Enhanced Cartel Enforcement Rules Target Executives’ Homes
By Anthony Rosen (McDermott Will & Emery, London)
Both the European Union (EU) and the UK government are placing a high level of emphasis on combating international cartels. In 2002, the European Commission enforced cartel decisions against more than 50 companies and imposed fines on several companies amounting to more than €1bn. Last year, the UK government imposed its first ever cartel fines in a series of decisions. These authorities have stated that they intend to expand their fight against cartels and abuses of dominance. With this in mind, the Commission published revised leniency guidelines in February 2002 and plans to expand its enforcement tools by strengthening its information gathering powers. The UK government also announced a groundbreaking set of reforms to combat cartels; therefore, it is crucial that companies are aware of the extent of these powers.
Executives’ Homes Subject to Dawn Raids
A sweeping reform of European competition rules will have a major impact on the Commission’s powers of investigation by giving it the power to search executives’ homes. Until now, company directors had to submit to unannounced inspections of their business premises that were carried out by Commission officials with or without notice (so-called dawn raids). These same executives, however, knew that sensitive documents they may have kept at home were beyond the reach of the inspectors. Recognising that this may frequently arise and the detection of infringements of the competition rules is becoming increasingly more difficult, the Commission sought to enhance its powers of investigation in this area. Consequently, the Commission was granted the power to carry out raids on other premises, including homes of directors, managers and other staff members of companies suspected of infringements. This draft council regulation was published in December 2002 and will come into force in May 2004. The Commission, however, must have reasonable suspicion that incriminating evidence may be held there. This should improve the Commission’s chances of gathering evidence of unlawful activities.
Criminal Liability Imposed on Executives
Simultaneous with the modernisation of European antitrust enforcement, the UK government criminalized “hard-core cartels” (i.e., price fixing, market allocation, limiting production and bid rigging) for individuals involved. The individuals responsible for these agreements will be subject to imprisonment for a maximum of five years, to a fine or both. The new legislation will enter into force in late spring, early summer 2003. Along with this development, the powers of investigation available to the Office of Fair Trading in the United Kingdom (OFT) were also strengthened. Inspectors will be able to search homes, use reasonable force to enter any premises and wire tap suspected individuals in order to discover cartels. This new “cartel offense” will remain separate from UK competition law investigations that will remain similar to EU investigations.
Authorities Expand Information Sharing Capabilities
The EU reforms also provide for increased information sharing between national competition authorities (NCAs) to improve the effectiveness of their enforcement effort. Bilateral (and in some instances multilateral) cooperation has also increased between the European Union and the U.S. Department of Justice, the EU and Japan, as well as between the EU and Australia, Canada, Russia and Switzerland. This cooperation would include each authority notifying the other of enforcement activities, exchanging information that would facilitate effective enforcement, assisting and even coordinating investigations (to the extent compatible with local laws), as well as holding regular meetings to share information on current activities, policy developments and other matters of mutual interest relating to competition laws. This improved information flow between the various competition authorities will require parties to supply consistent responses to the different authorities and will also inhibit any efforts by parties to hide data and information.
These reforms represent a clear statement from the Commission and the UK government that they intend to increase their enforcement efforts and expand their fight against cartels. Companies should re-evaluate their exposure by carrying out antitrust audits, as well as putting in place or reviewing compliance programs to ensure conformity with EU and U.S. antitrust rules. U.S. companies must ensure that any European subsidiaries are complying with European cartel law and are prepared in the event of a dawn raid. Equally, EU companies must review their existing procedures to be certain that they cover these major reforms. The European regulators are serious about cartel enforcement and will severely punish any violations. These reforms clearly raise the stakes, and companies must act now to minimize any potential exposure to fines.
FDA Challenges Food and Beverage Manufactures Worldwide
By Jay Taylor (McDermott, Will & Emery, Washington, D.C.)
On February 3, 2003, the U.S. Food and Drug Administration (FDA) proposed regulations implementing the Public Health Security and Bioterrorism Preparedness Act (BPA). The act establishes an information gathering system designed to allow the FDA to conduct more detailed surveillance of the United States’ food and beverage distribution system.
Issues in the proposed system affecting businesspeople include the registration of U.S. and international food and beverage producers and manufacturers as well as the submission of prior notice by importers or purchasers of most food and beverages imported into the United States. The new requirements, particularly the detailed prior notice provision, present a potential burden for food and beverage companies worldwide. The FDA estimates that 202,000 U.S. and 205,000 international facilities will be affected by the BPA’s registration requirement, and more than 77,000 importers and consignees and 100,000 international manufacturers will be affected by the prior notice system.
Facilities will be subject to the proposed registration requirements if they produce products such as fruits, vegetables, fish, dairy products, eggs, raw agricultural commodities, animal feed (including pet food), food and feed ingredients, dietary supplements and ingredients, infant formula, nonalcoholic and alcoholic beverages, canned goods, live food animals and snack foods.
U.S. and International Company Registration
Section 305 of the BPA would require all U.S. food and beverage facilities that manufacture, process, pack or hold food for human or animal consumption, whether or not food from that facility enters interstate commerce, to register with the FDA by December 12, 2003. The same deadline applies for international facilities exporting to the United States. Facilities that must register include those that produce any foods and animal feed products regulated by the FDA. An example of affected facilities are those that produce dietary supplements, infant formula, alcoholic and nonalcoholic beverages and food additives. The proposed rule exempts farms, restaurants, retail and nonprofit food establishments, in addition to facilities such as slaughterhouses and other meat or poultry processors, which are regulated entirely by the U.S. Department of Agriculture (USDA).
International facilities will be exempt from the registration requirement if their food and beverages undergo further processing or packaging by another international facility before exporting products to the United States. However, if the further processor merely affixes a label to the initial processor’s product, both the initial international facility and the company performing the de minimis activity must register with the FDA.
Prior Notice Registration Requirements
Section 307 of the BPA requires the purchaser or importer to register with the FDA all food and beverage shipments imported or offered for import into the United States beginning December 12, 2003. By requiring this type of prior notice, the FDA seeks to enhance its ability to detect accidental and intentional contamination of food and beverages as well as to deter deliberate contamination of U.S. food and beverage supplies by providing FDA inspectors with adequate time to respond to shipments that might be adulterated.
Importers or purchaser must register an import by 12:00 p.m. the day before its arrival at a U.S. port, and not more than five days before the importation. If prior notice is not submitted to or received by the FDA, the food or beverage will be refused entry into the United States. The products will also be held until adequate notice is provided. Until the U.S. Customs Service implements its automated customs environment and synchronizes it with the FDA system, importers will be required to file separate prior notices with both agencies.
Proper notice must include information such as the name of the firm and individual submitting the notice; U.S. Customs identification numbers for the shipment; identity of the article of food or beverage; the manufacturer’s name; and the names of all growers. The notice must also include information including the country of origin, the shipper’s name, the country from which the food was shipped and the names of the importer, owner, consignee and carrier. One amendment may be made to the notice of importation no later than two hours before the arrival of the shipment, and the amendment may not be used to change the nature of the product.
If affected businesses fail to register by the December 12, 2003, deadline, they may be subject to a FDA civil or a criminal action. Food and beverages imported to the United States from unregistered international facilities will be held at the port of entry. Imported foods or beverages not proceeded by proper notice will be refused entry into the United States.
In all instances where food and beverages are held, the carrier or the person responsible for registering or submitting prior notice will be responsible for making arrangements and paying for the costs associated with moving items to secure locations. Conviction of a food-related felony could lead to the banning of a company or individual from conducting business with the United States.
Precautionary Principle’s Effect on the International Legal System
By Jeffrey Bates (McDermott, Will & Emery, Boston)
The precautionary principle is a hotly disputed concept in international trade, health, consumer protection and environmental law. Its ultimate fate is certain to have far-reaching consequences for business innovation worldwide.
Core Concept of the Precautionary Principle
The core concept of the precautionary principle holds that precautionary regulatory controls should not be deferred even though there may be significant uncertainty as to whether they may be needed to prevent health or environmental risks. The controversy over the legal status and content of the precautionary principle has permeated the international legal system at virtually every level and in self-consciously, inter-connected ways.
For example, in 2002 the Supreme Court of Canada applied the precautionary principle to construe Canadian domestic law, while justifying its interpretation in part on the ground that it “respects international law’s ‘precautionary principle.’” In so doing, the Canadian Supreme Court referred to a 1999 decision by the Supreme Court of India. There, a single justice of the Indian Supreme Court opined (possibly misunderstanding an earlier decision of a three-judge court) that the precautionary principle had become a part of customary international law and so was incorporated into Indian national law. This is an approach that could be followed in other countries, including the United States, should their national courts also come to the conclusion that the precautionary principle has become international law. Unfortunately, national court decisions on international law can be especially problematic in developing legal areas, such as the precautionary principle. Such decisions can influence the development of the law, particularly at the plane of the national courts, where most of the activity affecting private parties may in fact occur. The judges writing these decisions, however, typically are not learned in international law and so are prone to follow mistaken or imperfect impressions of mainstream international public opinion.
At the regional organization level, also in 2002, the European Court of First Instance issued its own version of the precautionary principle. It ruled that the principle should be applied to all matters concerning health protection in the European Union, although the European Union Treaty only specifies that the principle should be applied in environmental matters.
At the international level, the principle was recently incorporated into the Cartagena Biosafety Protocol, which provides for an international regime for the regulation of certain genetically modified organisms (GMOs) and is expected to go into force in 2003. It can be anticipated that national signatories’ interpretations of the principle under that protocol may draw upon the elucidations provided by the Canadian, Indian and European courts, both when promulgating their own implementing regulations and when acting collectively in conferences of the parties to craft further protocols.
Since its enunciation in the Rio Declaration in 1992, there has been a good deal of discussion on the precautionary principle as international law. There were judicial decisions in the 1990s in U.S. federal courts and by World Trade Organization (WTO) dispute panels in the Beef Hormones case that rejected the proposition that the precautionary principle had become international law. They did so primarily on the ground that it lacked generally accepted, concrete content. The Canadian, European and Indian court decisions might well be considered to fill the void condemned by the U.S. and WTO decisions.
Ideal Benchmarks for Employing the Precautionary Principle
A suitably robust discussion on the principle must coherently and cogently address a number of concrete, subsidiary points in order to make this law more effective. For example, the nature and threshold level of risk required to invoke the principle must be addressed. As a practical matter, a zero risk standard is not tenable and could lead to political abuse and covert trade barriers. The nature of the relevant uncertainty and the modalities for addressing it, both initially and over time, must also be addressed. The uncertainty must be informed by rigorous, expert, even-handed and transparent scientific analysis if the principle is to be applied with integrity. Equally, if not more importantly, the plausible counter-vailing risks and benefits, including economic and social benefits, must be weighed, and neither side of the equation should be exaggerated. In addition, the extent of preventive actions or precautionary measures to be taken must be proportionate to the risks to be mitigated and to the potential countervailing risks to be avoided or benefits to be obtained. Finally, the appropriate decision processes for informing and resolving disputes must be considered: Legal tribunals should be supported by access to neutral experts with a continuing mandate to revisit decisions as developments in data, science, technology and society’s needs materialize.
It is no accident, and it should not be forgotten, that each of these points was raised and carefully considered by the first international law case that can be said to have prefigured the current debate, the celebrated Trail Smelter Arbitration between the United States and Canada almost three-quarters of a century ago. Now is the appropriate time to address these issues in order to strike the right balance in protecting public health and the environment while safeguarding the future business innovation worldwide.
Pretrial Discovery: Incipiency Introduced in Germany
By Thomas Hauss and Jonas Ewert (McDermott, Will & Emery, Düsseldorf)
In a software infringement case, the German Federal Supreme Court (FSC) has rendered a decision according to which a plaintiff has the right to inspect documentary evidence (a source code) in possession of the defendant. Although such a ruling will sound familiar to people used to U.S. common law, this decision is groundbreaking for the German Civil Law system.
One of the major differences between German and U.S. civil proceeding is the fact-finding stage. The German plaintiff has not only to prove all facts that support his claim. He has to provide the court with all-necessary documents and pieces of evidence. The defendant is (in general) not obligated to provide any information, to furnish or disclose any documents or to provide any pieces of evidence that might support the plaintiff’s claim. Thus, in many cases filed in German courts for the recovery of damages caused by infringement of intellectual property, in particular patents, the defendants prevailed just because they could not be forced to offer evidence about what they actually had done.
According to the rules of civil procedure in the United States, the plaintiff has several means to retrieve any kind of evidence from the defendant. During the pretrial discovery, the plaintiff can make use of subpoenas, interrogatories and more to acquire the information needed for a successful trial for intellectual property infringements. The FSC has now narrowed this gap between the German and the U.S. rules by strengthening the plaintiff’s position. With regard to changes in the German Code of Civil Procedure promulgated during the last year, the question arises whether some kind of pretrial discovery will be finally introduced into German law.
Section 809 of the German Civil Code (GCC) stipulates a claim for inspection against anyone in possession of a good for such persons, which have a claim with respect to this good. In fact the German courts adjudicated such right of inspection only if the plaintiff could, short of proving, convince the court that the utmost probability spoke for the correctness of the plaintiff’s statement. In all other cases where the plaintiff asked for the inspection of the good to verify the existence of his claim, the cases were dismissed. The FSC has now changed this attitude and is willing to grant the claim for inspection already when the interest of the plaintiff outbalances the defendant’s interests. For this evaluation, the degree of probability and the absence of any other means of getting the information must be balanced against the defendant’s interest for confidentiality.
Despite this nearly palpable evidence in the case now decided by the FSC, the plaintiff would not have been awarded the right to inspect the source code according to the previous case law. The decision of the FSC does not come as a complete surprise because the legislator recently promulgated a provision according to which a party of a trial may “ask” the court to order the other party to disclose certain information. However, such a decision lies entirely
in the discretion of the court.
In particular among intellectual property lawyers, the decision and the alteration of the German Code of Civil Procedure were welcomed as a first step of approximation between German and U.S. litigation. Perhaps it will reduce the number of cases in which intellectual property infringements cannot be prosecuted due to the lack of evidence. However, it should be noted that the German civil procedure is still far from introducing a comparable “U.S.-style” of discovery.
Companies Involved in Mergers Should Consider M&A Insurance
By Alexander Hirsch (McDermott, Will & Emery, Düsseldorf)
In mergers and acquisition (M&A) transactions, a purchaser has to protect him or herself from the potential risks involved. Therefore, the purchaser will normally conduct a thorough legal, commercial, tax and environmental due diligence. If the outcome of the due diligence is satisfactory, the purchaser will, nevertheless, require a catalogue of representations and warranties covering all of the risks associated with the transaction. Such a catalogue will not provide any benefit to the purchaser if the vendor falls insolvent; however, if mergers and acquisitions insurance is employed, parties involved in the transactions can protect themselves from any unforeseen perils.
To protect your business investment, there are provisions in the sale and purchase agreement that are crucial. Frequently used mechanisms include escrow arrangements or a staggered payment in two or more installments. For a variety of reasons, these mechanism may not be acceptable to the vendor of the transaction. The vendor may not be prepared to provide a complete set of representations and warranties. This is frequently the case where a financial investor disposes of a minority interest having had only limited insight and influence in the target company. The vendor may also have a need to receive the purchase price in full. This may be the case where a private equity investor winds down investment partnerships, desires to return investor funds or, in cases of private persons disposing of major interests in companies, if the vendor wishes to retire or needs funds to pay taxes. Such different interests endanger the successful completion of transactions. In Continental Europe, transactions have been abandoned in such situations because no workable solution can be found.
Certain types of mergers and acquisitions insurance could have offered a solution. Such insurances are uncommon and widely unknown in Continental Europe to date. Insurers governed and regulated under various jurisdictions in Continental Europe did not offer mergers and acquisitions insurances in the past due to the legal framework under which they operated. Only in recent years have some insurers increased their offering under the mergers and acquisitions umbrella in order to operate more internationally and offer this insurance for companies completing transactions involving Continental Europe.
European vendors and purchasers do show some reluctance in using this type of insurance. These reasons are only partly founded in the uncommon nature of mergers and acquisitions insurances. But often the costs may be substantial, and companies may be reluctant to reveal sensitive information to parties involved. Currently, cross-border transactions in the M&A market are experiencing a growing tendency to use these insurances. As a result, companies involved in mergers situations should consider this insurance during the early stages of negotiations in order to secure a successful transaction.
There are several types of insurances that can be employed during an M&A transaction. These include vendor insurance, vendor insurance with the purchaser as loss payee and purchaser insurance. With vendor insurance, the vendor may take out this insurance as the insured person to be covered for liabilities under the representation and warranties assumed in the transaction. The insurer cannot subrogate against the vendor under this insurance method. Vendor insurance with the purchaser as loss payee states the vendor may insure himself with the purchaser as a loss payee, entitling the purchaser to bring a claim against and be paid directly by the insurer. The insurer can, likewise, not subrogate against the vendor. Under purchaser insurance, the purchaser may insure itself against a breach of contract by the vendor, including fraud on the vendor’s side. The insurer will have the right of subrogation against third parties, including the vendor, once the insurance pays out. It is important to note that mergers and acquisition insurances do not cover embedded warranties (forward looking statements), fines, known claims or circumstances that could give rise to a claim or post-closing adjustments.
There are one-time premiums for mergers and acquisitions insurances. Vendor policies are currently being priced at between 1.5 and 4 percent of the limit of the indemnity agreed upon in the respective sale and purchase agreement. Extra coverage, such as environmental or pensions issues, may add to these figures. Purchaser policies are currently being priced at between 3 and 6 percent of the limit of indemnity. Factors affecting the premium are the type of industry but also the size of the risk sharing in the transaction, such as de minimis, excesses and thresholds. Conduct of a thorough due diligence by the purchaser’s lawyers giving comfort to the insurer will also be reflected in the premium.
In fast moving targets, timing is crucial. In an ongoing transaction, a preliminary statement on the insurability of the transaction can be obtained within a few days. However, it may last a few weeks to finally negotiate the insurance policy.
Japan’s Ongoing Legal Reform Enhances M&A Opportunities
By Koji Fujita and Ryugo Yoshimura (Anderson Mori, Tokyo)
The Japanese Ministry of Economy, Trade and Industry (METI) submitted a bill to amend the Industry Revitalization Law on January 28, 2003. U.S. and international media coverage of this bill is limited. But METI and Keidanren (an industrial organization that participated in amending the Commercial Code and Corporation Tax Law) have released the information and is receiving comments from the legal industry, which expects the new amended bill to mark a significant step towards opening Japanese mergers and acquisitions (M&A) markets to companies worldwide.
The Industry Revitalization Law is intended to assist industrial entrepreneurs to reconstruct their businesses by removing legal obstacles for troubled companies. These benefits are available to companies whose reconstruction proposals are approved by METI and will include the elimination of the required assessment by a court-appointed inspector. The Commercial Code presently requires an inspection of a newly incorporated company by a court-appointed inspector for contributions in kind for recently issued shares and acquisitions of certain assets. This requirement is inapplicable if an independent lawyer, accountant or accounting firm provides a certificate attesting to the value of the contribution in kind or the certain acquired assets. But these professionals will bear strict liabilities and, accordingly, demand expensive fees for such certificates. The new amendment will lift this burden by eliminating the necessity of the inspection and the professional certificate.
It will also eliminate the requirement of shareholders’ special resolution for mergers of a certain size. The current Commercial Code requires a special resolution with respect to mergers, corporate splits, acquisitions of business and other M&A transactions that exceed a certain threshold. The amendment will now increase the threshold significantly, enabling companies to carry out more M&A transactions without convening a shareholders’ meeting.
In addition to the aforementioned changes, the amendments to the bill will liberalize merger consideration. In its present form, the Commercial Code requires that both parties to a merger be Japanese companies and consideration for a merger to be paid entirely or partly by shares of the surviving company. This means shareholders of the merged company must receive shares of the surviving company. The amendment provides that merger consideration may be paid partly or entirely by cash or shares of other companies, which means minority shareholders may be squeezed out by cash payments. In addition, a listed company may use its shares to acquire a target company by having its subsidiary merge with the target company.
The amendment fails to contain several important changes that were proposed to METI. Representatives of Anderson Mori and McDermott, Will & Emery discussed the amendments to the bill with METI before it was finalized and submitted to Parliament. At that time, several issues concerning the liberalization of merger consideration were mentioned.
First, the scheme contemplated by the amendment is different from the conventional triangular merger often seen in U.S. or European transactions in that, under the amendment, the merging company is likely to first acquire shares of its parent and then distribute such parent shares to the shareholders of the merged company. This two-step transaction scheme will increase transaction costs because the subsidiary must first finance the costs of acquiring shares of its parent. It may also cause practical problems in terms of the transaction’s time schedule.
Secondly, the amendment does not include tax law reform in connection with the merger consideration. This problem will not arise in connection with cash mergers, because shareholders who receive cash upon merger will not complain if the transaction is taxable. However, without special tax treatment, a transaction using parent shares as merger consideration will not be characterized as a tax-qualified transaction and will, therefore, trigger the realization of all capital gains and losses of the acquired company’s assets and liabilities. This will substantially diminish the usability of the new amendment.
Another disappointment is that the amendment provides that only shares of Kabushiki Kaisha (a form of Japanese corporation) can be used as merger consideration. METI has been heard to argue that the words “Kabushiki Kaisha” should be interpreted to include comparable corporations under foreign laws. However, it is ordinarily understood that the words “Kabushiki Kaisha,” when used in a statutory context, refer only to Japanese corporations. Thus, the amendment leaves significant uncertainty of its interpretation.
The amendment is, therefore, not a perfect reform in terms of removing obstacles to cross-border M&A transactions presently contained in the Commercial Code. However, it is still a good indication that efforts to reform the Japanese legal system are ongoing. The above changes may be introduced into the Commercial Code in a better form as part of the upcoming 2005 Commercial Code amendments.
Koji Fujita is a partner at Anderson Mori, located in Tokyo, Japan. He focuses his practice on international and domestic mergers and acquisitions matters as well as tax and IPO matters.
He can be reached at firstname.lastname@example.org.
Ryugo Yoshimura is a partner at Anderson Mori, located in Tokyo, Japan. He also focuses his practice on international and domestic mergers and acquisitions, tax and IPO matters.
He can be reached at email@example.com.
Lula’s Road to Power Leads to Brazilian Tax Reform
By René Gelman (Machado Associados Advogados e Consultores, São Paulo)
For more than 10 years, Brazil has been the primary focus of foreign investments in South America. Coincidence or not, the country was governed during that period by Fernando Henrique Cardoso, who was the minister of finance in 1993 and 1994 (during Itamar Franco’s government) and president of the country for two consecutive periods (1995-1998 and 1999-2002). For a number of reasons, President Cardoso was not able to elect his colleague from the Social Democratic Party as his successor in command of the nation.
In the recent 2002 election, an overwhelming majority of the votes were cast for Luiz Inácio Lula da Silva, or simply Lula as he is better known, in his fourth try at the highest political position in Brazil. He was defeated by Collor in 1990 and by Cardoso in the last two elections. Finally, Lula found himself as the new leader of South America’s biggest economy, even though before this election he never occupied a leadership position as a governor in any of the 27 states nor as a mayor in any of the 5,500 cities of Brazil.
Lula is the first Brazilian president who did not graduate from a university. He was born in 1945 in the middle of the Northeastern Brazil, and his poor family later came to São Paulo looking for work. Lula went to school only until the fifth grade (he was 12 years old then), at which point he had to go to work. A natural leader, Lula was elected as president of the Union of Metalworkers of São Bernardo do Campo—a region where most automotive and auto parts industries established their operations when they came to Brazil. Thereafter, he started his public life by founding and heading Partido dos Trabalhadores (PT), the Workers’ Party and a major labor union named Central Única de Trabalhadores (CUT).
Of approximately 86 million votes cast on October 27, 2002, Lula received 53 million. Lula’s supporters are eager to see him deliver on the three major promises made during his campaign: more jobs (he promised to create 10,000,000 jobs by the end of his term), a better distribution of revenue and what he and his PT supporters call a “social inclusion” plan through which his major programs against hunger and misery will be implemented. Will Lula be able to deliver his promises during the next four years? The answer to this question is still unknown, of course. However, President Lula is already demonstrating to Brazil and to the international community that he is more prepared for this office than most Brazilians imagined before January 2003.
Although for several decades left-wing extremists surrounded Lula, after his election he appointed a team of ministers who were welcomed by Lula’s adversaries better than by most members of his PT party. The key ministries such as finance, development, justice, foreign relations and planning are being headed by Antonio Palocci, Luiz Fernando Furlan, Márcio Thomaz Bastos, Celso Amorim and Guido Mantega, all prominent and well-respected individuals in Brazil and abroad. This was a pleasant surprise for most of those who opposed PT, expecting radical nominees. The international community also liked the selection of Henrique Meirelles for the important office of president of the Central Bank of Brazil (Mr. Meirelles’ resume includes acting as chairman of BankBoston Brazil for years and of BankBoston Group for six years). These appointments seem to suggest that Lula is seeking a capable and democratic government, where negotiations within the Congress and with international governments (such as the ones to be held with the United States for the creation of a Latin American Free Trade Area) will be completed in a professional matter. This will be key to Lula’s success.
Lula’s ministers will have to face the difficult mission of implementing necessary crucial (although not necessarily popular) reforms in the current public system. Clearly, the tax and social security structures are flawed and, in some instances, broken and must be urgently reviewed. During his campaign, Lula promised changes in these areas during his first year in Brasilia. According to the PT program of action, Lula’s primary goal is to increase economic efficiency and reduce social differences by means of a correction of distortions in the current local tax system. It would not be a surprise to any company working in Brazil that the local tax system is unnecessarily complex, to say the least. Simplification of this chaotic system will be a basic tool to new government. Fortunately, Minister Palocci understands that the current Brazilian tax system must be simplified in order to collect taxes from local companies and individuals and assist national industry in its exports to foreign markets. Therefore, Minister Palocci not only intends to organize a fair tax system for Brazilians but also to assist Brazilian companies to be more competitive in the international market. The proposals that are being presented by the government to the federal deputies in the Congress will take into consideration that the production chain should not be subject to so many taxes; contributions such as Employees’ Profit Participation Program (PIS), the Social Contribution on Billings (COFINS) and the Temporary Contribution on Financial Transactions (CPMF) should cease; simplification of the Tax on Sales and Services (ICMS) should be done and its gradual replacement by a value-added tax (IVA); and there should be a reduction of taxes on exports and on investments made for production.
At the same time, the government promised to negotiate a new tax system that will be aimed at fortunes and inheritances that would be taxed at progressive rates; the reduction of the tax burden for the middle class; and setting taxes on basic goods for the masses (such as food, clothing and construction) at a low level.
In order to implement these measures, Lula and his powerful team of ministers, secretaries and allies will have to use all their technical skills in the art of negotiation. This is because the solutions to Brazil’s problems will not just be found in the new presidential leadership, but must also exist in the old big houses: the Senate and Congress.
René Gelman is a partner at Machado Associates Advogados e Consultores, located in São Paulo, Brazil. His practice focuses on corporate and contracts and, over the years, he has represented several international clients in complex transactions in Brazil.
He can be reached at firstname.lastname@example.org.
Canadian International Tax Rules Undergo Revisions
By J. Scott Wilkie (Osler, Hoskin & Harcourt, Toronto)
The Canadian tax rules applicable to income earned indirectly by Canadian residents have been undergoing considerable refinement in two principal ways. First, according to draft legislation generally effective from January 1, 2003, most recently released by the Canadian Department of Finance on October 11, 2002, the Income Tax Act will contain a comprehensive regime for taxing investment income, or perhaps more accurately, a proxy for that income, earned indirectly by Canadian investors who are holders of participating interests (generally shares and rights to shares) issued by non-resident entities of various kinds (foreign investment entities or FIEs) and beneficiaries of non-resident trusts (NRTs). These rules are targeted at limiting deferral opportunities for Canadian investors in what amounts to foreign portfolio investments, which for purposes of these rules will include investments that though typical in their form as share investments track the financial behaviour of underlying property. The FIE rules bear a striking similarity, at least in their objectives and broadly their mechanics, to the “passive foreign investment company” rules in U.S. tax law. The other area of recent change, reflected in technical legislative proposals released on December 20, 2002, addresses technical refinements to the Canadian “foreign affiliate” rules, whose United States cousin is the controlled foreign corporation rules and their subpart (f) component.
The NRT and FIE proposals, which are now in effect, reflect one of the most far-reaching tax initiatives in some time. Broadly, the Canadian tax rules for taxing international income fall into two categories. Investments in foreign affiliates (generally requiring a 10 percent investment in a class or series of shares of a non-Canadian corporation) and controlled foreign affiliates (foreign affiliates which according to a statutory formulation are controlled by Canadian residents and others who need not be resident in Canada) are addressed in the Canadian version of controlled foreign corporation rules. These rules, generally, target two objectives. First, investment income that is earned by a controlled foreign affiliate is directly taxable, whether or not distributed, to its Canadian shareholders as so-called foreign accrual property income (FAPI). Notably, this anti-deferral regime applies only to Canadian resident shareholders of a foreign affiliate who control the foreign affiliate or are part of a control group. Those who hold investments in a foreign corporation that do not constitute investments in a foreign affiliate because of the minority of their interest, or who in any event are not a controlled group, are not affected by these rules.
The other objective of the foreign affiliate rules is to broadly recognize the allocation of tax jurisdiction attendant upon earning business income indirectly outside of Canada. In short, Canada effectively has a territorial system for taxing foreign business income. Foreign business income is not taxable, if at all, until distributed by a foreign affiliate to its Canadian resident shareholders. Business income that is earned in jurisdictions with which Canada has a tax treaty generally is not subject to any Canadian taxation when received by corporate shareholders for which the foreign corporation is a foreign affiliate. Business income earned elsewhere will be taxable at Canadian rates when distributed with appropriate credit for foreign taxes that the income has borne.
In the case of minor investments in foreign entities, another regime has applied essentially to require Canadian investors to include, as a proxy for foreign underlying income, an amount of income computed using a statutory interest rate applied to the cost to the investor of the foreign investment (offshore investment fund property rules). These rules were thought to be ineffective and, therefore, have been replaced by the FIE rules. The NRT rules displace a more modest regime for taxing foreign trust income.
Under the new FIE rules, Canadian investors will be required to include in their income an amount that represents underlying income earned by a foreign investment entity unless one of a variety of exceptions apply. For example, there are exceptions, subject to a limitation where tax avoidance is involved, generally for publicly listed investments in entities that reside in jurisdictions with which Canada has a tax treaty or where a Canadian-recognized stock exchange is located, with some specific refinements for investments in U.S. investment collectives. If none of the exceptions applies, the amount of income will be computed either by applying a statutory rate of interest under the act to an investor’s cost of the investment (the designated cost approach), or, alternatively, seemingly as a closer approximation of the actual underlying income, as the change in market value of the investment measured monthly (i.e., a mark-to-market approach). In circumstances in which the investment in the FIE tracks other property, the mark-to-market regime applies as a default regime.
These rules are complex and not intuitive. Any Canadian investor acquiring an interest even in the most typical non-Canadian industrial company will want to take these rules into account in making a determination whether a proxy income inclusion results. Correspondingly, non-Canadian corporations, and particularly foreign financial institutions that offer investment products to Canadian residents, will need to be aware of the potential impact of these rules on their Canadian investor base.
The non-resident trust rules potentially are similarly far-reaching. Broadly, a non-resident trust affected by these rules is a foreign trust even without Canadian resident beneficiaries that in one manner or another received property from a Canadian resident. Receipt of property, for these purposes extends beyond that typically associated with the entrustment of property and includes various indirect acquisitions of property and services that benefit trust beneficiaries, for example where services are provided to a trust at less than fair market value by a Canadian resident service provider. Again, there are a variety of circumstances in which these rules will not apply, or in any event that relief from their continued application will be available in certain circumstances. However, if the rules do apply, then the trust is assimilated to the status of a Canadian resident and is fully taxable on its income to the extent not distributed to its beneficiaries. Furthermore, to the extent that the trust does not satisfy its tax liabilities, its beneficiaries, subject to only some limitations, are responsible for the unsatisfied tax liability of the trust. Furthermore, if a trust has ever acquired any property from a Canadian resident, then it may remain within the compass of these rules indefinitely even if it ceases to have Canadian beneficiaries.
Generally, interests in investment trusts are meant to be dealt with under the FIE, rather than the NRT regime. It is at this point unclear whether other commercial trusts, the interests in which are vested, will remain within the NRT system where they at present seem to be or will be dealt with under the FIE regime according to any refinements to these rules that may be expected in 2003. Again, any non-Canadian trust that conceivably ever will have acquired property directly or indirectly from a Canadian resident, or which in any event has Canadian resident beneficiaries, will need to take these rules into account both from the standpoint of evaluating its, and its beneficiaries’ potential liabilities for Canadian tax, and in any event with respect to extended tax reporting that applies for NRTs.
J. Scott Wilkie is a senior partner in the Taxation Department of Osler, Hoskin & Harcourt’s Toronto office. He is one of the highest profile tax practitioners in Canada with particular expertise in international taxation, corporate taxation, taxation of financial transactions and transfer pricing.
He can be reached at email@example.com.
German Tax Law Changes May Affect Investment Climate
By Ralf Eckert and Sabine Engl (McDermott, Will & Emery, Munich)
Significant changes to German tax law will likely be approved by the Lower House of the German Parliament in spring 2003. If the Upper House of the German Parliament approves these proposed changes (the so-called poison list), it may have significant tax consequences for companies doing business in Germany. The American Chamber of Commerce has criticized these proposed changes as creating an unfavorable investment climate in Germany. Whether the measures will find the necessary majority in the Upper House is an open question.
The proposed schedules of changes are in the form of 48 single measures including one that affects individual and corporate income tax, losses and deductions. These measures would restrict annual loss deductions for individual and corporate income to 50 percent of the individual or corporation’s annual income (compared to the current 100 percent). This measure, if passed, would take effect in 2003. Therefore, companies may find it advantageous to maximize income in their balance sheet calculations for 2002 in order to take advantage of full loss deductions for 2002 tax purposes, rather than be faced with taking limited loss deductions against only 50 percent of income beginning in 2003.
Capital gains measures would impose 15 percent lump-sum capital gains taxes on most sales of stocks and real estate, irrespective of the length of time held (previously capital gains taxes were only imposed on sales of stocks held for less than one year and for real estate held less then 10 years). For individuals, capital gains from the sales of stocks would be subject to a lower tax rate of 7.5 percent, while capital gains from real estate would still be taxed at 15 percent. These measures, if passed, would apply retroactively to February 21, 2003. Stocks and real estate purchased before February 21, 2003, would be subject to a capital gains tax rate of 10 percent of the sales price. Losses from private assets would only be allowed against capital gains from private assets. These measures would also require banks to notify the tax office of income generated from stock sales.
ditional measures to be approved will affect the International Tax Relations Law. Corporations with international activities in Germany should be aware that the rules of the International Tax Relations Law may be changed, and the double tax treaty protections may be abolished. Measures will also address private use of company vehicles. Employees in Germany who use company vehicles for private use should be aware that this would be added to the employee’s income for tax purposes at a rate of 1.5 percent (instead of 1 percent) of the purchase price of the vehicle.
While no increase to the German base value-added tax (VAT) regular rate, 16 percent, is currently being contemplated, several modifications are pending. First, for some previously preferred items, such as art and agricultural products, the reduced VAT rate (7 percent) that formerly applied would be increased to the regular rate. Second, non-EC internet download providers (IDL) companies that provide downloadable services over the internet (i.e., software, digital books, films and music) to consumers in European Commission (EC) countries, including Germany, would now be subject to VAT. IDPs would be subject to the VAT in effect in each EC country where the service is provided (i.e., the VAT rate in Germany is 16 percent, Denmark is 25 percent, Italy is 20 percent, the United Kingdom is 17.5 percent). IDLs would also be required to declare and file a tax return in each EC country in which consumers purchase its services. In order to simplify matters, these type of providers need only be registered in one EC country in order to provide such services in other EC countries.