Brazil's Alignment with OECD Transfer Pricing Guidelines: The Marcopolo Case

Brazil’s income tax authority - Receita Federal do Brasil (RFB) - is working with the OECD to align Brazil’s transfer pricing laws with global standards. Brazil’s unique rules have allowed multinationals to shift income to tax havens in certain situations, which may have reduced Brazil’s tax base.

The Marcopolo litigations were discussed by Francisco Lisboa Moreira and Ana Paula Saunders as illustration of how Brazil’s rules operate. I extend their discussion to demonstrate the possibility that Brazil could benefit from the adoption of the arm’s length standard. 

Financial and Transfer Pricing Model for a Bus Chassis Multinational

Table 1 presents the consolidated income statement and the income statements for the affiliates of a hypothetical bus chassis multinational. A US distributor sells 100,000 bus chassis at $10,000 per chassis and incurs selling expenses of 5% of sales or $50 million. The Brazilian manufacturing affiliate incurs production costs of $8,000 per chassis or $800 million. Consolidated profits equal $150 million or 15% of sales.

The intercompany structure includes an intermediary in a tax haven that pays the manufacturer $9,200 per chassis and charges the distributor $9,400 per chassis. The intermediary affiliate retains $20 million in profits even though it incurs no expenses.

Table 1: Marcopolo Transfer Pricing (in Millions/Year)

The representatives of this multinational prepared an analysis supporting the 6% gross margin received by the US distribution affiliate, which leaves this affiliate with operating margins of only $10 million or 1% of sales. The transfer pricing policies have also left the Brazilian affiliate with operating profits of $120 million, which represents a 15% markup over production costs.

Brazil has various rules for the evaluation of intercompany export prices including the acquisition or production cost plus taxes and profit (CAP) method, which is defined as the average cost of acquisition or production of exported goods and services -- increased by taxes and duties imposed by Brazil -- plus a profit margin of 15%. As table 1 shows, setting the intercompany price received by the Brazilian affiliate at 115% of its costs leaves the gross profits received collectively by the intermediary affiliate and the distribution affiliate at 8% of sales. If the gross margin received by the distribution affiliate is only 6%, the intermediary affiliate retains profits equal to 2% of sales or $20 million.

Moreira and Saunders described this intercompany structure and how RFB challenged it in the Marcopolo case. The Brazilian parent sold its production to two related parties: Marcopolo International Corporation (MIC), incorporated in the British Virgin Islands, and Ilmot International Corporation (Ilmot), incorporated in Uruguay. These two intermediary affiliates relied on distribution affiliates to perform the actual selling functions. Brazil’s intercompany price affords the manufacturing affiliate with production costs plus a 15% markup. RFB viewed MIC and Ilmot as mere rebilling centers used by Marcopolo to lower the intercompany price received by the Brazilian affiliate and to obscure the distribution functions of the multinational. 
In various litigations, RFB attempted to disallow the discounts received by the intermediary affiliates. The court rulings, however, upheld the intercompany price paid to the Brazilian affiliate, as it afforded a 15% markup consistent with the CAP method. 

Given the fact that the intermediary affiliates performed no functions, the IRS could challenge the price the US distribution paid. If this intercompany price is lowered to $9200 per chassis, then the US affiliate would receive the entire 8% gross margin increasing its operating profit from $10 million to $30 million. Under this alternative intercompany pricing structure, the Brazilian affiliate retains its 15% markup, as shown in table 2. Table 2 also shows the approach suggested by the RFP where the intercompany price received by the manufacturing affiliate is increased to $9400 per chassis. Under the RFB approach, the distribution affiliate’s gross margin stays at 6% but the markup over production costs rises to 17.5%.

Table 2: Two Alternative Transfer Pricing Policies (in Millions/Year)

Analysis of the Marcopolo Transfer Pricing Issue Under the OECD Guidelines

The OECD transfer pricing guidelines and the US transfer pricing regulations similarly note that the most reliable approach for evaluating intercompany pricing issues depends on the surrounding facts, including the functions and assets of the involved affiliates. We noted earlier that the representatives of the bus chassis multinational provided the IRS with a justification for the 6% gross margin for the distribution affiliate. This justification is traditionally provided in the form of a Comparable Profits Method (CPM or Transactional Net Margin Method (TNMM) in OECD nomenclature), with the distribution affiliate as the tested party. 

The typical representation of facts in such reports is that the manufacturing affiliate owns all valuable intangible assets while the distribution affiliate performs only modest, routine selling functions and holds modest amounts of tangible assets, such as finished goods inventory and accounts receivable. If the Brazilian affiliate owns valuable intangible assets, then the determination of the appropriate markup over production becomes difficult. Any approach based on the manufacturer’s cost plus a markup would likely not be the most reliable form of analysis.

A CPM or TNMM analysis seeks to determine the appropriate gross margin as the sum of the distributor’s operating expense to sales ratio and an appropriate operating margin that depends on the functions and assets of the distributor. Since the functions of the distribution affiliate are very limited, a 1% operating margin may be appropriate if the distribution affiliate’s assets to sales ratio is very modest. Under this view, the RFB’s claim that the intercompany price should be $9,400 per chassis would be plausible.

The IRS could agree to the use of CPM but argue for an 8% gross margin under certain conditions, which would justify an intercompany price equal to $9,200 per chassis. In an earlier blog post that considered Chilean exports of salmon with a US distribution affiliate that had similar financials to our US distributor of chassis, we considered a controversy over how to apply CPM. The controversy was generated by an unfortunate choice of alleged comparables where the third party distributors had significantly more functions that the distribution affiliate being evaluated. 

Imagine a set of third-party distributors with operating expenses equal to 15% of sales and gross margins equal to 18%. While their operating margins are 3%, their returns to operating expenses are only 20%. A 3% operating margin for the distribution affiliate would represent a 60% markup over operating expenses. This debate over the use of operating margins versus markups over operating expenses would be mitigated if the companies chosen as potential comparables had similarly limited functions as the distribution affiliate being tested. 

An additional consideration must be addressed in the evaluation of the appropriate gross margin for this distribution affiliate. The presumption that its appropriate operating margin is only 1% rests on the assumption that its tangible asset to sales ratio is very modest. If the distribution affiliate holds greater relative assets, then a capital adjusted margin or markup approach would suggest a higher profit margin for the distribution affiliate. 

The OECD transfer pricing guidelines would suggest an analysis of the distribution affiliate’s gross margin in situations where the Brazilian manufacturer owns the valuable intangible assets, which appears to be the situation in the Marcopolo case. The appropriate application of TNMM with the distribution affiliate as the tested party also requires careful consideration of the affiliate’s functions and assets as well as the selection of the alleged comparable distributors. 

References

Francisco Lisboa Moreira and Ana Paula Saunders, “The Importance of the Marcopolo Cases for Understanding the Application of the Brazilian Transfer Pricing Rules,” Kluwer International Tax Blog, July 10, 2019.

Harold McClure, "Comparability Issues Are a Slippery Slope in Transfer Pricing," EdgarStat Blog, December 15, 2020.