Behind the Curve – Brazil Inefficiencies Threaten International Investment

By Rolf Lindsay, Partner, Global Investment Funds Group, Walkers, Cayman Islands (01/01/2013)

Against the backdrop of the dramatic rise in fortunes of the emerging markets of Latin America, with growth elsewhere still cramped by the global financial crisis, international investors have zeroed in on investment opportunities across the region in economies such as Brazil and Chile. Latin America has also been a hotspot for numerous international private equity funds, which have focused their portfolios on high growth opportunities, while also reducing exposure to traditional investments.

A 2011 survey from the major secondary market investor Coller Capital highlighted the global shift in sentiment towards Latin America. It revealed that Limited Partner appetite for emerging markets private equity investment stood at an all-time high, with Brazil overtaking China as the most attractive market for dealmaking over the next 12 months. Brazil was also expected to attract the largest influx of new investors, with 14 per cent of Limited Partners planning to start investing there.

This development is extremely welcome for Brazil, not just in order to maintain its economic advance, but with a rash of infrastructure projects underway ahead of its hosting of the football World Cup in 2014 and the Olympic Games in Rio in 2016 the need for international capital has never been greater. In fact, some observers reckon that Brazil needs to spend an additional three per cent of its GDP on infrastructure to meet these requirements, as well as the growing needs of its own rising middle class.

Competition for international capital, however, is intense and the traditional regulations and mechanisms in Brazil in place to restrict the movement of capital do few favours in this climate. The rules in Brazil regarding the tax regime for the investment entity appear to be less directed towards attracting investment to the country and more in favour of preventing funds being expatriated by Brazilians.  


Brazil's Experience

In short, the inability to efficiently access tax neutral platforms from International Financial Centres (IFCs) such as the Cayman Islands for investment into Brazil threatens to constrain international capital flowing to Brazil at the time its economy needs investment the most.  It is well accepted – and reinforced by a slew of academic research[i] – that global economic growth has been enhanced by the free and efficient movement of international capital through IFCs, which have been essential to economic liberalisation and the improvement in living standards in the developing world.

Brazil's attitude runs in stark contrast to other key emerging markets currently favoured by investors such as China, which engineered the most dramatic move out of poverty ever seen by being open to foreign investment. Of most significance has been the PRC Government's moves to gradually relax regulations to allow foreign direct investment in certain industries, while embracing the many efficiencies and benefits of engaging with IFCs.

In the fight to attract global investment, efficient mechanisms to raise and deploy international capital provide real structural benefits for local economies, and those nations which have embraced these realities have taken a lead over rivals who are unable to see past outdated policies and misplaced suspicion about global capital.

Foreign investment into Brazil typically takes place through the use of Fundo de Investimento em Participações – also known as FIP structures which act like private equity funds providing a whole range of tax and regulatory incentives for foreign investors. The FIP structure is primarily used for private equity investments such as acquisition finance, bridge financing, management  buyouts, mezzanine investments and PIPE securities (Private Investment in Public Equity). The incentives mean that foreign holders of the shares can receive an exemption on income tax for up to 40 per centof the fund's issued shares. This exemption, however does not apply to investors using vehicles formed in ‘tax havens’ or ‘paraiso fiscal’. Foreign investors in these vehicles are treated in the same manner as domestic investors and subject to the same 15 per cent tax rate, in addition to any tax liability in the investor's home country.


China's Approach

In contrast, China has embraced IFCs and has long been aware of their benefits which have helped power growth and development. Research by Professor Jason Sharman of Griffith University in Brisbane, Australia, states that the primary conduit for foreign flows of investment in China– both inbound and outbound – has been IFCs, which have afforded cost-effective and efficient capital deployment, providing a major contributor to growth and the reduction in poverty. The two countries, meanwhile, which have consistently provided the greatest level of foreign investment to China, are both IFCs (British Virgin Islands and Hong Kong) and both of them feature on Brazil's list of tax havens. Also of significance is the fact that 10 times more Chinese outbound investment passes through the Cayman Islands than compared with the US.

China's success in terms of attracting foreign direct investment has been stunning, which has helped maintain growth of 10 per cent during most of the past 30 years. Additionally, according to a 2010 World Bank report, China received some 20 per cent of all FDI to developing countries over the previous decade. It has been a gradual and prudent approach that has served China well, initially opening up to foreign investment on the manufacturing side before focusing on services around the time of its WTO accession in 2001.

The importance that China places on the IFCs which have so well served its economic development is clear from how it resisted any interference in Hong Kong as a financial centre when taking control in 1997, while China also went to great lengths to avoid an international crackdown on the activities of Hong Kong and Macau at the G-20 meeting in London in 2009.

China's double taxation treaty with Hong Kong, which drops the withholding tax to five per cent, has made the Hong Kong vehicle the favoured method of entry into China, with a Cayman Islands exempted company or BVI business company often interposed upstream to allow the company to take advantage of these flexible corporate regimes. Among the benefits of the IFC structures are no requirement for BVI companies established since 2005 to have authorised share capital, no stamp tax on share transfers as well as the speed of incorporation and lower costs. In the private equity context, the Cayman Islands exempted partnership has been the vehicle of choice for attracting foreign capital to be deployed in China. Domestic RMB funds have been in favour for the global private equity houses looking to make inroads in China, while the country is now looking to open its door to capital raising for hedge funds to boost investment into the funds industry.


A Better State

Clearly the tax neutrality offered by financial centres such as the Cayman Islands plays an important role in the overall efficiency of a transaction and the presence of a blacklist in Brazil means that additional analysis is required to ensure that the overall structure in play is tax efficient for all participants. Just looking at the infrastructure projects required for Brazil's development over the medium term, which produce steady rather than spectacular returns, it is critical to eliminate all inefficiencies from the structure if margins are to be maintained.

Just in the last few years, some important progress has been made in removing some of the hindrances to attracting global investment to Brazil, which has been quite encouraging. We have seen a Memorandum of Understanding (MoU) signed between Brazil's securities regulator (CVM) and the Cayman Islands Monetary Authority, as well as an initiative by AIMA the global investment funds association to forge closer links with the industry in Brazil. In addition, the 2011 cut in tax on foreign investment in private equity funds (to two per cent from six per cent) is another step in the right direction, along with the discussions between Cayman and Brazil on the possible implementation of a Tax Information Exchange Agreement. This important development demonstrates that Brazil is now catching on to the shift in sentiment in the global debate regarding tax evasion which among leading industrialised countries now focuses more on transparency and information exchange.

At such an opportune time, with Brazil squarely in the minds of international investors, it is to be hoped that further policy changes can be introduced which recognise the importance of IFCs and encourage efficiencies into the process of attracting international investment.

[i] 2009  'International Financial Centres and the World Economy'   James R Hines Jr  - University of Michigan; and 2007 ‘Offshore Financial Centres and Canadian Economy’ Professor Walid Hajazi - University of Toronto's Rotman School of Management