Brazil: The impact of tax complexity on M&A activity

Both Brazilian companies and foreign investors alike express increasing confidence in the Brazilian economy. For example, 89% of Brazilian respondents to Ernst & Young's most recent Capital Confidence Barometer survey rated the local economy as either "stable" or "improving," and 42% expect to pursue an acquisition in the next 12 months (a significant improvement from the 23% in the last survey in April 2012). Anecdotally, we are seeing this increased optimism in our transactions business with Brazilian companies looking to buy and sell.

Foreign direct investment (FDI) has continued to boom. In 2011 (the last full year for which, at the time of writing, we have full data), Brazil saw a record number of FDI projects, making it the second most popular global destination in terms of value and fifth in terms of number of projects (according to Ernst & Young's Brazil attractiveness survey). While, at the time of writing, full data is not available for FY12, it is widely discussed in Brazilian media that FDI dropped in FY12, but it is still expected to be high with the drop reportedly being around 2%. All of this is further boosted by the swathe of infrastructure projects being promoted by the Brazilian government ahead of the 2014 FIFA World Cup and the 2016 Olympic Games. The leading geographical investor group into Brazil continues to be the US, with 29% of all FDI into the country. The UK, Spain, Germany and Japan are also all significant investors, and while not yet significant in absolute terms, inbound investment from China is growing exponentially (up 70% in 2011).

Balanced against this undoubted investor appetite, Brazil remains a complex place to do business. In 2008, Ernst & Young began using data from the World Bank's Doing Business report to demonstrate to clients the importance of performing a deep analysis of the tax and labour aspects of Brazilian target companies. At that time, according to the report, Brazil was ranked 122nd among the major economies of the world in terms of "ease of doing business" (first place being the best). In the 2013 edition of the Doing Business report, Brazil had slipped to 130th in the world.

The World Bank creates the ranking score based on its analysis of the ease of doing business according to the following 10 factors: Starting a business, dealing with construction permits, getting electricity, registering property, getting credit, protecting investors, paying taxes, trading across borders, enforcing contracts and resolving insolvency.

In particular, Brazil's "ease of paying taxes" index of 156 has dragged down its overall ranking. Brazil's complex tax environment and heavy tax burden have been reflected in low rankings year after year.

Back in 2008, many potential investors into Brazil were unaware of the complexity of the local business environment. Increased familiarity through transactions, together with the efforts of Ernst & Young and other advisers, has raised the profile of some of these challenges, and today, the intricacy of the Brazilian tax environment is a more familiar issue to investors. Most have accepted that there is a degree of risk in the complex tax system, which is in many ways seen as the price to be paid in exchange for the growth potential afforded. Nevertheless, the tax complexity can still be a significant factor in transactions. It can, in a worst case, be a deal-breaker if not addressed up front with appropriate local tax advice, and the complex tax environment may still come as a surprise to investor groups newer to the Brazilian market, such as those from Asia, now entering the market.

In this context, it is not surprising that tax issues are frequently among the last ones to be cleared off the table during an acquisition process. These may arise from drawn-out tax audits, differing interpretations of complex rules by the buyer and seller, or uncertainties regarding tax incentives that may trigger a material impact in cash flow projections. All these go directly to the valuation of the company to be acquired. The latter point about incentives is frequently the case, for example, in deals relating to companies whose main consumer markets are located out of the state in which the goods are produced – a common situation because the several tax incentives for investments in less developed areas. In particular, ICMS (state value added tax, levied by the individual states in Brazil on goods, supply of electricity and some services) incentives, related to reductions of the tax burden in the state of production with a subsequent recognition of credit in the state where the consumer market is located (without approval of that state or all the states), are often subject to litigation and uncertainties. Understanding the history of discussions involving such tax incentives and the trend of the rulings and decisions is crucial as a way to forecast future impacts.

Also, a frequent and important role of the M&A tax adviser in Brazil is advising on the integration of the acquired business and how the supply chain may be structured so that synergies with the business being acquired may arise. A combined approach adapting both structures (existing and acquired), managing indirect taxes in the integrated supply chain is very often what successfully turns a potential tax deal-breaker into a feasible and profitable commercial operation.

Less complexity in the tax and business environment could benefit both local and foreign entities, but chiefly for the foreign investor for whom dealing with tax exposures and uncertainties may still be an unfamiliar and unwelcome risk factor.

One of the major tasks of an M&A tax adviser is helping foreign investors understand the many aspects of the Brazilian tax system so they can bridge this mindset gap. In Brazil, tax disputes can be extremely lengthy, with different jurisdictions and court levels. Additionally, local tax authorities have historically granted partial amnesty to taxpayers by means of very beneficial programs whereby companies are allowed to pay the outstanding tax obligations over several years (in some cases, in over 15 years). Debts that are being discussed before administrative or judicial courts can be included in these refinance programs, provided that the taxpayer withdraws the claim. There is therefore a need for practical discussions between a taxpayer and his or her adviser as to the likelihood of success before the courts in the case of any given dispute, compared with the benefit of very generous payment terms if they do not pursue the claim.

This area is one that we believe the Brazilian government should keep under close review. The 2013 edition of the Doing Business report suggests that there is a direct link between the ease of doing business index and the foreign direct investment in each country. Places with more favourable ease of doing business rankings typically tend to receive more foreign investment. While Brazil has seemingly been immune to this trend in the past (perhaps because the overwhelming attractiveness of such a significant emerging market), there are signs that this is changing, for example the slight reduction of 2% in foreign direct investment in 2012, compared with 2011. From a Brazilian perspective, one might therefore wonder if the economy as a whole would do much better with a less complex tax, regulatory and business environment.

The annual Doing Business reports show that Brazil has historically had only limited tax reform (usually only one item of reform per year and that item only of limited scope and breadth). Such tax reforms stop short of what we consider to be much-needed systematic and comprehensive changes required to fix Brazil's burdensome system of taxation. To date, reforms have generally not targeted long-term goals or addressed core issues of the existing system (for example the complex multi-tier nature of the tax regime or the "tax competition" within the country referred to below). In practical terms, the understandable perceived risk of a short-term decline in tax revenues has probably deterred more comprehensive tax reform.

The government's favoured approach to tax reform, particularly to address the effect of the recent economic downturn, has been to reduce the tax burden on a particular sector but only for a limited period of time. This was the case recently with the reduction of federal VAT (IPI) for a series of goods (such as cars and domestic appliances) and the recent reduction in payroll tax burdens in some cases. Clearly, that is welcome in those affected sectors but will inevitably have had only relatively narrow impact.

At the same time, and less advantageous to investors, recent tax reforms have included caps on interest deductibility, and the government still seems to be considering making changes to the rules surrounding tax relief for goodwill amortisation, which could eliminate the beneficial deductions system in existence. This may also partially be a result of ongoing litigation surrounding goodwill amortisation.

The ease of paying taxes indicator that feeds into the World Bank's overall ease of doing business ranking, noted above, is based in part on the amount of time (an average of 2,600 hours or 108 days per year) required for companies located in Brazil to prepare, file and pay their taxes. This number is more than twice the time typically spent by companies located in the second highest ranking country, Bolivia, and 15 times what is typically spent by companies in the US.

Much of that complexity derives from the fact that Brazil's government is organised as a federation comprising the union (central government), states and municipalities and each has been granted power guaranteed by the constitution (and which cannot be altered or abolished unilaterally by the union to collect taxes within the limits established by the constitution.

A considerable part of the average 2,600 hours that are typically required to undertake tax compliance in Brazil is spent trying to understand the impact and applicability of the tax laws – both existing and new – in the different states and municipalities within Brazil in which a company operates. Many of these tax laws are subject to multiple interpretations, demanding additional rulings and resulting in different taxpayer behaviors.

The ICMS and ISS (municipal tax on a wide range of services levied by each of the 5,564 municipalities in the country), the main tax and source of income at the state and municipal levels, respectively, contain core rules established by federal law, but each state and municipality can interpret and administer these core rules on an autonomous basis, within constitutional limits. This contributes to the high cost and time associated with the preparation, filing and payment of taxes as companies need to comply with state and municipal tax regulations applicable to the jurisdictions in which they operate. Moreover, taxpayers must take into consideration the regulations applicable to their suppliers and customers, as this can have an impact on the calculation of input tax credits.

Further, a strategy adopted by some state and municipal authorities to attract investment has been to grant ICMS and ISS tax incentives to companies that bring their operations to particular jurisdictions. The competition between states and municipalities to attract investors via the concession of tax incentives is commonly referred to as "fiscal war".

Such competition, per se, could be seen as a constructive way of fomenting the growth and development throughout the country. However, recent years have seen a marked increase in litigation involving these tax incentives. In other words, a taxpayer choosing in good faith to start up business in a particular jurisdiction that offers tax advantages may end up being challenged by tax authorities at different levels of the federation.

All of the above complexity means that potential investors should thoroughly investigate, through detailed due diligence, the target company or business (and should keep in mind that such diligence is likely to be lengthy and, by the standards of other countries, costly) and should structure their investments with great care. Investors who have rushed to invest in emerging economies previously may have regretted a lack of advance thought surrounding tax implications of their investment even if such regret only becomes fully apparent at the point at which they finally look to realise their investment.

In Brazil, many M&A deals are directly impacted by regional tax incentives, with sellers factoring in their economic upsides in the purchase price. On the other hand, buyers are keen to understand if the company being acquired has complied with the incentive rules and what is the future of the incentive, in terms of granted remaining period, risk of suspension, and possibility of extension or renewal.

As the incentives usually generate substantial tax savings and as the Brazilian system means that there are multiple granting, compliance and renewal rules, a view from a local tax team, experienced in dealing with tax authorities and regional development agencies, is always recommended. In our experience, contact with the governmental agencies granting the incentives has been fruitful in giving good confidence around the likelihood of a smooth transfer of the benefit to the acquirer and future extension or renewal.

Besides complexity, the country has been criticised for giving too little back to its citizens in the form of basic and social services given its high tax levels. While not directly relevant to M&A activity, it is interesting to consider, in the context of understanding the creative approach that the tax authorities can take, some of the tax incentives offered by government at both the state and municipal levels, which provide a dual benefit to consumers and the government in terms of increased compliance with formal tax policies.

Several states and municipalities have put a system in place that encourages taxpayers to ask for fiscal invoices when acquiring a wide range of goods and services, providing their taxpayer numbers and receiving cash back and rewards. For example, the state of São Paulo, the country's economic powerhouse, implemented a new system in 2007 called the Paulista Tax Invoice (Nota Fiscal Paulista). Under the regime, 30% of the VAT paid by the entity issuing the invoice is paid back to the consumer. Also, for each BRL100 ($50) in invoices turned in to the taxing authorities, consumers get the chance to participate in drawings for cash prizes.

Users of the Paulista Tax Invoice system may log in and access their balances, invoices and rewards electronically at any time. Since 2007, nearly $3.5 billion has been distributed as cash back and prizes to more than 14 million users of the São Paulo State system.

Overall, these are exciting times in Brazil. Appetite for acquisitions is high, and the upcoming 2014 FIFA World Cup and the 2016 Olympic Games are resulting in significant infrastructure projects. While investors need to acknowledge the risks inherent in the complex Brazilian tax system, there is an opportunity for significant returns from the right investments. Although many may consider that the Brazilian economy would benefit from a less complex tax, regulatory and business environment, in the meantime successful investment is likely to require appropriate, local and practical tax advice. In particular, it will require ensuring that an investment makes commercial sense before the benefit of any tax incentives and that valuation models make sensible assumptions about tax risks and opportunities.

The views reflected in this article are the views of the authors and do not necessarily reflect the views of the global Ernst & Young organisation or its member firms.

Fábio Kenji Ota
		Tax partner, transaction advisory services Ernst & Young Terco – São Paulo Tel: +55 11 2573 3085 Email: fabio.ota@br.ey.com Fábio Ota is a senior transaction tax partner at Ernst & Young Brazil, with more than 17 years of experience assisting multinational and local clients in tax advisory, due diligence and structuring projects. He has advised clients in more than 500 transactions, including some of the largest deals in the country. He has a law degree from Catholic University of São Paulo (PUC-SP) and is a member of the Brazilian Lawyers Bar (OAB-SP). Fabio is also a CPA who graduated in accounting from University of São Paulo (FEA-USP) and a member of the Brazilian Accounting Association (CRC-SP). He has a post-graduate degree in tax law from FGV/Fundação Getulio Vargas (GVLaw). Fábio is the leader of Ernst & Young transaction advisory services for Japanese clients in Brazil. He is fluent in Portuguese, English, Japanese and Italian.

Juliana Deslandes
		Executive senior manager, transaction advisory services – tax / labour Ernst & Young Terco – Rio de Janeiro Tel: +55 21 3263 7208 Mobile: +55 21 7193 7993 Email: juliana.deslandes@br.ey.com Juliana Deslandes has more than 11 years of experience, having worked in other Big 4 firms and companies during this period. After working in São Paulo, she became the transaction tax champion in Rio de Janeiro in 2010. Her experience includes participation in processes of acquisition for both foreign and Brazilian companies. She has experience in health care, education, agrobusiness technical services, mining, and industrial and consumer products. Juliana has bachelor's degree in law from the Universidade Federal de Minas Gerais. She speaks Portuguese (native speaker) and is fluent in English, French and Italian.