter X of the OECD TP guidelines on inter-company financial transactions into effect. The new system could reduce the possibility of double taxation and double non-taxation while also luring international capital to Brazil.

As long as inter-company transactions do not follow the ALP, taxpayers will continue to pay higher interest rates.

By fLEXI tEAM