But the chill probably will not last for long. Private equity investors may lack confidence, but they have ample funds. Given their business imperative to invest, even if uncertainty lingers, they are expected to ramp up their activity in Latin America in the near to mid-term. National economies are thriving, natural resources and commodities are abundant, and domestic spending by growing populations is on the rise. For those investors who are actively seeking deals, Latin America offers plenty of prospects.
Opportunities in energy, natural resources and infrastructure
Across the region, tremendous opportunities are available in the energy and natural resources sector. Local players are entering joint ventures to help develop production, for example, in Brazilian oil and gas, in Argentine natural gas, and in mining operations in Colombia and Peru. Latin American companies are looking to global producers for capital, training and know-how. They are also seeking to acquire service companies to help build transportation networks, processing facilities and other infrastructure.
Among Latin American countries, Brazil clearly stands out. Even though growth has slowed, it remains one of the most attractive economies in the world. The country has a rapidly expanding middle class with disposable income, credit and an appetite for new goods and services. There are significant opportunities in specific sectors such as infrastructure, which require major investment as the country gears up to host the 2014 FIFA World Cup and 2016 Olympics.
Red tape and other challenges
While the region holds strong opportunities for foreign investors, those based in more developed regions like Europe and North America may find it challenging to do business there. Latin American governments are highly bureaucratic, and investors may be surprised at the amount of formal requirements, detailed paperwork and other red tape that they need to contend with to complete their deals. Sellers in the region are setting relatively high prices, driving acquisition costs higher than they are elsewhere. Foreign exchange controls in some locations can make it difficult to expatriate profits. Foreign investors need to do their homework to make sure they understand the intricacies of their target’s business environment.
Latin America’s developing tax systems also create business challenges. As with the legal environment, tax systems tend to be highly formalistic. In countries like Brazil and Argentina, complex national tax systems are further complicated by the profusion of taxes levied at the state and local levels. Their tax authorities are growing more aggressive in their enforcement and collections efforts, and they are adopting more sophisticated tactics to identify cases of non-compliance.
Rising cross-border tax risks
In the cross-border M&A context, tax authorities are setting their sights on international holding structures, especially those located in lower-tax jurisdictions. Many tax authorities in Latin America and worldwide are challenging these structures based on a lack of business substance in the holding company jurisdiction. With traditional international holding structures under increasing threat, investors seeking to reduce risk should consider using a holding company that has genuine substance where practical, and that has ample documentation to support the underlying business rationale.
Tax authorities are also challenging transactions between local and international related companies on the basis of their transfer prices, especially where profits from national resources such as oil and gas and metals are involved. Transfer pricing disputes are often about how the profits are allocated, based on the amount of value added at each step along the supply chain. Transfer prices should reflect the risks at each stage and be flexible enough to adapt to changing circumstances, such as commodity price fluctuations, that could change the allocation of risk among the various parties.
As part of their due diligence, acquiring companies should assess the potential implications of possible legislative changes that could affect existing transfer prices, especially for targets with high export volumes. For example, scenario modeling should account for the possibility that Brazil is carrying out macro changes in the tax system, including changes to address transfer pricing, goodwill on acquisitions, and the impact of International Financial Reporting Standards.
Keys to success – do your homework and seek local advice
In summary, Latin America’s dynamic markets continue to offer investors opportunities for higher returns, especially in infrastructure projects and in the oil and gas and mining sectors. Given the unique complexities and challenges of doing business in the region, potential investors should seek advice from business and tax advisors with deep local knowledge of the tax system and business environment in target’s home jurisdiction, supplemented with knowledge of international tax enforcement trends and tax-effective global business structures.
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