Latin America: Land Of Opportunity But Know The Risks

Friday, October 1, 2004 - 01:00

The Editor interviews Steven D. Guynn, Jones Day Chair, Latin American Practice, Kenneth J. Krupsky, Tax Partner, and Mauricio F. Paez, Attorney, focusing on Outsourcing.

Editor: Steve, what has Jones Day been doing recently in Latin America?

Guynn: Latin America is a necessary and growing part of the global law practice of Jones Day, a law firm with more than 2,200 lawyers and offices in the major centers of business and finance. With more than 271 lawyers in New York (now our largest office), more than 200 lawyers in London, and more than 90 lawyers in greater China - Beijing, Shanghai, Hong Kong, and Taiwan, and with mature, advanced and close relationships with institutional clients in the United States, Europe, Asia and Latin America, our active practice in Latin America is inevitable. That is especially true in matters of strategic importance to our clients and has resulted in high levels of activity in M&A, financing work, restructurings, tax planning and outsourcing matters in Latin America for clients of our offices in New York, Washington, D.C., Madrid and several others.

Editor: Are there some notably high profile matters involving novel issues or significant trends?

Guynn: Absolutely. We assisted two major airline clients in their bid to purchase and reorganize Avianca Airlines, the Colombia flagship carrier out of Chapter 11 bankruptcy proceedings in a multi-party, competitive and contentious auction process. It was essential to organize a first-rate team of bankruptcy and M&A lawyers in the U.S., a highly able legal team in Colombia, and a trusted colleague as strategic advisor, the former Colombian Minister of Finance. We faced numerous critical issues including how to create the best structure to address historical pension obligations that were potentially huge. The strategic advisor was able to assist our side in meeting with appropriate governmental authorities at the right time and in the right way. The board of directors of Avianca ultimately selected a Brazilian investor and owner of a Brazilian airline as the new owner of Avianca, but our clients' strategic commitment to Latin American markets and strong management teams remain a highly positive influence on the airline industry in LatinAmerica.

We also represented a major mobile communications company in global outsourcing transactions involving Brazil, Mexico, Colombia,Venezuela and Argentina; a leading restaurant franchisor in the sale of its Kentucky Fried Chicken, Pizza Hut, and Taco Bell assets throughout Puerto Rico, retaining the brand names and the rights as franchisor, in which we helped to resolve a contract consent process that threatened the successful outcome; and a large Mexican manufacturing company in a financial restructuring in Mexico and the U.S. involving an exchange offer of highly creative Contingent Value Rights for all outstanding Debentures.

Editor: Based on this recent experience, what are the main drivers, trends, opportunities and risk factors behind these Latin American transactions?

Guynn: The rule of law is strong in the largest economies in the region. There are many compelling business opportunities in Brazil and Mexico as well as in Argentina, Chile, Colombia and Venezuela, as well as a few others. At the same time, the risks can be challenging, as shown by the losses of European and U.S. investors in Argentina when the peso crisis occurred a few years ago. But there are some imperatives: our clients need access to business expansion opportunities in Latin America, and our Latin American clients require access to the New York and European capital markets.

Finally, every client needs the best tax structuring advice obtainable, and many clients seem to be increasingly interested in outsourcing opportunites. So I have asked two members of our Latin America Practice Team, Ken and Mauricio, to take us through the highlights in each of these areas and to explain what they have done to deliver to our clients unified, cost-effective, and timely solutions to complex legal problems.

Editor: Kenneth, what are some of the international tax planning issues now facing US companies doing business in Latin America?

Krupsky: From a US perspective, several major issues present real challenges. The most prominent is the absence of double taxation treaties between the US and most countries in the region - Mexico and Venezuela being exceptions. A treaty with Argentina was signed in 1981, but has never been ratified by Argentina.

Besides Mexico and Venezuela, Argentina and Brazil have treaties with other major foreign trading partners whose companies compete with US companies. Treaties are important for several reasons. First, they are generally effective to prevent double taxation of the same income by the two countries involved. Most people agree that items of business income should be subject to one level of corporate income tax - either in the home country of the foreign corporation or the Latin American country where the business is conducted. Second, treaties reduce withholding taxes on earnings from cross-border capital flows, such as interest, dividends and royalties. Third, they reduce the risk of local country taxation of transitory or sporadic business operations in the local country, by limiting tax jurisdiction to the case of so-called "permanent establishments." These positive features of tax treaties have proven to work well and stimulate economic growth in all the industrialized nations, but unfortunately Latin America has lagged behind, especially as regards treaties with the U.S.

Editor: How do Latin American income tax systems compare to tax systems elsewhere in the world?

Krupsky: Most countries identify those companies that are subject to local income taxation - i.e., they identify who is the taxpayer. Thus, a company may be taxed on its worldwide income, based either on its "citizenship" (e.g., place of incorporation) or "residence" (place of effective management and control or of a registered office). For example, the U.S. taxes U.S. corporations on their worldwide income, but taxes foreign corporations that have a U.S. trade or business (or a U.S. "permanent establishment" under treaties) only on income effectively connected or attributable to the U.S. business. Major countries such as Argentina, Brazil, Chile, Venezuela and Mexico usually tax on a residence basis.

On the other hand, a few countries, including a few Latin American countries, tax on the basis of the source of the income, not the characteristics of the taxpayer. This means the country taxes all income earned from local sources, even if the foreign company has no real place of business or other nexus to the country. These "source" tax countries include Bolivia, Costa Rica, Guatemala, Nicaragua, Paraguay, and Uruguay. In these countries, local tax liability is generally not affected by whether the business is incorporated locally or abroad, or whether the company involved is a local tax resident.

Accordingly, corporate structuring and business planning need to take careful account of the differences among the tax systems of Latin America. There can be important and differing opportunities and risks presented for investment in both "residence" and "source" countries. When you also layer in the presence or absence of a tax treaty, the situation becomes even more complex. For example, we have seen costly and time-consuming tax controversies, arising from the application of US tax rules to businesses operating in both source countries and residence countries. Careful planning in advance can minimize the risk of such controversies, whether the business is profitable and pays local taxes or has losses that may produce a tax benefit currently or in the future.

Editor: What kind of internal corporate restructurings have you advised on recently in Latin America?

Krupsky: U.S. loss utilization is a major motivation for many recent transactions. While our rules permit U.S.-source losses to offset US-source income within a consolidated tax return, the consolidation rule generally does not apply to income and losses of foreign subsidiaries of a U.S. parent group. So restructuring may be needed to make the Latin American operations tax-efficient.

For example, one of our clients has manufacturing and/or sales operations in Brazil, Argentina, Chile and Uruguay. The existing companies are "sociedad anonimas" ("SAs"), and under the U.S. tax law SAs are not eligible to flow through and offset their income and losses into a U.S. consolidated tax return. However, SAs can be converted to local law "limitadas" without material tax or other costs in each country. A limitada can then produce flow through tax treatment, based on the U.S. "check the box" election. A check the box election treats the limitada as a "disregarded entity" for U.S. tax purposes only and has no foreign tax or other effect. This type of planning minimizes worldwide tax liability.

Editor: What are the tax issues in outsourcing of services to Latin American countries?

Krupsky: The risk arises when a U.S. (or other foreign) company outsources some of its activities to a related or unrelated operation in the Latin American country. The tax issue is the proper attribution (and thus, local taxation) of the global profits of the U.S. company to the local business, even where the business is unrelated. To determine the attributable amount, the local country tax authorities routinely seek the global books and records of the foreign enterprise.

Moreover, international tax treaties limit local taxation to "permanent establishments" - typically, cases where the local business has the power to legally bind the foreign client, for example by concluding contracts, by telephone, with the customers of the foreign client. Unfortunately, only Mexico and Venezuela have treaties with the U.S., and the other Latin American countries do not. Absent a tax treaty, there is little protection from aggressive local tax collectors.

Editor: Mauricio, there have been many reports of a surge in the number of technology outsourcing initiatives by major corporations. Is this a short-term phenomenon or a long-term trend?

Paez: We have experienced a significant growth in the number of major outsourcing initiatives by our clients. IT (information technology) operations remain the most outsourced area. Recent technology innovations (especially technologies that leverage the Internet), modern telecommunications infrastructure, English proficiency, and labor arbitrage (i.e.,the ability of a company to substitute one labor pool for another at lower cost) in other countries will continue to fuel offshore outsourcing. Thus, I believe that IT outsourcing is a long-term trend.

Editor: Will Latin America benefit from this growth as an offshore destination?

Paez: Yes. Latin America will likely experience growth in this area as well, but outsourcing growth will most likely involve the top six markets (Argentina, Brazil, Chile, Colombia, Mexico, and Venezuela). In terms of in-bound services in these countries outsourcing of call centers will likely dominate, with Brazil, Mexico and Argentina leading the way. Another area of interest to our clients is application maintenance and support functions that can be handled remotely. Most clients see these countries as attractive opportunities because of lower labor costs, available expertise, time zone advantages and geographical location.

According to a recent report from Datamonitor, about 12,900 customer service positions are outsourced from the U.S. and Europe into Latin America. Although this pales in comparison to the number of call center agents in the U.S. today, the Latin American call center market is the fastest growing market in the world. Researchers expect call centers in Latin America will grow at an 18% annual growth rate compared to less than 1% in the U.S.

Application development and maintenance is the specialty of Brazilian IT programmers. Although the average programmer total costs is higher than that of India, the labor costs in Brazil are the cheapest in the Americas, representing some 25% percent to 45% percent less than in the U.S.

However, English proficiency appears to continue to be a significant barrier. Despite these limitations, there have been a number of initiatives involving application development, application maintenance, and data center outsourcing.

Editor: What are some of the most significant risks a customer should consider when outsourcing in Latin America?

Paez: Outsourcing in Latin America is not without risk. Negotiating the outsourcing relationship in these markets can be very complex, and requires familiarity with the local business culture, legal requirements, and country risks. Most of my projects involve negotiation of a regional or global outsourcing relationship involving a client with operations throughout the region or around the globe, typically involving a regional or global framework agreement containing master terms and conditions. Obviously, a regional or global master agreement cannot address every local requirement and local practice. Thus, to accommodate local regulatory and service requirements, the master agreement typically provides for the negotiation and implementation of a local services agreement. This is especially true in Brazil, where local law requires a local services agreement. Because our clients have significant operations in Latin America, it has been necessary to require additional protection measures and risk allocation provisions in the local services agreements that protect clients from certain local risks.

In addition to customary provisions, contracting a service provider in this market requires the client to address in the master agreement and the local services agreement (i) country risks (such as political instability), (ii) legal compliance, (iii) data, intellectual property and confidentiality protection, (iv) export controls, (v) currency risks, (vi) taxes, (vii) labor and employment regulatory requirements, (viii) choice of law and jurisdiction for resolving disputes, and (ix) enforceability. These can, and often are, very difficult issues to negotiate and resolve. This also requires effective transition planning and management, requiring the service provider, as a contractual matter, to play a key role in transitioning the services.

Service or performance levels are also a critical ingredient to the outsourcing relationship, as are performance credits in the event the service provider fails to meet the customer's expectations. In addition, a good governance structure is required to manage these and other risks, such as (i) deficiencies in IT infrastructure, (ii) English proficiency and other multi-lingual issues, (iii) limited access to growth capital, and (iv) operational deficiencies. Labor arbitrage poses a significant challenge in managing these risks and in sustaining the labor arbitrage benefit as demand for labor in this market increases.

There are heightened concerns for U.S. companies in highly regulated industry sectors, such as financial services and healthcare. For these companies, outsourcing to offshore entities requires that the company ensures compliance with U.S. industry regulations that are unfamiliar to service providers in Latin America.

Editor: What does the future hold for outsourcing in Latin America?

Paez: Outsourcing, and offshoring in particular, is here to stay. The trend cannot be stopped. For Argentina, Brazil, Mexico, and Venezuela, this presents a significant opportunity to provide offshore and near shore outsourcing services. To take advantage of these opportunities, service providers must leverage technological advances, increase English language proficiency among their workers, and work with the government to increase educational opportunities to satisfy expertise requirements. For customers, this means greater choice among services providers, low cost labor within geographical proximity, and the potential to mitigating risks attendant to offshoring across the globe.

Please email the authors at sdguynn@jonesday.com, kkrupsky@jonesday.com or mpaez@jonesday.com with questions about this article.