Executive summary: Analyzing the attribution requirement
In 2022, Treasury and the IRS released final regulations (the 2022 Final Regulations), a set of technical corrections, and proposed regulations (the 2022 Proposed Regulations) all aimed at addressing the creditability of foreign income taxes for purposes of the foreign tax credit (FTC). These new rules are generally applicable to foreign income taxes paid or accrued in tax years beginning on or after Dec. 28, 2021 (e.g., 2022 calendar year taxpayers) and have wide-reaching impacts.
In general, these new rules revised the net gain requirement, ensuring that a foreign tax is only a creditable net income tax if the determination of the foreign tax base conforms in essential respects to the determination of taxable income under the Code. Under these rules, taxpayers may credit a foreign tax against U.S. tax liability if foreign law computes the foreign tax using principles that are analogous to those that apply in calculating the U.S. federal income tax. In particular, these rules require a foreign tax to satisfy a “net gain” test consisting of four separate elements: realization, gross receipts, cost recovery, plus a new attribution requirement.
The 2022 Final Regulations further stipulate that whether a foreign tax satisfies each component of the net gain requirement is generally based on the terms of the foreign tax law governing the computation of the tax base rather than empirical analysis. The 2022 Final Regulations maintain the long-standing all-or-nothing rule. A foreign tax is a creditable foreign income tax, in its entirety, for all persons subject to the foreign tax.
Under these new rules, historically creditable taxes may no longer be creditable. In particular, the Brazilian Imposto de Renda sobre Pessoa Juridica (IRPJ) (i.e., corporate income tax) is at risk of failing the new attribution requirement.
Brazil’s new transfer pricing regulation seeks OECD alignment
Over the last few years, Brazil has taken active measures towards joining the Organization for Economic Co-operation and Development (OECD). In 2016, Brazil adopted the country-by-country report (CbCR) in a manner consistent with base erosion and profit shifting (BEPS) Action 13 recommendations and in 2018, Brazil began a joint project with the OECD to align its regulations to the OECD standard.
On Dec. 29, 2022, Brazil took another important step in this long-lasting process towards alignment by publishing new transfer pricing (TP) rules through the issuance of the Provisional Measure no. 1,552. The Provisional Measure was approved both by the Congress and the Federal Senate and was then sent to be sanctioned by the Brazilian President on May 25, 2023.
On June 14, 2023, the Brazilian President signed the Provisional Measure, enacting the new TP rules into Law no. 14,596.
New legislation highlights
The new legislation:
- Formalizes the arm's length principle concept
- Implements all TP methods according to the OECD standard (resale price method (PRL), comparable uncontrolled price (PIC), cost plus method (MCL), transactional net margin method (MLT), and the profit split method (MDL)), and the best-method rule for intercompany transaction analysis
- Introduces TP analysis carried out by transaction, where the functions performed, contractual terms, economic circumstances of both parties involved, business strategies and risks borne by the parties must be observed
- Introduces advance pricing agreements (APAs) and mutual agreements procedures (MAPs) to mitigate uncertainty and double taxation
- Includes cross-border financial transactions such as guarantees, centralized treasury functions, insurance transactions, intercompany loans
- Eliminates the royalty deductibility limitation currently in force in Brazilian tax legislation and now includes royalty transaction analysis from a TP perspective
- Introduces the spontaneous, compensatory and primary adjustments
- Introduces a comparable range considering profit-level indicators
Early adoption in 2023
The new TP rules are mandatory for 2024. However, taxpayers may opt to early adopt in 2023. The procedures for early adoption are established by Normative Instruction n. 2,132 which were published on Feb. 24, 2023. Pursuant the aforementioned legislation, the adoption of the new TP rules in 2023 must be formalized between Sept. 1 through Sept. 30, 2023, by filing an option term through a digital portal known as e-CAC (Portal do Centro Virtual de Atendimento (Portal e-CAC)). The choice applies retroactively for the entire calendar year of 2023 and will be irrevocable.
The new ruling establishes how the income tax calculation adjustments should be done, as described below:
- Spontaneous adjustment: the taxpayer will make this adjustment directly to their income tax calculation. The intent is to include the amount that would have been obtained if the terms and conditions of the controlled transaction had been established in accordance with the arm’s length principle;
- Compensatory adjustment: the parties to the controlled transaction will carry out this adjustment until the end of the calendar year in which the transaction is carried out. The intent is to adjust their value in such a way that the result obtained is equivalent to what would be obtained if the terms and conditions of the transaction controlled had been established according to the arm’s length principle; and
- Primary adjustment: the tax inspection will carry out this adjustment. The intent is to adjust the income tax calculation with the results that would have been obtained by the taxpayer, if the terms and conditions of the controlled transaction had been established in accordance with the arm’s length principle.
The spontaneous adjustment must be completed on Dec. 31, 2023, except in incorporation cases, merger or closure of activities, in which the adjustment will be carried out on the date of the special event. The compensatory adjustment must be decided by the end of the 2023 calendar year. The primary adjustment will only be imposed by the RFB (Brazilian IRS) if the taxpayer does not observe the spontaneous and compensatory adjustments.
The Normative Instruction outlines that royalties (including technical, scientific, administrative assistance or similar amounts) will be non-deductible when paid, credited, delivered, employed or remitted to related parties, when the deduction of amounts results in double non-taxation, in any of the following scenarios:
- The same amount is treated as a deductible expense to another related party;
- The amount deducted in the country is not treated as taxable income of the beneficiary in accordance with the legislation of its jurisdiction; or
- The amounts are intended for financial, directly or expressly, deductible expenses of related parties, which include the scenarios referenced above.
Next Steps
The new TP rules intend not only to fix existing voids, flaws and weaknesses in existing rules, but also to sort the issues arising from inconsistencies of the local rules with the OECD guidelines.
On July 3, 2023, the Brazilian IRS published a Normative Instruction that will regulate aforementioned Law no. 14,596 (the new TP legislation). According to the Normative Instruction, the Brazilian IRS will hold a public consultation from July 3, 2023 to July 25, 2023 where taxpayers can proactively participate in the discussion of the implementation of the new TP rules because of the huge impact the new TP rules are expected to have on Brazilian entities as well as foreign multinationals
The public consultation will serve as a forum for the Brazilian IRS to publish additional regulations providing guidance and defining the requirements to be followed by taxpayers.
Pending Brazilian tax reform
The Brazilian model of taxation on consumption, instituted in the 1960s and modified by the Brazilian Constitution of 1988, has become, over time, complex, inefficient and somewhat outdated. For this reason, Congress is proposing tax reform. Among other topics, the two main proposals include the PEC No. 45 and No. 110. The intent is to replace all five current consumption taxes (i.e., the tax on industrialized products (IPI), employees’ profit participation program (PIS), social contribution for social security financing (Cofins), tax on the circulation of goods and services (ICMS) and tax on services (ISS)) with one or two consumption taxes (i.e., the tax on goods and services (IBS) and contribution for goods and services (CBS)) and a selective tax (IS).
Tax reform in Brazil is still in the early stages of the legislative process. Changes to the corporate income tax and taxation of dividends remain unclear. The tax reform proposals still need to be analyzed and voted on by Congress. This process will likely include several amendments prior to finalization.
Nevertheless, the broad consensus on tax reform is that tax reform is as necessary as it will be complex. Given tax reforms long debate, as well the emphasis placed on it by the new government, there are high expectations for Congress to accelerate this analysis.
U.S. FTC Attribution requirement
The 2022 U.S. Final Regulations introduced an attribution requirement as a new element to the net gain requirement. The attribution requirement is intended to allow a FTC only if the country imposing the tax has sufficient nexus to the taxpayer’s activities or investment of capital that generates the income included in the tax base. For resident taxpayers, the attribution requirement will be satisfied if the foreign base is determined using arm's length principles (i.e., no destination-based criteria). For non-resident taxpayers, the attribution requirement will be satisfied if the foreign base meets one of the following tests: activities, source or property (e.g., situs).
For resident taxpayers, the regulations are clear on the attribution requirement. A fixed-margin TP system violates international norms, resulting in disqualification of the foreign tax entirely from creditability. Now that Brazil has adopted the arm’s length principle and OECD norms, U.S. multinationals will need to analyze whether the Brazil corporate tax system satisfies the attribution requirement as it remains unclear whether the Brazilian IRPJ will satisfy the attribution requirement in 2023, when the new TP rules are merely elective. One consideration is that an election to early adopt may be viewed by the IRS as a noncompulsory payment.
Final Reminders
Analyzing whether the new attribution requirement is satisfied requires consultation with local country tax experts and an in-depth knowledge of foreign tax law which will take time. Therefore, U.S. multinationals considering using Brazilian taxes as a credit on their U.S. tax returns should plan accordingly.
Taxpayers can find additional information on the 2022 Final Regulations and 2022 Proposed Regulations, through the following links (Treasury releases technical corrections to final FTC regulations, Treasury releases much anticipated proposed FTC regulations and Ten quick reminders for FTC). These RSM tax alerts provide detailed insights on how taxpayers can satisfy the revamped cost recovery requirement, along with the new attribution requirement, which are two key steps in determining whether a foreign income tax is creditable under the new framework.
