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U.S. companies are keen to expand into Latin America's biggest market, but CFOs report that Brazil poses unique challenges.
Kate O'Sullivan, CFO Magazine
July 15, 2010
As the world's 10th largest economy and one of the fastest to emerge from the global recession, Brazil is the hot market of the moment, and not just because of its famous beaches. With a stable currency; a growing, consumption-oriented middle class; and a gross domestic product expected to rise at 4% to 5% per year over the next 10 years, it's no surprise that Latin America's biggest market is attracting CFOs' attention: nearly one-third of finance chiefs considering international market expansion over the next two years have set their sights on Brazil, according to the Duke University/CFO Magazine Global Business Outlook Survey.
But the promise of growth — so enticing in the face of a weak recovery in the United States and Europe — doesn't come without strings attached. Finance chiefs and other experts who have been in the market for years warn that Brazil's tax and legal systems are among the world's most convoluted. A thicket of labor laws can also ensnare unsuspecting businesses, and corruption and personal security remain much more significant concerns than in more-fully developed markets.
Yet despite these serious risks, companies continue to flock to Brazil. Larry Harding, president of High Street Partners, an international business-services firm that advises companies on overseas expansion, has more clients interested in entering the country than ever before. High Street recently opened a Miami office to serve as a support hub for its growing volume of business in Brazil.
Paul Lehmann, finance chief at Overhead Door, a maker of residential and commercial garage doors, began researching the opportunities in Brazil in 2007. Although the company sells doors there through its international sales group, it has yet to establish its own subsidiary in the region. "Brazil is certainly on our radar screen," Lehmann says, "not only for its own population, but also as a portal to the rest of Latin America." Still, he notes that the country's infrastructure continues to develop, posing potential distribution challenges, and that for a small company like Overhead Door, import duties are prohibitively high. As a result, "we're hunting for joint-venture partners that would allow us to expand there." Lehmann is also considering partnerships in other Latin American countries that might provide entree to Brazil without the crippling import taxes.
"Brazil is an interesting and unique blend of opportunity and risk," says Thack Brown, CFO of SAP Latin America and a nine-year resident of the country. "The biggest advice I would give to someone looking to expand into Brazil would be to take the time to really understand the environment. You want to get into Brazil a little bit slower than you would some other more-developed, more-transparent markets."
To that end, here are a few of the most commonly cited stumbling blocks on the road to success in Brazil, and some seasoned market participants' suggestions for avoiding them.
Finance chiefs love to complain about taxes the world over, but Brazilian taxes are in a class of their own, say many CFOs. "If it's not the most complicated tax system in the world, it's certainly right up there," says Mark Buthman, finance chief at Kimberly-Clark, the consumer packaged goods giant, which has approximately 3,000 people in its Brazilian operation. "It's not uncommon to have disagreements with the taxing authorities that you have to work through over time." Often, the existing tax rules do not apply neatly to a modern business's products or services, which can lead to misinterpretation, notes Brown.
Developing an awareness of Brazil's complex tax environment before entering the market is helpful, says Harding, but he adds that many clients don't fully understand just how complicated it can be until he walks them through some examples. "Everything in Brazil tends to have a different applicable tax rate," he says. "Even the simple fact of selling to a Brazilian customer is vastly more complicated than any other place a client might be used to." For example, "if you have a million-dollar sale as a foreign company in Brazil, there's a significant withholding tax. If you send a million-dollar invoice, you will get paid $800,000 and the other $200,000 will go off to a bunch of different places in the government," he explains. (See "No Day at the Beach" at the end of this article.)
A strong local tax team is thus a top requirement for a finance chief preparing to establish a presence in Brazil. Strong internal experts as well as sophisticated external advisers, such as an accounting firm and a law firm, are critical, says Buthman. At Kimberly-Clark, about 70 people work in the company's finance group in Brazil, and most are native Brazilians or longtime residents. "We have good access to strong, seasoned finance talent there," says Buthman, in part due to a university recruiting program.
Global consulting, law, or audit firms, and fellow CFOs who are already in the market, can provide helpful services and leads. While such expertise can be pricey, "this is a country where you should feel comfortable spending a little bit more than you might elsewhere to keep up with the tax system," says SAP's Brown. The U.S. State Department also regularly fields inquiries from companies looking to vet local service providers. The American Chamber of Commerce has a strong presence in Brazil as well.
Lost in Legalese
In addition to the byzantine tax system, labor laws also stymie many newcomers. The legislation is complex and outdated in many cases, says Brown, and heavily favors workers over companies. "There are very legal, viable opportunities to avoid costs on benefits or tax-related employee costs, but you need to take time to really understand the legislation and get very good advice on how it can be interpreted by your company," he says. "If you don't do that, you run the risk of getting yourself into trouble with the government or paying far more than you need to."
For example, companies that traditionally pay year-end bonuses in the United States and try to continue that tradition in Brazil find that they must remit an array of taxes on those payments. But, "there is a completely legitimate structure that allows employee participation in profits that tremendously reduces the taxes on a bonus," explains Brown. Once a company adopts a certain approach, however, it can take time to change course.
Corina Monaghan, vice president of political risk at global consultancy Aon, urges finance chiefs to not only familiarize themselves with federal laws in Brazil but also with the laws for the Brazilian states in which they are doing business. "States themselves hold a lot of power in Brazil," she says. "You really should know how the government in each individual state behaves, what they enforce, and what other taxes they might have in addition to federal taxes."
Any misstep regarding a labor or tax regulation can prove costly. "If you do have an issue, not only can the penalties be large, but you can spend 3 or 4 or even 10 years working through the judicial system," Brown says.
"The court system is very, very tedious to work through, and it's not clear you're going to get the right answer at the end of the day," says Greg Hayes, finance chief at United Technologies, the $53 billion global industrial conglomerate. He cites the example of a value-added tax dispute the company had several years ago in which it won its case at the Supreme Court level in Brazil but still couldn't achieve effective enforcement at the local level.
Still, Brown points out that while the courts can be maddeningly slow, at least there is a system. "Compared to China, where the legal system is much less structured and capable of dealing with issues, in Brazil you will work your way through the courts and eventually come out with a result," he says.
The Wild South
Brazil also has its share of other problems that are common to many emerging markets: namely, corruption and security threats. "It is the corruption issue that scares me the most," says Hayes. To combat the risk of fraud, United Technologies has implemented a rigorous audit and ethics program in Brazil and at all of its international locations. The company's internal audit team travels to its large branches in Brazil multiple times a year, its outside auditor visits regularly, and members of the finance team in the United States make frequent trips to the company's operating units in Brazil. "It may be overkill, but we're trying to make sure we never have a big problem," says Hayes. The company also requires ethics training and course work for all employees throughout the year. An online system allows for anonymous reporting of any problems. "The combination of those things lets me sleep at night," Hayes says.
Personal security remains a significant risk in Brazil, says Aon's Monaghan. "The kidnapping level is high and they target businesspeople," she says. "It hasn't been proven whether that has deterred foreign direct investment, but I don't see how it can't." But Monaghan adds that the international spotlight that will shine on the country as it prepares to host the 2014 World Cup and the 2016 Summer Olympics has increased the government's sense of urgency about tackling the problem. "Crime prevention is a serious topic of discussion in Brazil, and it's being addressed, but at the moment, it's still there," she says.
For now, High Street's Harding urges executives planning a trip to Brazil to line up carefully vetted drivers and bodyguards to escort them from the airport to the hotel and then to all meetings during their stay. "It's a different risk profile than in Europe or China," he says. "Security has to be at the forefront of your planning."
As Brazil continues to welcome more foreign companies, and as the country's own businesses expand abroad, many executives expect eventual reforms to the tax and legal systems. Monaghan notes that there are several proposals currently before Brazil's congress that aim to simplify the tax code, but action is not likely to be quick, particularly as the country prepares for a Presidential election in the fall.
Harding says that, despite Brazil's fast growth, the pace of regulatory change has been slower than in some other countries. "The complexities and security concerns that were there 10 years ago are still there," he says. "What has changed is the strength and stability of the market itself."
That strength and stability has won over many CFOs, despite the tax and legal headaches they must often endure. "Brazil has its challenges, as all these emerging economies do, but it has a very bright future," says Hayes. "It's really one of the key markets for us in the next 5 to 10 years."
Kate O'Sullivan is senior editor for strategy at CFO.
No Day at the Beach
Brazil's tax code poses one of the most significant challenges to U.S. CFOs looking to do business there. "Everything in Brazil will tend to have a different applicable tax rate, depending on the type of service or product," says Larry Harding, president of High Street Partners, an international business-services firm that advises companies on overseas expansion. He outlines two hypothetical examples for companies trying to sell into the market from outside Brazil:
Product invoice scenario:
A U.S. company invoices a Brazilian company for a computer-hardware purchase. Once the buyer in Brazil receives the product and related invoice, the buyer will have to pay taxes on the item as follows:
• Importation tax: 16%
• Industrialization tax: 15%
• Social-integration program contribution tax: 1.7%
• Social Security financing tax: 7.6%
• Tax on circulation of goods and services: 18%
Service invoice scenario:
A U.S. company invoices a Brazilian company for a consulting service. Once the customer in Brazil receives the service and related invoice, the customer will have to pay taxes on the service as follows:
• Withholding tax: 15%
• São Paulo services tax: 5%
• Cross-border royalties and services tax: 10%
• Social-integration program contribution tax: 1.7%