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Brazil’s approach to intercompany financing may respect the currency of denomination of a multinational’s intercompany loan policies but falls short of other key aspects, such as the term of the intercompany loan. The OECD released its transfer pricing guidance on financial transactions on February 11, 2020. The guidance on the pricing of intercompany loans placed appropriate focus on the contractual terms as well as the credit rating of the borrowing affiliate.

Chapter 10 of Transfer Pricing in Brazil Towards Convergence with the OECD Standard (2019) is entitled “Transfer pricing aspects of financial transactions / intra-group financing”. This chapter discusses the OECD guidance on the extent that financing can be classified as debt versus equity as well as the issue of hybrid mismatches. In terms of the pricing of an intercompany loan, this document describes the Brazilian approach and how it differs from the OECD approach. In particular, it notes that the Brazilian approach “does not take into consideration all the relevant economically significant characteristics of transactions, e.g., the term of the loan, or the size and creditworthiness of the lender”. The chapter also notes that the OECD and Brazilian approaches need to converge in order to avoid double taxation.

A standard model for evaluating whether an intercompany interest rate is arm's-length can be seen to have two components — the intercompany contract and the credit rating of the related party borrower. Properly articulated intercompany contracts stipulate:

• The date of the loan;
• The currency of denomination;
• The term of the loan; and
• The interest rate.

The first three items allow the analyst to determine the market interest rate of the corresponding government bond. This intercompany interest rate minus the market interest rate of the corresponding government bond can be seen as the credit spread implied by the intercompany loan contract.

The Brazilian approach requires that verification of the appropriate interest rate for transfer pricing purposes must be done on the date of the closing of the loan agreement, and renewals and renegotiations are considered as new agreements for this purpose.

The Brazilian approach also includes an appropriate focus on the currency of denomination. If the intercompany loan was denominated in Brazilian Real using a fixed rate, then the intercompany rate must be the yield on Brazilian sovereign bonds plus the fixed spreads (3.5% inbound and 2.5% if the Brazilian entity is the lender). If the intercompany loan was a fixed interest rate loan denominated in U.S. dollars, then the yield on Brazilian sovereign bonds plus the fixed spreads.

If the intercompany loan was issued in a foreign currency where a London Interbank Offer Rate (LIBOR) exists, then the intercompany loan must be based on that currency’s 6-month LIBOR rate plus an appropriate loan margin. For example, a German parent loaning to its Brazilian affiliate could use the interest rate on the 6-month LIBOR based in euros plus 3.5% as established in the Brazilian Law. If no LIBOR rate exists for the intercompany loan’s currency of denomination, then the Brazilian approach requires the use of the 6-month LIBOR rate based in U.S. dollars.

As an example, let's assume that a Germany-based multinational extended a 10-year fixed interest rate intercompany loan of €1 billion to its U.S. affiliate on January 2, 2014. Interest rates for very short-term financial instruments in both Germany and the U.S. were low on this date. The following figure shows the six-month LIBOR rates by month over the period from January 2014 to December 2021 for both dollar-denominated and euro-denominated instruments. Both rates were 0.35% on January 2, 2014. Brazilian rules would therefore allow a maximum interest rate of 3.85% whether the intercompany loan was denominated in dollars or euros.

Before the pandemic, these interest rates diverged as dollar-denominated interest rates rose while euro-denominated interest rates turned negative. Since the pandemic, U.S. rates have declined but remained positive while short-term rates on euro-denominated debt have remained negative. The reporting of LIBOR rates denominated in euros ceased after 2021, which creates an issue of how to implement the current Brazilian rules. Note that while the six-month LIBOR rate for dollar denominated instruments has been near 0.3%, the six-month LIBOR rate for euro-denominated instruments has been near negative 0.5%.

We shall argue that the lack of reporting for LIBOR rates starting in 2022 is not the only problem with current Brazilian rules. On January 2, 2014, the term structure for German government bonds was upward sloping. The term structure for U.S. government bonds was even more upward sloping. The following table presents the interest rates on January 2, 2014, for 2-year, 5-year, 10-year, and 30-year German government bonds, as well as for U.S. government bonds. The interest rates of short-term Treasury bills were only 0.1% on this date, so the six-month LIBOR rates already embedded a 0.25% credit spread for interbank debt. Adding the 3.5% loan margin would result in a 3.75% credit spread if the intercompany loan were a floating rate instrument.

Six-month LIBOR rates for dollar and euro-denominated instruments: 2014 to 2021

Interest rates for January 2, 2014 on various financial instruments in Germany and the U.S.

Our example, however, assumes a fixed interest rate loan with a 10-year term. The German 10-year government bond rate was 1.95% so a 3.85% interest rate would be consistent with a 1.9% credit spread. If the credit rating for the Brazilian affiliate were BBB-, then this 3.85% interest rate would be consistent with the arm’s length standard. If the appropriate credit spread, however, was BB, then the German tax authorities could readily assert that the arm’s length interest rate should be closer to 5%. If the interest rate deduction under Brazilian law were restricted to €38.5 million per year while the German tax authorities expected the German affiliate to receive €50 million per year in intercompany interest income, the multinational faces double taxation.

This double tax issue is less pronounced if the term of the fixed-rate intercompany loan were between 2 years and 5 years. If the term of a euro-denominated loan were 30 years, double taxation would be more pronounced unless the credit rate of the Brazilian affiliate was a strong investment-grade credit rating. Note also that intercompany loans denominated in dollars would face even more severe prospects of double taxation given the fact that the term structure for U.S. financial instruments was steeper than the term structure for German government bonds.

Brazilian affiliates that are extended intercompany loans in currencies of a denomination other than the U.S. dollar starting after 2021 will not be able to base the interest rate on LIBOR rates plus a loan margin since LIBOR rates will no longer be published. Brazilian tax law, therefore, needs to find another mechanism for determining the appropriate interest rate. The current approach for intercompany loans initiated after 2021 under Brazilian law would be to use LIBOR based on the U.S. dollar even if the intercompany loan was denominated in a foreign currency. This practice overstates the arm’s length interest rate if the intercompany loan was denominated in euros as long as short-term rates in Germany are below short-term rates in the U.S. Even for intercompany loans that were initiated before 2022, the Brazilian use of LIBOR plus a fixed loan margin was inconsistent with the arm’s length standard for long-term fixed interest rate loans.

Tax authorities that follow the pricing approach noted in the OECD transfer pricing guidance on financial transactions are able to properly evaluate the arm’s length interest rate if the terms of the intercompany loan contract are properly articulated and the appropriate credit rating can be agreed to. The OECD guidance is similar to the Brazilian rules in its focus on the date of the loan as well as its currency of denomination. The OECD guidance also recognizes the distinction between longer term fixed interest rate loans versus floating rate loans. While the OECD guidance never mentions the use of LIBOR, it does allow for the general use of interbank rates as the base rate for floating rate loans. As such, domestic interbank rates could be used for floating rate loans even after the demise of LIBOR. Brazil’s tax authority is therefore encouraged to adopt this sensible approach.