International Treasurer

The Journal of Global Treasury and Financial Risk Management

March 22, 2004 http://www.intltreasurer.com Treasury & taxation Emerging markets

FX Vols Refocus Attention on VaR

By Nilly Essaides

The dramatic shift in the dollar/euro rate has increased the visibility of FX risk management as well as accelerated the quest for an aggregate measure of risk.

FX Vols Refocus Attention on VaR

By Nilly Essaides
The dramatic moves in the dollar/euro rate have reignited interest in using VaR to help assess the impact of FX on business results.

Managing Treasury And Tax in Brazil

By Susan A. Hillman, Treasury Alliance LLC Lionel Bonner Nobre, Grant Thornton LLP
While the banking infrastructure has been made super efficient, tax and FX regulations make liquidity planning often counter-intuitive.

page 1

Managing Treasury And Tax in Brazil

By Susan A. Hillman & Lionel Bonner Nobre

Sometimes, it takes a 20 percent move in the currencies to show you the FX exposures you did not know you had, an FX manager recently commented. But thats the last way management wants to find out just how critical FX is to its financial performance. Even companies with an EPS sensitivity to FX of 3-5 percent (i.e., the potential impact of FX were they not hedging) say that they are under increased pressure to insulate quarterly results from the impact of currency shifts. The visibility of FX risk management has increased, asserts Ade Odunsi, director at Merrill Lynch risk advisory group. The US dollars decline has highlighted the shortcomings of some US corporate hedge programs in an environment of prolonged US dollar weakness. Large negative mark-to-market losses on hedges have both a negative impact on cash flow and an opportunity costi.e., if a rival firm has not hedged this would likely give it a competitive advantage. FX options offer a flexible solution to these problems, but their use has been in decline in recent years, largely for the wrong reasons (many managements consider them relatively expensive). Not coincidently, the dollar/euro trend has also driven greater interest in how VaR can help frame the discussion of business sensitivity to FX. The role of VaR is to provide an indication of how bad things can get, Mr. Odunsi says. Wide vs. narrow VaR lens There are numerous ways to look at risk via the VaR lens: On the narrow end, treasury can use VaR to look at the worst-case scenario of only the
continued on page 3

Despiteor perhaps because ofa volatile economy and currency and an onerous regulatory/tax environment, Brazil has given rise to excellent financial professionals who operate with a banking system that has long been one of the most sophisticated and electronic in the world. Yet the existing regulatory and tax constraints can make it difficult to manage local liquidity effectively. Excess cash can be a significant problem, as well as an unwanted exposure from the parent company perspective; meanwhile, funding deficits in the Brazilian operations cash flow is not a straightforward exercise. Banking structure Brazils banking system is renowned for its efficiency. During the 70s, the large banksled by Bradescoworked to link far-flung branches and provide timely clearing of checks. As a result, clearing zones throughout the country are completely integrated, and checks can clear nationwide on an overnight basis. Today, checks have been nearly entirely replaced by electronic payments. Most companies pay using some type of bloquete or duplicata, which is a multipart form issued by the seller, or the sellers bank. The buyer uses the form to pay at any bank in the country. The bar-encoded form is processed through the clearing system for credit to the sellers account. Over the past few years, economic uncertainty and the fallout from Argentinas collapse have dramatically altered the local banking scene. Banks have new owners; some foreign banks have dug in more deeply, while others upped
continued on page 6

While Brazils banking system is highly evolved, tax regulations and exchange controls make liquidity planning a complicated and sometimes counter-intuitive task.

page 1

More Time to Pull Up Your SOX

By Joseph Neu

The SEC gives firms (and their auditors) more time to comply with Sarbanes-Oxleys internal control mandates and understand how to determine their effectiveness.

page 2

Anticipated Exposures
Credit derivatives; FTC ruling; and more.

page 4

Turning Cold Money into Hot

The recovery in Japan is for real,and it will likely help shift the balance of economic and monetary power back to Asia.

page 5

Editor & Publisher Joseph Neu Research Director Nilly Essaides Advisory Board Barbara Hill Vice President, Treasurer Adobe Systems Mark Rawlins Senior Director, Corp. Fin and Risk Management Anheuser-Busch Companies James Haddad VP-Corporate Finance Cadence Design Systems Nancy Fox Director, Global Cash Managment Deutsche Bank Peter Marshall Partner, Global Treasury Advisory Services Ernst & Young LLP David Rusate Deputy Treasurer General Electric Company Jeffrey Wallace Managing Partner Greenwich Treasury Advisors Martin Trueb Senior VP & Treasurer Hasbro, Inc. Kala Srinivasan Assistant Treasurer Intel Corp. Stephen I. Piccininni Senior Vice PresidentTreasury Marsh Inc. Darin Aprati Director of European Finance McDonalds Corporation Peter Connors Partner Orrick, Herrington & Sutcliffe LLP Robert Vettoretti Director, Treasury and Financial Management Services PricewaterhouseCoopers LLP Roger Stewart Vice President-Global Treasury Procter & Gamble Orville Lunking Treasurer Smithfield Foods Inc. Susan A. Hillman Partner Treasury Alliance LLC Michael Collins Managing Director UBS Academic Advisors George Allayannis University of Virginia Gunter Dufey University of Michigan Donald Lessard Massachusetts Institute of Technology Richard Levich New York University The company and organizational affiliations listed above are for identification puposes only. Advisors to International Treasurer are not responsible for the information and opinions that appear in this or related publications and web sites. Responsibility is soley that of the publisher.

Editors Notes
Regulatory watch by the CFOs of five accelerated filersi.e., Microsoft, Procter & Gamble, Cardinal Health, Costco Wholesale and W-D 40for making this practical dilemma clear. In particular, we believe it will be very difficult for companies and auditors to properly implement the new rules for a fiscal year that is nearly complete when the Auditing Standard is final, the corporate commenters noted. As they pointed out: if a June 30 fiscal year end company were to determine, as of March 31, that some key controls require remediation, or that their assessment must include additional testing based on a fresh interpretation of the final rules, the first quarterly close in which testing could occur would be as of June 30, 2004. At that date there will be a genuine, serious question as to whether the company and the auditors will have observed the control in operation for a reasonable period of time sufficient to conclude the control is effective. It comes down to effectiveness testing. The inability to make an effectiveness determination in such a short time, the commenters noted, could result in a modified report that could have unintended capital market consequences, despite the fact that the control in fact after passage of a reasonablc period of time would be proven effective. The letter also pointed out that the definitions of significant deficiency and material weakness, which are to be used in qualifying assessments of effectivness, are not consistent with the definition of internal control over financial reporting in the proposed Auditing Standard and that the definitions are causing considerable confusion among registrants and their auditors. Treasurers may again wish to analogize with FAS 133 (IT, 10/6/03) and never let up on efforts to understand or challenge auditor intepretations of AS 2s effectiveness guidelines.

More Time to Pull Up Your SOX

By Joseph Neu he SEC decided last month to delay the compliance deadline for SOX Section 404-mandated rules concerning Managements Report on Internal Control Over Financial Reporting and Certification of Disclosure in Exchange Act Periodic Reports. The impact varies, depending on a companys filing status: Accelerated filers (i.e., fiscal years ending on or after June 15, 2004) must comply for the fiscal year ending on or after November 15, 2005 (vs. 5/15/04). Non-accelerated filers must begin to comply for first fiscal years ending on or after July 15, 2005 (vs. 4/15/05). A foreign private issuer that files its annual report on Form 20-F or Form 40-F must begin to comply with corresponding requirements for the first fiscal year ending on or after July 15, 2005. Time to sort out audit requirements. As a practical matter, the delay will allow audit firms and their clients more time to digest the rules governing internal control audits, and hence compliance objectives. These rules were finalized March 9 by the Public Company Accounting Oversight Board (and must be endorsed by the SEC) in Audit Standard No.2: An Audit of Internal Control Over Financial Reporting Performed in Conjunction with an Audit of Financial Statements. Based on the accounts of many treasurers (IT, 11/17/03), auditors, lacking a clear idea under the prior proposed standard, were running the socks off their compliance teams in an attempt to cover all the bases. Time was running out in a race to an as yet unmarked finish line. Thanks to some early adopters. In announcing the delay, the SEC credited a January 23, 2004 comment letter signed

New Advisors
We are pleased to welcome the following new members to our editorial advisory board: Barbara Hill, vice president, treasurer of Adobe Systems; Mark Rawlins, senior director of corporate finance and risk management at Anheuser-Busch; Nancy Fox, director and US corporate senior sales manager for global cash management with Deutsche Bank; Peter Marshall, partner with Ernst & Youngs global treasury advisory services practice; Robert Vettoretti, director for treasury and financial management services with PricewaterhouseCoopers; Roger Stewart, vice president-global treasury for Procter & Gamble; Michael Collins, managing director and head of corporate equity risk management at UBS; and George Allayannis, associate professor at the University of Virginias Darden Graduate School of Business.

ISSN:1075-5691 Vol. 11, No. 3 2004 The NeuGroup, Inc. 135 Katonah Avenue Katonah, NY 10536 (914) 232-4068 Fax (914) 992-8809 backoffice@intltreasurer.com http://www.intltreasurer.com

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Risk Management
Refocus on VaR, continued from page 1

derivatives portfolio; some treasuries are utilizing VaR models to optimize their hedge programs, i.e., identify efficient strategies. But perhaps most important is the potential use of VaR as a way to generate a probabilistic forecast of the underlying business performance, i.e., not just FX and interest rates but taking into account the volatility of operating results, says Mr. Odunsi. This approach produces a more objective way to stress the business model. Yet, its not how it is widely used at this stage. A recent unscientific poll of over 20 corporate treasuries supports this notion: For the most part, companies use VaR to help quantify FX exposures, not to look at their business across risk or asset types. Designer models? The next generation of models will go beyond FX or interest rates to stress the business model, including items such as pensions, legal liabilities, etc. Theres a move to build models to bring all of these risks into a single perspective, says Mr. Odunsi. Banks have been at the forefront of developing sophisticated models, but for corporates, ultra-sophisticated designs may get in the way of practical application. It is so complex and almost nebulous so that pushing the envelope on model design is not necessarily the way to improve VaRs applicability. Simpler models can provide valuable information when used in the right way (e.g., by complementing with stress testing). Plus, they will be easier to explain to a CFO. Indeed, highlighting the need for a different approach for corporates is that much of their

risk is made of brick and mortar, and a daily exit is not really an option. FX risk managers concur: We dont care about what happens overnight, or even in one week, notes one practitioner. What we care about is the next quarter and the year. Taking measured steps Perhaps the greatest hurdle for corporates in using VaR is the time/intellectual demands of building a detailed VaR model.
The crux of VaR is building the business model for your exposures and how they feed into the financial statements. The statistical part can be as complex or simple as you want it to be, but what takes time and skill is getting the information and building an accurate business model, says Mr. Odunsi.

VaRs Achilles Heel

A key weakness of currentday VaR models is that they tell managers about probabilities of an outcome, but nothing about the really important questioni.e., When that five percent event happens, what will be the expected cost to the business? says Ade Odunsi, a director with Merrill Lynchs risk advisory group. This is like trying to value an option with a far out-ofthe-money strike, he says. Financial techniques have been developed to answer this question; however, corporate focus remains on regular VaR; it may only be a matter of time before an inquisitive CFO asks the question, how bad is bad? For corporates, a simpler approach may be to drill down to identify concentration of risk and use stress testing to see how these risks affect performance under different scenarios. The real problem then is how to define the universe of tail risks. One possible approach: Focus on the scenarios which keep senior/business management up at night, one FX manager recommends. I T

To this end, Mr. Odunsi offers some tips: (1) Be scaleable. Whatever treasury builds must be able to survive people and business model shifts; (2) Be simple. Start simply and get management used to thinking in VaR terms by looking at basic confidence intervals for probable scenarios; it may also help to initially focus on unhedged exposures. Its a halfway house, which makes it easier to get the VaR concept accepted into the management decisionmaking process; and (3) Be realistic. Finally, use stress testing to highlight risk concentration, but also to model the impact of changes in market rates on business performance. Its often easier to build that into a stress test scenario rather than the actual VaR model, Mr. Odunsi says.

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Anticipated Exposures
credit risk management system and infrastructure that would support the trading of credit derivatives, Mr. Josephson reports. Operational responses instead Three years of severe credit strains in the supply chain have pushed many corporates to improve their credit risk management approach. However, the response has been largely operational, in the form of more sophisticated analytical models, which place limits on risk concentration or require collateral. If the recent spate of bankruptcies has not driven companies into the credit derivatives market, what will? Here are a couple of reasons why companies may up their credit derivatives market activity: (1) New transparency. One possibility is that the development of exchange-traded products would generate corporate interest. Granted, corporates have never been big users of exchange-traded derivatives, preferring the flexibility of the OTC market instead. Yet dealers ability to lay off risk has indirectly created greater transparency and stability, in turn making derivatives more acceptable to the conservative corporate crowd. (2) System migration. Another motivating factor may be emergent corporate credit risk management systems. Its important to remember that the transformation of IR and FX risk management systems from bank to corporate world has taken over a decade and is still ongoing. Still, says Mr. Josephson, while the participation of corporates stands to increase, the extent of their participation is not going to approach that of banks and other dealers. I T
Treasury & taxation

Credit risk management

Credit Derivatives Spike

recent report on the evolution of the credit derivatives market (Credit Derivatives: Friend of Foe) from Celent Communications contains some very good news: Dramatic growth. Measured in notional outstanding, the market has grown from $800 billion in 2000 to over $2 trillion in 2002; Surging confidence. The manner in which the market withstood the two largest bankruptcies of all time (Enron, WorldCom) has lent it increased credibility; and Signs of maturity. Finally, the development of exchange-traded products will drive growth and liquidity. All this will help attract participants; however, will the market provide a practical way for treasurers to manage their credit exposures? Credit derivatives are becoming liquid and efficient as a means of hedging risk, asserts Celent Analyst, and report author, Adam Josephson. But while banks and insurance firms are increasingly active, corporates only account for a fraction of the market. Banks come a calling... Treasury practitioners report increased activity by bank credit derivatives sales reps. Most say that they have looked at the products but are yet to actually use them. When credit derivatives are used, it is typically in a very limited and unique circumstance, for example to hedge the counterparty risk in tax transactions which typically involve very large notional amounts, hence counterparty risk concentration. It has to be fairly big to consider it; its not something that we use in the normal course of business, notes one treasury practitioner. While there are plenty of other reasons treasurers may want to utilize credit derivatives (reduce risk to portfolios of receivables or hedge debt issues), most corporates do not have a formal credit policy complete with a

Backtracking on FTCs?

n February, the IRS repealed notice 98-5 (with Notice 2004-19). In some ways the repeal is inconsequential: While 98-5 was highly controversial (see IT, 2/16/98), no regulations were ever published to support it, and it has

since been replaced by a host of other anti-abuse rules (see below). With Notice 98-5,the issue was: for every $10 of tax credits, was there a need for a pre-tax profit on the underlying transaction, and if so, how much? explains Peter Connors, a tax lawyer with Orrick, Herrington & Sutcliffe LLP. While in general, the practice of backtracking on past Administrations rulings is worrisome, says Keith Martin, a tax lawyer with Chadbourne & Parke, he too sees the recent notice in a positive light: The trouble with 98-5 was that it adopted a mathematical test for looking at two broad classes of transactions, he says. The new approaches take a principle-oriented stance. Bright-line tests pull into their net things that do not belong there while leaving room for further gaming. The IRS clearly does not intend to give up on abusive FTC structures. In Notice 2004-19, it lists the following existing tools that it might use: Substance over form doctrine; The step transaction doctrine; Debt-equity principles; Section 269; Partnership anti-abuse rules; and The substantial economic effect rules of 1.704-1. The Administrations FY 2005 Budget also includes a proposal for broad regulatory authority to address transactions that involve inappropriate separation of foreign taxes from the related foreign income in cases where foreign taxes are imposed on any person with respect to income of an entity, says Mr. Connors. Unfortunately, there are still circumstances in which US MNCs cannot fully utilize legitimate FTCs. The only remedy is to use tax-deferral structures, says Mr. Martin, though that might lead to cash and retained earnings getting trapped offshore. A proposal that would allow a onetime, 5.25-percent repatriation (see IT, 1/12/04) meanwhile, is still bogged down in the Congress, as part of the FSC/ETI bill. I T
International Treasurer / March 22, 2004

Anticipated Exposures
Economic outlook though nominal sales have declined steadily since 1979. Thats good news for Japanese companies but not necessarily good news for foreign competitors, since it has involved a tightening of the supply chain relationships; which already made it difficult for non-Japanese players to break into the market. Supply chain restructuring is only half the story, though. The other is the restructuring of corporate balance sheets: Since 1996, most of [corporate debt] has been paid back, Mr. Koll reports. Debt repayment by corporate Japan has been almost 40 percent of GDP; in the US, post the S&L crisis, the equivalent was 10 percent. With the bulk of debt now paid back, the local banking sector has also recovered. By March of 2005, the money center banks in Japan will have clean balance sheets, he predicts. Cash-flow positive and with record profits levels and healthy balance sheets, Japanese multinationals will start using their cash flows for buybacks, dividends and business investment. The FX policy impact Japanese monetary policy has been highly unorthodox. Given a 0 percent interest rate, banks have basically had an infinite borrowing capacity, but that has not jumpstarted economic activity because the Japanese dont borrow. It has, however, given the Bank of Japan (on behalf of the Ministry of Finance), a carte-blanche to intervene in the FX markets, with the hope of halting any yen surge against dollar-pegged, neighboring Asian currencies. The Japanese are running a de facto pegged exchange rate with a downward bent, and they are determined, and capable of maintaining that rate, says Mr. Koll. The MoF is desperate to keep the currency stable. But thats not where the BoJ has stopped its unusual brand of central banking. It has used its large coffers to buy Japanese companies equity and has been lending directly to small and midsize companies. It has also foot the bill for the recapitalization of the banks, and has bought up as much as 40 percent of government bond issues. None of this sits well with traditional economists and other central bankers. We have found only three central banks in history that have bought more than 20 percent of their government debt, says Mr. Koll: Turkey, Argentina and Venezuela. The methods may be controversial but the results are incontrovertible: Bankruptcies are declining. Cash is growing on corporate balance sheets, and Japanese consumers may finally take the money from under the mattress and generate domestic demand. The velocity of circulation is going to start to increase. Years of deflation have given consumers every incentive to take money out of circulation. A change in inflationary expectations will help turn cold money into hot. The indicator to watch is nominal GDP figures: Once that starts to grow, the BoJ will begin to raise rates, he says. Heres the catch... The future is not all rosy for Japan, of course, even if one buys this set of arguments. Mr. Koll admits that the debt coverage ratio for the government is high, a fact that will ultimately catch up with the economy and can be resolved in one of several ways: defaults (unlikely), inflation (the most likely one) and/or some unconventional approach such as forcing longterm demand deposits into mandatory zero-rate fixed time deposits. And then, the China card... Ironically, the cheap labor costs in nearby China (a source of much angst in the US) is not as troubling for the Japanese. Twelve percent of Japans production capacity is already in Japan, Mr. Koll says, yet companies find that for the next level of product, they cannot find the engineers in China. In addition, as China becomes a normal developing economy, it develops the prototypical logistics bottlenecks, he says. Chinas factory of the world status will affect regional and global exchange rate dynamics, however. The official word from Merrill and other banks is that the yuan will be adjusted upward in the next 12-18 months. Mr. Kolls predicts no such thing (and recent trade data supports his forecast). He does expect the yuan to take over the dollars pivotal FX role: Over the next 30 years, the yuan will become the anchor currency of the world. If, for example, 90 percent of the worlds semiconductor production takes place on its shores, what prevents China from forcing pricing in yuan? Ditto for its vast holdings of foreign (read: US) government debt. I T

Japan: Turning Cold Money Into Hot

eports of Japans loss of competitive edge may have been exaggerated: Thats the key message from Merrill Lynchs Managing Director and Chief Japan Analyst, Jesper Koll. The implications for US MNCs are twofold: (1) They will face growing competition from their Japan-based brethren; and (2) The China/Japan axis and resulting shifting of the balance of power in the FX markets will create new financial risk management challenges. Its for real... In a recent presentation before the members of the FX Risk Managers Peer Group (The FXMPG is a group of 15 leading companies FX risk managers facilitated by the NeuGroup) the message from Mr. Koll was very clear: Japans economy is staging a comeback; its for real; and as Japan regains its economic footing, it will help orchestrate a shift in global power back to Asia. Japans turnaround is for real this time around, he asserts. He forecasts growth of 3.5-4 percent in the next 15-18 months. He also predicts that by 2007, Japan will be one of the highest-inflation nations in the world. Inflation in Japan? The economic argument behind the forecast is that the current economic recovery in Japan is different from past, orchestrated (and not sustainable) efforts; it is also combined with Japans decoupling from the US economy: In the past, the only way for the local economy to pull out of recession has been via an export-led recovery and mainly to the US. This has been a vary narrow transmission mechanism, and 65 percent of that was car-export related. The current cycle may have been kickstarted by exports, Mr. Koll concedes, but 85 percent of export growth in Japan has been to China. Exports to China are of a different nature: The export channel is broader and more diversified. It includes steel, textiles, machinery, etc. Meanwhile, local corporates have plenty to show for years of deflationary economics. Contrary to popular opinion, Japanese companies can restructure, Mr. Koll notes. Corporate operating profits have recently hit record highs, even

International Treasurer / March 22, 2004

Emerging Markets
Managing in Brazil, continued from page 1

Key FX controls
The following apply to specific transactions: Borrowing from abroad is allowed, but terms/rate must receive Central Bank approval (can be done ad hoc). Repatriation of capital is not restricted for capital registered with the Central Bank, but the bank can prohibit/restrict this during times of extreme economic crisis. Remittance of dividends is allowed at the FX sell rate in effect on the date of the transaction; there is no withholding tax, but it is not deductible from the Brazilian subs taxes. Remittance of royalties and fees requires prior registration and certification. Funds sent to parent companies are limited to 5 percent of gross receipts from the product sold (for tax deductibility purposes by the Brazilian subsidiary); there is a 15 percent withholding tax, plus the Brazilian importer is responsible for an additional 10 percent surtax, which does not qualify as a foreign tax credit for the beneficiary. The authorities are still very suspicious of these transactions and scrutinize them carefully, specially if they occur with the so-called low tax jurisdictions. Intercompany netting is not allowed. Offshore accounts are allowed for legal entities only, as long as they are duly disclosed to banking and tax authorities. I T

and left. Two of the most longstanding foreign banks in Brazil, Citibank and BankBoston (Fleet), still operate aggressively in the country. However, Fleets commitment may come into question, in the wake of its acquisition by Bank of America, which has closed its own local commercial banking operations. Lloyds Bank, a local for over 140 years, pulled out, as did Deutsche Bank. Two Spanish banks (Banco Santander and Banco Bilbao Viscaya, or BBV) entered the market at around the same time and fought for dominance. The emerging winner is Santander: It is now the third largest bank in Brazil (in terms of assets), due to its acquisition of Banespa (Banco Estado Sao Paulo). As a result, perhaps, BBV pulled out. ABN AMRO took over Banco Real and still has a strong presence, as does HSBC, which bought Bamerindus. Overall, however, foreign bank control of the Brazilian market has shrunk from around 30 percent to about 20 percent. The major Brazilian banks, Bradesco, Itau and Unibanco are the major retail institutions, but also cater to both local and multinational businesses. Exchange controls Although relaxed to a certain extent in recent years, local exchange controls remain cumbersome and complicated (for a list of specific regs which apply to treasury transactions, see box on left): Documentation and reporting requirements are strict and done electronically. Only importers and exporters are allowed to purchase foreign currency through a financial institution duly authorized to operate in the exchange market. Any FX transaction must be authorized by the Central Bank. For payments made in respect of imports, all importers must be registered with the Technical Exchange Coordinators office in the Central Bank, as well as with the competent Import-Export authority. However, each importation must have an import license. Restrictions have eased on the import of capital goods and equipment. Each FX contract is linked with the customs declaration. Two interconnected systems at the Central Bank SISBACEN for FX and SISCOMEX are used to track customs decla-

rations, and allow the importers/exporters and customs brokers to electronically report and monitor transactions. However, the electronic transaction should be duly supported by physical documentation presented to the Central Bank for the FX to take place. Counter-intuitive Implications Although the banking system provides efficient cash management services, the restrictive FX and tax regimes (for a list of key tax rules affecting liquidity operations, see box on next page) turn the relatively straightforward task of liquidity management into a complex exercise. Ironically, the resulting Brazilian liquidity rules of thumb are counterintuitive for many treasury managers: Companies with excess cash: (1) No overnight sweep benefits. Theres no real benefit to moving excess cash into overnight money market accounts daily. In order to break even (given the IOF and CPMF tax impacts), funds can really only be invested for a minimum of 28 days. Excess cash also creates a significant exposure from the parent company perspective. (2) No centralization benefits. Theres also no advantage for centralizing the liquidity management of separate legal entities because this would subject the centralized account to a 0.38 percent CPMF tax on either end of the transfer (i.e., the funds would be double taxed). Companies can set up zero-balance accounts with their banks, for same-legal entities with multiple offices or locations. This arrangement would have no CPMF or IOF implications as long as the sub account holders are part of the same legal entity (i.e., a Limitada-type company). Companies in a net-operating loss: A Brazilian operation in a net operating loss position has three basic alternatives: (1) Local bank borrowing (2) Intercompany lending (3) A capital injection. Each has different accounting, exchange control and tax implications (see chart next page). Since intercompany netting, the other handy liquidity/risk management tool, is not permitted in Brazil (see box on left) these three options are the only ones available. (1) Local borrowing is an essential risk manInternational Treasurer / March 22, 2004

Emerging Markets
agement tool in an environment like Brazil. However, there are some difficulties with local borrowing at local rates, in addition to the mere relatively high cost of funds: The local tax bite. CPMF and IOF taxes will apply (see box on right); Debt covenants. US companies that have loan covenants in place may find they are restricted in their ability to borrow locally; Limited liquidity. Finally, available funds disappear rapidly when theres a threat of devaluation. (2) Intercompany loans. Businesses in a NOL position cannot immediately deduct the interest on interco loans, while the interest income in the US is subject to tax at essentially 34 percent. There is also 15 percent Brazilian withholding tax on the interest that would need to be creditable on the US return. In essence, interco loans have a 34 percent out-of-pocket tax loss (on the US interest income) that would not exist if capital were injected instead. Also, from the Brazilian operations perspective the dollar-denominated debt is a transaction exposure. On the local financial statements, the currency variation must be booked as an expense or gain for the subsidiary on a monthly basis. There is a strict local currency-dollar correlation in the case of loan amounts (adjusted on a monthly basis), when compared to capital. This (assuming that the sub is local-currency functional) would translate into US GAAP FX gains/losses upon remeasurement of the dollar-denominated interco loans. (3) Capital injection has fewer negative implications from an accounting, cost or tax perspective, but it may be more administratively cumbersome. If the funds are sent to Brazil as capital they are immediately converted into local currency and frozen at the FX rate at the time of remittance; they will remain so in the subsidiarys financial statements until they are repatriated. As long as the capital is registered with the Central Bank, there should be no problem in repatriating funds (although this may be slow with the threat of a devaluation). US multinationals can register a set amount and then send it in incrementally throughout the year, thus avoiding the paperwork and documentation thats required each time a new capital injection application is made. However, accurate forecasting and planning is required (the amount registered must be sent). Sending in too much cash would result in flooding the sub with cash, and (see earlier section), very few alternatives for investment; too little cash would create transactional costs and may force the Brazilian operation to seek emergency funding locally at a very high interest rate. Seeking: tax effective funding. In summary, the day-to-day cash management and banking in Brazil will never be an issue; the banking infrastructure and savvy of financial professionals insure efficiency. The overall cash position of Brazilian operations is the much larger consideration, and needs to be carefully evaluated by the US parent: Excess cash is disadvantageous , and operating at a loss may be the better alternative. Its a good idea to have local credit lines in place as a safety measure; however, periodic capital injections appear to be the most tax effective way of funding the shortfalls in a Brazilian operation.
Susan A. Hillman is a Partner of Treasury Alliance LLC (sahillman@treasuryalliance.com) Lionel Bonner Nobre is a Director of Grant Thornton LLP (lnobre@gt.com)

Key tax regs

The following taxes are critical to treasury liquidity management operations: CPMF. Reinstated in 1999 and recently extended to 2007, CPMF is assessed on all debit transactions from a bank account held by a nonbank entity (e.g., finance, factoring and leasing companies). All payments made from a bank account by check or transfer are taxed at 0.38 percent, payable at sourcei.e., the bank debits the amount from the account on payment. The tax is on any bank account debit, whether it is for a vendor payment, payroll, or investment movement. IOF. Another tax on financial operations, IOF, also extends to non-bank institutions, affecting intercompany loans or direct loans from companies to non-related businesses or individuals. The rates are .0052 percent for companies and .0175 percent for individuals and factoring companies. This tax affects companies using intercompany borrowing or offsets as a financing method. It also affects leasing businesses. However, the IOF tax typically does not apply if the parties to the transaction are foreign. ISS or Local Service Tax is a municipal tax, which varies by location, with rates between 2 and 5 percent. The ISS is included within a banks charging structure. Most bank services related to collections, payments or credit cards include an ISS charge. This can influence where a company will locate their bank accounts. I T

TAX, ACCOUNTING AND RISK MANAGEMENT IMPACTS OF ALTERNATIVE FINANCING STRATEGIES

Funding Type
Local Loan

Acct. Impact
Maintained in local currency

FX Regs
None

Tax on Funding
IOF

Tax on Usage
CPMF

Treasury Impact
Cost, availability, guarantees

Capital injection

Converted & maintained in local currency Indexed to US dollar

Registered w/ Central Bank

None

CPMF

Forecasting, timing, US parent exposure

Interco loan

Registered w/ Central Bank

IOF

CPMF

Exposure for the local operations

International Treasurer / March 22, 2004

Spring 2004 Meeting

FX Managers Peer Group

February 25-26, 2004

We would like to thank the participants at our Spring 2004 FXMPG meeting for their open dialogue and relevant contributions to our discussions. Your active involvement continues to make the FX Managers Peer Group an unqualified success. Thank you!
The FXMPG is a NeuGroup meeting alternative.
SM

Sponsored by:

Facilitated by:

N euGroup
the publisher of
International Treasurer

The