TELEFONICA BRASIL S.A. 20-F 2006
Documents found in this filing:
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
For the fiscal year ended December 31, 2005
For the transition period from to .
Commission file number: 001-14475
TELECOMUNICAÇÕES DE SÃO PAULO S.A. TELESP
(Exact name of Registrant as specified in its charter)
Telecommunications of São Paulo Telesp
(Translation of Registrants name into English)
Federative Republic of Brazil
(Jurisdiction of incorporation or organization)
Rua Martiniano de Carvalho, 851 21º andar
01321-001 São Paulo, SP, Brasil
(Address of principal executive offices)
Securities registered or to be registered pursuant to Section 12(b) of the Act:
Securities registered or to be registered pursuant to Section 12(g) of the Act:
Securities for which there is a reporting obligation pursuant to Section 15(d) of the Act:
Indicate the number of outstanding shares of each of the issuers classes of capital or common stock as of the close of the period covered by the annual report.
The number of outstanding shares as of December 31, 2005 was:
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. ¨ Yes x No
If this report is an annual or transition report, indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934. ¨ Yes x No
Note Checking the box above will not relieve any registrant required to file reports pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 from their obligations under those sections.
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. x Yes ¨ No
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act. (Check one):
Large Accelerated Filer ¨ Accelerated Filer ¨ Non-accelerated Filer x
Indicate by check mark which financial statement item the registrant has elected to follow. ¨ Item 17 x Item 18
If this is an annual report, indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). ¨ Yes x No
TABLE OF CONTENTS
References in this annual report to Telesp, we, our, us and the company are to Telecomunicações de São Paulo S.A. TELESP and its consolidated subsidiaries (unless the context otherwise requires). In addition, all references in this annual report to:
Unless otherwise specified, data relating to the Brazilian telecommunications industry included in this annual report were obtained from ANATEL.
The Glossary of Telecommunications Terms that begins on page 90 provides the definition of certain technical terms used in this annual report.
The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements. Certain statements included in this annual report, principally in Item 3.ERisk Factors, Item 4Information on the Company and Item 5Operating and Financial Review and Prospects, contain information that is forward looking, including, but not limited to:
Forward-looking statements may also be identified by words such as believe, expect, anticipate, project, intend, should, seek, estimate, future or similar expressions. Forward-looking information involves risks and uncertainties that could significantly affect expected results. The risks and uncertainties include, but are not limited to:
We undertake no obligation to update publicly or revise any forward-looking statements because of new information, future events or otherwise. In light of these risks and uncertainties, the forward-looking information, events and circumstances discussed in this annual report might not occur. Our actual results and performance could differ substantially from those anticipated in our forward-looking statements.
PRESENTATION OF FINANCIAL INFORMATION
Our consolidated financial statements as of December 31, 2005 and 2004 and for the years ended December 31, 2005, 2004 and 2003, have been prepared in accordance with the Corporate Law Method, which differs in certain significant respects from generally accepted accounting principles in the United States, or U.S. GAAP. Note 33 to our financial statements appearing elsewhere in this annual report describes the principal differences between the Corporate Law Method and U.S. GAAP as they relate to us, and provides a reconciliation to U.S. GAAP of net income and shareholders equity. These consolidated financial statements have been audited by Deloitte Touche Tohmatsu Auditores Independentes (Deloitte) (for the years ended December 31, 2003 and 2004) and Ernst & Young Auditores Independentes S.S. (E&Y) (for the year ended December 31, 2005).
We have made rounding adjustments to reach some of the figures included in this annual report. Accordingly, numerical figures shown as totals in some tables may not be an arithmetic aggregation of the figures that preceded them.
ITEM 3. KEY INFORMATION
A. Selected Financial Data
Our consolidated financial statements included in this annual report on Form 20-F and the selected financial data presented for the periods described below have been prepared in accordance with the Corporate Law Method, which is the same basis of accounting used in our annual and interim financial statements published in Brazil, audited by Ernst & Young Auditores Independentes. For consistent presentation, we have used the Corporate Law Method for all periods described in this annual report on Form 20-F. See Note 2 to the consolidated financial statements.
The following tables present a summary of our selected financial data at the dates and for each of the periods indicated. You should read the following information together with our audited consolidated financial statements and the notes thereto included elsewhere in this annual report and with Item 5Operating and Financial Review and Prospects.
The regulations governing the Brazilian foreign exchange market were changed on March 14, 2005. Prior to such date, there were two principal legal foreign exchange markets in Brazil:
On March 4, 2005, the Brazilian Monetary Council issued Resolution No. 3,265, which created a single foreign exchange market for all transactions effective as of March 14, 2005.
Additionally, on March 9, 2005, the Brazilian Central Bank issued Circular No. 3,280, containing the regulations for the foreign exchange market and for international investments, which governs the Brazilian foreign exchange market, Brazilian investments abroad and foreign investment in Brazil.
From March 1995 until January 1999, the Brazilian Central Bank allowed the gradual devaluation of the real against the U.S. dollar. In January 1999, the Brazilian Central Bank allowed the real/U.S. dollar exchange rate to float freely. Since then, the real/U.S. dollar exchange rate has been established mainly by the Brazilian interbank market and has fluctuated considerably. The Brazilian Central Bank has intervened occasionally to control unstable movements in the foreign exchange rate. However, the exchange market may continue to be volatile, and the real may depreciate or appreciate substantially in value in relation to the U.S. dollar in the future. It is not possible to predict whether the Brazilian Central Bank or the Brazilian government will continue to let the real float freely or will intervene in the exchange rate market through a currency band system or otherwise.
The following table set forth the exchange rate (subject to rounding adjustments), expressed in reais per U.S. dollar (R$/US$), for the periods indicated:
Source: Brazilian Central Bank.
B. Capitalization and Indebtedness
C. Reasons for the Offer and Use of Proceeds
D. Risk Factors
This section is intended to be a summary of more detailed discussions contained elsewhere in this annual report. The risks described below are not the only ones we face. Additional risks which we do not presently consider material, or of which we are not currently aware, may also affect us. Our business, results of operations or financial condition could be impacted if any of these risks materializes and, as a result, the market price of our preferred shares and our ADSs could be affected.
Risks Relating to Brazil
The Brazilian government has exercised, and continues to exercise, significant influence over the Brazilian economy. Brazilian political and economic conditions have a direct impact on our business, operations and the market price of our preferred shares and our ADSs.
In the past, the Brazilian government has intervened in the Brazilian economy and occasionally made drastic changes in policy. The Brazilian governments actions to control inflation and affect other policies have often involved wage and price controls, currency devaluations, capital controls, and limits on imports, among other things. Our business, financial condition, results of operations and the market price of our preferred shares and ADSs may be adversely affected by changes in government policies, as well as general economic factors, including:
Uncertainty as to future government policies may contribute to an increase in the volatility of the Brazilian securities markets and securities issued abroad by Brazilian companies. The Brazilian economy grew 2.3% in 2005, 4.9% in 2004 and 0.5% in 2003. Due to the limited economic growth in recent years, it is not certain whether the current economic policy will succeed. We can not predict whether Brazils monetary, tax, social security and other policies will cause an adverse impact to the economy, to our business and results of operations or to the market price of our preferred shares and ADSs.
Political instability may have an adverse impact on the Brazilian economy.
Political crises in Brazil in the past have affected the trust of investors and the public in general, as well as the development of the economy. Political crises may have an adverse impact on the Brazilian economy, our business, financial condition and results of operations and the market price of our preferred shares and ADSs.
Additionally, the Brazilian presidential election is scheduled to occur in October 2006. Considering that the Brazilian President has great powers to determine and change the governmental policies, including the economic ones, the result of the presidential run up may result in the implementation of new policies which might have an adverse impact in the transactions and results of operations of Brazilian companies, including our company. It is impossible to foresee the future development of the Brazilian economy and if it will or not affect us, our business, results of operations and the market price of our preferred shares and ADSs.
Inflation and government efforts to curb inflation may contribute to economic uncertainty in Brazil, adversely affecting our business and results of operations.
Brazil has historically experienced high rates of inflation. Inflation and certain of the governments measures taken in the attempt to curb inflation have had significant negative effects on the Brazilian economy. Since 1994, and after enactment of the Real Plan, Brazils inflation rate has been substantially reduced than in previous periods. The Consumer Prices Index (Índice de Preços ao Consumidor), or the IPCA, published by the Instituto Brasileiro de Geografia e Estatística, rose 5.7% in 2005, the lowest rate of inflation in five years, helped by the exchange rate appreciation. This index had presented variations of 7.6% in 2004, 9.3% in 2003 and 12.5% in 2002. The General Prices Index (Índice Geral de Preços), or IGP-DI, as published by Fundação Getúlio Vargas, which is more influenced by exchange rates variations due to the inclusion of producer prices, registered inflation rates of 1.2% in 2005, 12.1% in 2004, 7.7% in 2003 and 26.4% in 2002.
Starting in 2006, at ANATELs direction, telephone fees will be indexed to the IST, which is a basket of national indexes that reflect our sectors operating costs, which could reduce the inconsistencies between our industrys revenues and costs and thus reduce the adverse effects of inflation on us. However, Brazilian monetary policy will continue to call for the IPCA as an inflation targeting system. This means that upon rises in inflation beyond the Brazilian Central Banks 4.5% 2006 target, basic interest rates may rise, the indirect effects of which could be damage on demand for telecommunication goods and services.
Fluctuations in the value of the Brazilian real against the value of the U.S. dollar may adversely affect our ability to pay U.S. dollardenominated or U.S. dollarlinked obligations and could lower the market value of our preferred shares and ADSs.
The Brazilian currencies have experienced devaluations in the past. The real devalued against the U.S. dollar by 18.7% in 2001 and 52.3% in 2002. In contrast, the real appreciated in 2003, 2004 and 2005 against the U.S. dollar by 18.2%, 8.1% and 11.8%, respectively. See Item 3.ASelected Financial DataExchange Rates for more information on exchange rates.
It should be noted that the IST, the new index applicable to telecommunication fees from 2006 onward, reflects exchange fluctuation to a lesser degree than the previously applicable index, the IGP-DI. This means that from 2006 onward, telecommunication revenues, when converted to U.S. dollars, might also reflect exchange fluctuations to a lesser degree, which would weaken the results of our operations during periods of devaluation.
As of December 31, 2005, 36.5 percent of our R$2.40 billion total indebtedness was denominated in foreign currencies and primarily in U.S. dollars and Japanese yen. As of December 31, 2005, we had currency hedges in place to cover virtually all of our foreign currency denominated debt. See Item 11(a)Quantitative and Qualitative Disclosures about Market RiskExchange rate risk. Part of the costs relating to our network infrastructure is payable or linked to payment by us in U.S. dollars. However, other than income derived from hedging transactions and international long distance interconnection, all of our revenues are generated in reais. To the extent that the value of the real decreases relative to the U.S. dollar, our debt becomes more expensive to service and it becomes more costly for us to acquire technology and goods necessary to operate our business that have their prices linked to the exchange rate fluctuation. Certain additional costs, however, are offset by revenues from corresponding hedging transactions. Nevertheless, currency fluctuations are expected to continue to affect our financial income and expense.
Political, economic and social developments, and the perception of risk in other countries, especially emerging market countries, may adversely affect the Brazilian economy, our business, and the market price of Brazilian securities, including our preferred shares and ADSs.
The market for securities issued by Brazilian companies is influenced, in varying degrees, by global economic and market conditions, and especially by those of Latin American countries and other emerging markets. The reaction of investors to developments in other countries may have an adverse impact on the market value of securities of Brazilian companies. Crises in other emerging countries or the economic policies of other countries, in particular those of the United States, may reduce investor demand for securities of Brazilian companies, including our preferred shares. Any of the foregoing developments may adversely affect the market value of our preferred shares and hinder our ability to access the capital markets and finance our operations in the future on acceptable terms and costs, or at all.
Exchange controls and restrictions on remittances abroad may adversely affect holders of our preferred shares and ADSs.
Brazilian law provides that, whenever there is a significant imbalance in Brazils balance of payments or a significant possibility that such imbalance will exist, the Brazilian government may impose temporary restrictions on the remittance to foreign investors of the proceeds of their investment in Brazil (as it did for approximately six months in 1989 and early 1990) and on the conversion of reais into foreign currencies. Any such restrictions could hinder or prevent the holders of our preferred shares or the depositary for the ADSs from converting dividends, distributions or the proceeds from any sale of such securities into U.S. dollars and remitting such U.S. dollars abroad. The imposition of these restrictions would also likely have a material adverse effect on the market price of our preferred shares and the ADSs.
Risks Relating to the Brazilian Telecommunications Industry and Us
Extensive government regulation of the telecommunications industry and our concession may limit our flexibility in responding to market conditions, competition and changes in our cost structure or impact our fees.
Our business is subject to extensive government regulation. ANATEL, which is the primary telecommunications industry regulator in Brazil, is responsible for, among other things:
The initial monthly and usage fees for our services (local and long-distance) were initially determined in our concession agreement, which also sets the annual price adjustment. We derive a substantial portion of our revenues from services subject to this
price adjustment. The method of price adjustment is basically a price cap. ANATEL applies annually a price index correction that reflects the inflation index of the period (in accordance with the concession contract) and a productivity factor (in accordance with the concession contract) to our local and long-distance fees. ANATEL has complied with the fee range set by the concession agreement. We are currently involved in litigation relating to the inflation index used to calculate the price adjustment of our fees that may negatively impact our financial results. See Item 4BLocal Rates and Item 8ARegulatory and Antitrust Litigation for additional information on these claims.
In July 2005, ANATEL published new rules regarding interconnection systems which substantially changed the interconnection model. These changes include: (i) an obligation to offer the public all types of interconnection services, in addition to interconnections between fixed line service providers and mobile service providers; (ii) an offer of interconnections for Class III and Class V services; (iii) the establishment of criteria for the treatment of fraudulent calls; and (iv) the reduction of terms for the availability of interconnections. As a result of these reforms, new operators may enter the market and increase the competition we currently face.
Our concession may be terminated by the Brazilian government under certain circumstances.
We operate our business under a concession granted by the Brazilian government. According to the terms of the concession, we are obligated to meet certain universal services requirements and to maintain minimum quality and service standards. For example, ANATEL requires that we satisfy certain conditions with respect to, among other things, expansion of our network to provide public telephone service for all areas with populations in excess of 100, expansion of our network to provide private individual telephone service for all areas with populations in excess of 300 and, with respect to quality of service, targets for call completion rates. Our ability to satisfy these terms and conditions, as well as others, may be affected by factors beyond our control. There is no guarantee that, going forward, we will be able to comply with all of the requirements imposed on us by ANATEL or the Brazilian government. Our failure to comply with the requirements of our concession may result in the imposition of fines or other government actions, including the termination of our concession. Any partial or total revocation of our concession would have a material adverse effect on our financial condition and results of operations.
On December 1, 2005, we sent to ANATEL the necessary evidence that we had attained our network expansion and universal service targets established by the Serviço Telefônico Fixo Comutado, or the STFC, of 2005. The evidence of our accomplishment was submitted by ANATEL to a public hearing on December 22, 2005, which was completed on February 6, 2006. ANATEL is in the process of issuing a certificate.
The expiration date of the original Concession Agreement was December 31, 2005, but it has been renewed as of December 22, 2005 for an additional 20-year term.
We face substantial competition from other fixed-line providers that may reduce our market share.
The satisfaction of ANATELs universal service targets by several fixed telecommunications services providers opened our region to the provision of local and long-distance telecommunications services by other providers. We have experienced, and expect to continue to experience, market adjustments in which providers take actions in order to compete for clients, especially corporate and premium residential clients. Such actions tend to result in lower prices and impacts market share. The Brazilian telecommunications market continues to reorganize and the profile of our competitors remains subject to change. This move towards reorganization and consolidation during 2005 is well illustrated by Carso Groups acquisition of a significant corporate stake in the biggest Brazilian cable company Net Comunicações S.A. through Teléfonos de Mexico S.A. Telmex. Such consolidation could allow our competitors to threaten our market share by providing bundled services or by making increased investments or offering more discounts as a result of greater financial viability.
We face increasing competition from cellular service providers.
Rapid growth of the cellular telecommunications industry and intense competition among cellular services providers have resulted in lower prices for cellular services. Cellular services are increasingly becoming an alternative to fixed-line services for residential customers. We expect this to negatively impact the use of fixed telecommunications services and, therefore, mobile services are still the main competitive product to our services. See Item 4Information on the CompanyCompetition. In 2004,
the number of cellular phones surpassed the number of fixed phones in the State of São Paulo. While some of the negative impact from the migration to cellular services is mitigated by the interconnection fees we receive from cellular to fixed-line calls, we cannot assure you that this will continue or that the continued growth of cellular services, and possible combination packages of services between fixed-line and mobile services, will not ultimately have an adverse impact on our business. In 2005, the mobile network interconnection fees paid by fixed operators to mobile operators should have begun running based on free negotiation among the operators, whereby each operator would negotiate the mobile interconnection fee directly with each other operator. However, the operators failed to reach an agreement and so ANATEL intervened in their negotiations and arbitrarily set the terms thereof, extending the then current fixed mobile interconnection conditions for at least one year. In respect of the interconnection fees paid to fixed operators, the extension of the Concession Contract, which began on January 1, 2006, set new conditions for the calculations of the fees. Now, the local network interconnection fee is defined as 50% of the price of one minute of local traffic and the long distance interconnection fee is defined based on the price of long distance traffic. As a result, the fees were significantly reduced (by between 30% and 40%). Further, there is uncertainty regarding this issue due to a postponing of the conversion of the fees from per pulse to per minute. This situation increases the chances of legal claims related to the conversion process, which could in turn affect the defined values for the interconnection fees.
The industry in which we conduct our business is subject to rapid technological changes that could have a material adverse effect on our ability to provide competitive services.
The telecommunications industry is subject to rapid and significant technological changes. Our future success depends, in part, on our ability to anticipate and adapt in a timely manner to technological changes. We expect that new products and technologies will emerge and that existing products and technologies will be further developed.
The advent of new products and technologies could have a variety of consequences for us. New products and technologies may reduce the price of our services by providing lower-cost alternatives, or they may also be superior to, and render obsolete, the products and services we offer and the technologies we use, thus requiring investment in new technology. If such changes do transpire, our most significant competitors in the future may be new participants in the market without the burden of any installed base of older equipment. The cost of upgrading our products and technology in order to continue to compete effectively could be significant.
Risks Relating to the Preferred Shares and the ADSs
The Preferred Shares and ADSs generally do not have voting rights.
In accordance with Brazilian Corporate Law and our bylaws, holders of preferred shares, and therefore of the ADSs, are not entitled to vote at meetings of our shareholders, except in limited circumstances set forth in Item 10.BMemorandum and Articles of Association.
You might be unable to exercise preemptive rights with respect to the preferred shares unless there is a current registration statement in effect which covers those rights or unless an exemption from registration applies.
You will not be able to exercise the preemptive rights relating to the preferred shares underlying your ADSs unless a registration statement under the U.S. Securities Act of 1933, as amended, or the Securities Act, is effective with respect to those rights, or an exemption from the registration requirements of the Securities Act is available. We are not obligated to file a registration statement. Unless we file a registration statement or an exemption from registration applies, you may receive only the net proceeds from the sale of your preemptive rights by the depositary, or if the preemptive rights cannot be sold, they will lapse and you will not receive any value for them. For more information on the exercise of your rights, see Item 10Additional InformationMemorandum and Articles of AssociationPreemptive Rights.
Certain Factors Relating to Our Controlling Shareholder
Our controlling shareholder has a great deal of influence over our business.
Telefónica Internacional S.A., or Telefónica Internacional, our principal shareholder, currently owns directly and indirectly approximately 84.71% of our voting shares and 87.49% of our total capital. See Item 7.AMajor Shareholders and Item 7.BRelated Party Transactions. As a result of its share ownership, Telefónica Internacional has the power to control us and our subsidiaries, including the power to elect our directors and officers and to determine the outcome of any action requiring shareholder approval, including transactions with related parties, corporate reorganizations and the timing and payment of our dividends. Given this degree of control over our company, circumstances could arise under which the interests of Telefónica Internacional could be deemed to be in conflict with the interests of our other shareholders.
ITEM 4. INFORMATION ON THE COMPANY
A. History and Development of the Company
Following the restructuring and privatization of Telebrás, discussed below, we were incorporated on November 30, 1999, as a corporation (sociedade anônima) organized under the laws of the Federative Republic of Brazil. We are registered with the CVM, as a publicly held company and our stock is traded on BOVESPA. We are also registered with the SEC in the United States and our ADSs are traded on the New York Stock Exchange, or NYSE. Our headquarters are located at Rua Martiniano de Carvalho, 851 21º andar, 01321-001, São Paulo, SP, Brasil. Our telephone number is 55-11-3549-7922.
As of December 31, 2005, we had 164,061,698 outstanding common shares, with no par value per share, and 327,968,193 preferred shares, with no par value per share, after the reverse stock split that was approved on May 11, 2005. See Item 8Financial InformationDividends and Dividend Distribution PolicyReverse Stock Split. Our shareholders equity was in the amount of R$10,204,207,000 as presented under the Corporate Law Method.
We provide fixed-line telecommunications services in the State of São Paulo under a concession agreement granted in 1998 by the Brazilian government entered into in connection with the restructuring and privatization of the Telebrás System, as described below. The concession authorizes us to provide fixed-line telecommunications services in a specific region, which includes all of the State of São Paulo except for a small area (Sector 33), where a previously existing fixed line service provider, CTBC Telecom, that was not part of the Telebrás System continues to operate independently.
In addition to the services we provide under the concession agreement of 1998, we also provide international and interregional long distance services, as permitted under Act 23,395 of March 1, 2002, by which ANATEL also acknowledged our having accomplished the network expansion and universal service targets as of September 30, 2001.
As of December 31, 2005, our regional telephone network included approximately 14.3 million installed lines, including public telephone lines, of which 12.3 million lines were in service. Of the access lines in service, approximately 74.7% were residential, 19.9% were commercial, 2.7% were public telephone lines and 2.7% were for our own use and for testing.
The Restructuring and Privatization
Before the incorporation of Telecomunicações Brasileiras S.A. Telebrás in 1972, there were more than 900 telecommunications companies operating throughout Brazil. Between 1972 and 1975, Telebrás and its operating subsidiaries, collectively the Telebrás System, acquired almost all of the telephone companies in Brazil and monopolized the provision of public telecommunications services in virtually all areas of the country.
On April 12, 1973, our principal predecessor company, which carried the same name as we do, Telecomunicações de São Paulo S.A. Telesp, or TDSP, began providing telecommunications public services as a Telebrás System operating company in the State of São Paulo. In 1973, TDSP acquired Companhia Telefônica da Borda do Campo, or CTBC, which had long been active in the São Paulo metropolitan area as a telecommunications public services concessionaire. With this acquisition, TDSP became the main supplier of fixed-line telecommunications services in the State of São Paulo and remained so until a wave of deregulation in the 1990s.
In 1995, the Brazilian government began a comprehensive reform of its system of telecommunications regulations. In July 1997, Brazils national congress adopted the General Telecommunications Law, which provided for the establishment of a new regulatory framework, the introduction of competition and the privatization of the Telebrás System.
In May 1998, just prior to its privatization, the Telebrás System was restructured to form, in addition to Telebrás, twelve new holding companies. Virtually all assets and liabilities of Telebrás were transferred to the new holding companies, or the new holding companies. The resulting new holding companies, together with their respective subsidiaries, consisted of (i) eight cellular holding companies, each in one of eight cellular regions, and holding one or more operating companies that provided cellular services; (ii) three fixed-line holding companies, each in one of three fixed-line regions and holding one or more operating companies that provided local and intraregional long-distance services; and (iii) Embratel Participações S.A., a holding company of a single one of Telebrás operating companies, Empresa Brasileira de Telecomunicações S.A. Embratel, which provides international long-distance services throughout Brazil. Telesp Participações S.A., or TelespPar, was a new holding company formed in connection with the Telebrás privatization. Pursuant to the privatization, TelespPar received the shares held by Telebrás in the operating subsidiaries of the Telebrás System in the State of São Paulo, including TDSP and CTBC, that provided fixed-line telecommunications service in the State of São Paulo.
In July 1998, the federal government privatized the Telebrás system, selling substantially all its shares in the new holding companies, including TelespPar and its shares in TDSP and CTBC, to private sector buyers. The federal governments shares of TelespPar were purchased by SP Telecomunicações Holding S.A., or SP Telecomunicações, formerly known as Tele Brasil Sul Participações S.A., a consortium comprised of Telefónica Internacional, Portelcom Fixa S.A., Banco Bilbao Vizcaya S.A., Iberdrola Investimentos S.U.L., CTC Internacional S.A. and Telefónica de Argentina S.A. As a result of a subsequent reorganization of SP Telecomunicações on January 10, 1999, one of its subsidiaries, SPT Participações S.A., or SPT, became the controlling shareholder of TelespPar. SPT was controlled by Telefónica Internacional, S.A (69.04%), Portugal Telecom, S.A (19.85%), PTELECOM, S.A (3.15%), Iberdrola Energia, S.A (6.04%), Iberdrola Investimentos S.U.L. (0.96%) and Banco Bilbao Vizcaya (0.96%).
The Reorganization of TelespPar
On November 30, 1999, the respective shareholders of TelespPar, TDSP, CTBC and SPT approved a reorganization involving a series of mergers. Pursuant to the restructuring, the operations of TDSP, CTBC and SPT were merged with and into TelespPar, which remained as the surviving entity. Telespar simultaneously became the telecommunications services company operating under our current name, Telecomunicações de São Paulo S.A. Telesp.
On December 22, 1999, we acquired, through a public auction from the municipal government of the City of Ribeirão Preto, in the State of São Paulo, 51.0% of the voting shares and 36.0% of the total outstanding shares of Centrais Telefônicas de Ribeirão Preto S.A., or Ceterp. Ceterp provided fixed-line and cellular services in the State of São Paulo, outside the Telebrás System, and had been one of our minor competitors. According to the terms of the acquisition, on December 30, 1999, we acquired an additional 45% of the voting shares and 36% of the total outstanding shares of Ceterp from certain pension funds.
Under the terms of the acquisition, we were also required to launch a tender offer for the remaining minority shares of Ceterp at a price equal to that paid to the selling pension funds, with adjustments for inflation and interest. This tender offer was completed on October 4, 2000 and, as a result, we increased our holdings to 99.85% of Ceterps voting shares and 96.97% of its preferred shares.
In order to comply with regulatory requirements, on October 27, 2000, Ceterp sold for cash Ceterp Celular S.A., its wholly owned cellular subsidiary, to Telesp Celular.
On November 30, 2000, Ceterp was merged with and into us.
The Spin-off of Certain Data Transmission Operations
On January 30, 2001, our shareholders approved the spin-off of certain operations of our data transmission business into an independent Brazilian corporation, Telefônica Data Brasil Holding S.A., or TDBH. This spin-off was part of Telefónicas global business reorganization to allow managerial and operational consolidation of business lines through separate, but affiliated, global business units and to enhance the strategic and competitive position of the group. As a result of the spin-off, we hold no interest in the equity share capital of TDBH, and TDBH holds no interest in our equity share capital. The relationship between TDBH and us is limited to certain arrangements in the ordinary course of business between us as a fixed-line network operator and TDBH as a data transmission services provider. However, TDBH and we still remained under the common control of Telefónica, S.A., or Telefónica, and certain of its affiliates, including Telefónica International S.A. and SPT, both of which are wholly-owned subsidiaries of Telefónica.
Attainment of Targets
On September 30, 2001, in anticipation of a December 31, 2003 deadline, we attained the service targets set by ANATEL in respect of network expansion and service universalization. This was acknowledged by ANATEL through Act 23.395 of March 1, 2002. Pursuant to our fulfillment of the targets, on April 29, 2002, ANATEL granted us a concession allowing us to offer international and interregional long-distance services outside our concession region, thereby enabling us to have a presence throughout Brazil. Accordingly, on May 7, 2002, we began providing international long-distance service and on July 29, 2002, we began providing interregional long-distance service. See Regulation of the Brazilian Telecommunications IndustryObligations of Telecommunications CompaniesNetwork ExpansionGeneral Plan on Universal Service Targets for information relating to ANATELs network expansion and universal service targets.
Acquisition and Reorganization of Atrium
On December 30, 2004, we acquired indirect control of Atrium Telecomunicações Ltda. from Launceston Partners CV (a company incorporated in the Netherlands and controlled by the investment funds Advent Latin American, Advent PGGM Global, J.P. Morgan Partners Latin America, J.P. Morgan Capital and Sixty Wall Street Fund). Atrium provides various types of telecommunications services in Brazil, including internet and intranet services, telecommunications management services and the sale and rental of telecommunications representatives and related equipment. The acquisition was carried out through the purchase of the total share capital of Santo Genovese Participações Ltda., which held 99.99% of the representative share capital of Atrium. The purchase price was approximately R$113.4 million and was paid in cash.
On November 21, 2005 we approved the corporate reorganization of our controlled companies A. Telecom S.A. (formerly Assist Telefônica S.A.), Santo Genovese Participações Ltda., or Santo Genovese and Atrium Telecomunicações Ltda., or Atrium. The capital reorganization consisted of the following steps: (i) Atrium was merged with and into Santo Genovese, which survived; and (ii) Santo Genovese was merged with and into A. Telecom S.A., which survived. Also under the reorganization, our shares of Santo Genovese were replaced by newly issued shares of A. Telecom S.A. as a result of the capital increase that followed the merger with Santo Genovese. We believe that the reorganization created value for A. Telecoms shareholders, generated synergies and simplified the administrative structure of the constituent companies by offering to their clients more integrated services with commercial presence. The reorganization was implemented and became effective on March 1, 2006.
The SCM Restructuring
On March 9, 2006, our Board of Directors and the boards of directors of TDBH and Telefônica Empresas S.A., a wholly owned subsidiary of TDBH (T-Empresas and together with us and TDBH, the Companies), approved the restructuring of the Companies serviços de comunicação multimédia (SCM), or multimedia communications services, and data transmission activities (the SCM Restructuring).
The terms and conditions of the SCM Restructuring are set forth in an agreement executed by the Companies on March 9, 2006. The SCM Restructuring consisted of (i) the merger of TDBH into our company (the Merger); and (ii) the spin-off of all T-Empresas assets and activities except its SCM assets and activities in sectors 31, 32 and 34 of Region III of Annex II of the General Concession Plan (the Spin-off). The SCM Restructuring will be submitted for approval to the Companies respective general shareholders meetings scheduled for April 28, 2006. Upon shareholder approval of this restructuring: (i) TDBH will be dissolved; (ii) its shareholders will receive shares of our common or preferred stock, or ADSs, as appropriate; (iii) we will succeed TDBH in all of its rights and obligations; and (iv) T-Empresas will become our wholly owned subsidiary. See the Contract and Justification of the Merger of Telefônica Data Brasil Holding S.A. into Telecomunicações De São Paulo S.A. Telesp and Partial Spin-Off of Telefônica Empresas S.A. dated March 9, 2006, which is included in this Annual Report as an exhibit.
Subsequent to the Merger and Spin-off, we intend to consolidate our existing SCM operations, currently carried out by our subsidiary A. Telecom S.A., with those of T-Empresas in order to develop SCM activities in the remainder of Brazil. We expect that the SCM Restructuring will result in: (i) greater operational and financial efficiencies; (ii) a share liquidity increase, particularly for TDBHs shareholders, but also for our shareholders; and (iii) cost reductions all of the Companies activities into one listed company, Telesp.
The increase in our capital stock as a result of the Merger, and the reduction in T-Empresas capital stock as a result of the Spin-off, will each be based on appraisals of TDBHs and T-Empresas respective net equity values, by Hirashima & Associados Ltda., an independent appraisal firm, issued on March 6, 2006 (the Appraisals). The Appraisals were based on TDBHs and T-Empresas respective balance sheets as of December 31, 2005, each audited by Ernst & Young Auditores Independentes S.S.. According to the Appraisals, as of December 31, 2005, TDBHs net equity value was R$597,164,881.58 and T-Empresas net equity value was R$304,234,227.25 (with the equity value of T-Empresas spun-off components being R$273,797,261.22). NM Rothschild & Sons (Brasil) Ltda. (Rothschild) was retained to support the share exchange ratio determination between us and Brasil Data. On the basis of the value range average determined by Rothschild (using the discounted free cash flow method), the following exchange ratios were established:
As a result of the Merger, and based on the foregoing exchange ratios, a maximum of 4,758,172 shares of our common stock and 9,449,209 shares of our preferred stock will be issued, in exchange for outstanding TDBH shares of common and preferred stock (except for our existing minority shares in TDBH which will be cancelled). After the Merger, our capital stock will be divided into a maximum of 506,237,272 shares, of which 168,819,870 will be common shares and 337,417,402 will be preferred shares, all being book-entry shares without par value. Shares of our preferred stock that will be distributed to the preferred shareholders of TDBH will have the same rights as TDBHs outstanding preferred stock, except for the right to vote for the approval of related party transactions. Regarding the Spin-off, considering that at the time of its implementation, T-Empresas will be our wholly owned subsidiary, the transfer to Telesp of the spun-off components of T-Empresas will not result in any increase or decrease in the net equity of Telesp, nor in the number of shares that comprise its capital stock.
In connection with the Merger, TDBHs shareholders will have the right of withdrawal in accordance with Brazilian Corporate Law until 30 days from the shareholders approval thereof. Our shareholders will not be entitled to a right of withdrawal as a result of the Merger or Spin-off. As a result of the Merger, our shareholders are expected to approve an amendment to our bylaws which will
increase the subscribed capital stock of our company. The Spin-off will not result in any amendment to our bylaws. Notwithstanding the fact that approval of ANATEL is not required, the SCM Restructuring will be submitted to the agency for filing purposes. Since the Merger and Spin-off involve companies belonging to the same group, the SCM Restructuring is not subject to approval from the Brazilian antitrust agency. The transaction costs of the SCM Restructuring are estimated at approximately R$ 3.5 million, including costs related to appraisal, auditing, legal counseling, publications and other expenses.
Corporate Structure and Ownership
Our general corporate and shareholder structure is as follows:
Prior to privatization, our capital expenditures were planned and allocated on a system-wide basis and subject to approval by the Brazilian government. These constraints on capital expenditures prevented us from making certain investments that otherwise would have been made to improve telecommunications services in our concession region. These restrictions were lifted, and we are permitted to determine our own capital expenditure budget, subject to compliance with certain obligations to expand service under the concession.
The following table sets forth our capital expenditures for each year in the three-year period ended December 31, 2005.
In addition to the consolidation of our broadband market leadership position, the primary focus of our capital expenditure program has been, and continues to be, the expansion, modernization and digitalization of the network in order to comply with ANATELs targets and to provide quality service for our clients. See Item 4.BInformation on the CompanyBusiness OverviewRegulation of the Brazilian Telecommunications IndustryObligations of Telecommunications Companies.
We anticipate that our capital expenditures for 2006 will be approximately R$1.8 billion. We expect to fund these expenditures with funds internally generated from our operations and through external sources of credit.
B. Business Overview
The State of São Paulo covers an area of 248,809 square kilometers, representing approximately 2.9% of Brazils territory. The population of the State of São Paulo is approximately 40.4 million, representing 22% of Brazils total population. The gross domestic product, or GDP, of the State of São Paulo in 2005 was an estimated R$600.2 billion, or approximately US$246.6 billion, representing approximately 31% of Brazils GDP for the year. The State of São Paulos annual per capita income during 2005 was an estimated R$14,841, or approximately US$6,097.
The concessions granted by the Brazilian government in 1998 allowed us to provide fixed-line telecommunications services to a region that includes mostapproximately 95%of the State of São Paulo. The portion of the State of São Paulo that is excluded from our concession region represents approximately 1.5% of total lines in service and 2.2% of the population in the state. This concession is operated by CTBC Telecom.
Our concession region is Region III, which is comprised of 622 municipalities, including the City of São Paulo, with an aggregate population of approximately 40.4 million. Of the municipalities in Region III, 70 have populations in excess of 100,000. The City of São Paulo has a population of approximately 11 million. According to the plan established by the federal government, whereby the government granted licenses to four providers of fixed-line telecommunications services, the State of São Paulo was divided into four sectors including sectors 31 (our predecessor companys area prior to the reorganization), 32 (the area corresponding to Ceterp prior to our acquisition), 33 (corresponding to the portion of the State of São Paulo that we do not service) and 34 (CTBCs area prior to the reorganization). Through transactions that took place in November 1999 and December 2000, CTBC Borda do Campo and Ceterp merged into our company, which now holds Sectors 31, 32 and 34. Sector 33 is held by CTBC Telecom.
On September 30, 2001, we attained our December 31, 2003 network expansion and universal service targets, as further described below in ServicesInterregional and International Long-Distance Services. As a result, on April 29, 2002, ANATEL granted us an operating concession to provide international and interregional long-distance services outside our concession region, thereby enabling us to have a presence throughout Brazil. On May 7, 2002, we began offering international long-distance service and, on July 29, 2002, we started offering interregional long-distance service.
The conditions for the provision of interregional and international long-distance services outside the concession area contemplate that providers already operating services under a selection code (a two-digit code to be input by the caller as a prefix to the number dialed) shall keep such code under the new licenses authorizing operation outside the applicable concession area. Accordingly, we continue using the provider selection code 15 which permits our callers to originate calls using our services even though such caller is outside our concession area. All interregional and international cellular calls, whether in our concession area or that of another provider, dialed using Personal Mobile ServiceSMP, through which mobile services users choose the provider for interregional and international long-distance calls, require dialing our code 15 in order to use our services. See ServicesNetwork Services.
Our services consist of:
In March 2002, ANATEL certified our compliance with the 2003 universal service targets and authorized us in April 2002 to start exploiting local and intraregional services in certain regions in which we were not operational and interregional and international long-distance services throughout Brazil. See Competition and Regulation of the Brazilian Telecommunications IndustryObligations of Telecommunications CompaniesPublic RegimeService Restrictions.
We provide interconnection services to cellular service providers and other fixed telecommunications companies through the use of our network. In April 1999, we also began to sell handsets and other telephone equipment through A. Telecom S.A. (formerly Assist Telefônica S.A.), our wholly owned subsidiary. Until January 2001, we provided data transmission services, but spun off our data transmission operations into TDBH. See Item 4.AInformation on the CompanyHistory and Development of the Companythe SCM Restructuring.
The following table sets forth our operating revenue for the years indicated. Our fees for each category of service are discussed below under Rates and Taxes. For a discussion of trends and events affecting our operating revenue, see Item 5Operating and Financial Review and Prospects.
Local service includes installation, monthly subscription, measured service and public telephones. Measured service includes all calls that originate and terminate within the same local area or municipality of our concession region, which we refer to as local calls, and the leasing of our network for paging and trunking services. Excluding the portion of our region that was serviced by Ceterp before our acquisition in December 1999, we were the only supplier of local fixed-line and intraregional long-distance telecommunications services in our region until July 1999. At that time, licenses were auctioned to permit a competitor to provide local fixed line and intraregional long-distance telecommunications services in our region, including the area formerly served by Ceterp. Vésper São Paulo S.A. received authorization and began operations in December 1999. Embratel also began to provide local services in our concession region in January 2003. See Competition.
Telesp became the first telephone service concessionaire in Brazil to offer local services outside its concession region (the State of São Paulo). In May 2003, we achieved the network expansion and universal service targets established by ANATEL, and began providing local services to six other states in Brazil, including Sergipe, Espírito Santo, Rio Grande do Sul, Paraná, Santa Catarina and certain areas in Rio de Janeiro. In May 2004, we began providing local telephone services in seven other states in Brazil, including in the capitals of Pará, Roraima, Amapá, Rondônia, Maranhão, Tocantins and Acre. In May 2005, we also began to provide local telephone services in the capitals of the following states: Ceará, Amazonas, Pernambuco, Rio de Janeiro, Bahia, Mato Grosso do Sul and Mato Grosso.
Intraregional Long-Distance Service
Intraregional long-distance service consists of all calls that originate in one local area or municipality and terminate in another local area or municipality of our concession region. We were the sole provider of intraregional long-distance service in our region until July 3, 1999, when the federal government also authorized Embratel and Intelig to provide intraregional long-distance services. Vésper also began to provide intraregional long-distance services in our concession region in December 1999. See Competition.
Interregional and International Long-Distance Service
On March 1, 2002, ANATEL acknowledged that we had satisfied its network expansion and universal service targets two years prior to the scheduled date. As a result, on April 25, 2002, ANATEL published an order that allowed us to be the first fixed-line telephone company to provide the full range of STFC services and expanded our concession to develop services in the local, intraregional, interregional and international markets throughout Brazil.
On April 29, 2002, certain provisions of the ANATELs order were partially suspended as a result of injunctions sought by Embratel. The injunctions prevented us from commencing our interregional services that originated in our concession region, Region III, and terminated in other concession areas, namely Region I (Telemars concession region) and Region II (Brasil Telecoms concession region). However, our concession to provide local and interregional services in Region I, Region II, Sector 33 of Region III and international services in all three regions was not affected. These injunctions were lifted in June 2002, however, the lawsuits brought by Embratel have not yet been dismissed. Therefore, the possibility that we may be barred from providing interregional services still exists, although our risk of loss in this legal proceeding is deemed remote.
We began operating international long-distance service in May 2002 and interregional long-distance services in July 2002. Interregional long-distance service consists of state-to-state calls within Brazil. International long-distance service consists of calls between a point in Brazil and a point outside of Brazil.
In 2003, the most important development in network services was the migration of the mobile cellular service to the Personal Mobile Service SMP, through which mobile services users began to choose the provider for interregional and international long-distance calls, as they had already been choosing for fixed telephone service. The introduction of the Carrier Selection Code CSP required us to negotiate and enter into new interconnection agreements in order to implement the new rules and regulations specifically applicable to the rendering of this new service.
In 2004, four new mobile service providers entered the SMP market:
In 2005 we expanded our long-distance network in the main Brazilian cities of regions I and II, to new regions, such as the concession areas of CTBC Telecom, mainly in sector 33 of São Paulo, Minas Gerais and Sercomtel in Londrina. We have also entered in several new interconnection agreements that have allowed us to begin our operations in seven capital cities of BrazilPorto Alegre, Curitiba, Brasília, Rio de Janeiro, Vitória, Belo Horizonte and Salvadorby means of supplying such markets with the necessary infrastructure based on new generation platforms.
We have also, during 2005, worked to optimize new business opportunities in the State of São Paulo through services to other telecommunication companies, which resulted in a significant increase in the number of providers that are also clients of Telesps inter-connection services using our local and long-distance telecommunication services.
One of the most important developments in network services initiated in 2004 and concluded in 2005 was the adjustment by regulatory requirement of the network topology in the state of São Paulo, which consisted of the integration of 92 municipalities in the state which allowed customers to make local calls that had previously been long-distance calls.
Currently, we also provide a variety of other telecommunications services that extend beyond basic telephone service, including interactive banking services, electronic mail and other similar services.
In 2004, ANATEL published proposed amendments to the interconnection rules in general and, specifically, to the interconnection charging rules. In July 2005, ANATEL published new rules regarding interconnection systems which substantially changed the interconnection model. These changes include: (i) an obligation to offer the public all types of interconnection services, in addition to interconnections between fixed line service providers and mobile service providers; (ii) an offer of interconnections for Class III and Class V services; (iii) the establishment of criteria for the treatment of fraudulent calls; and (iv) the reduction of terms for the availability of interconnections. As a result of these reforms, new operators may enter the market and increase the competition we currently face.
We have entered into seven interconnection agreements that conform to the new interconnection rules. New contracts have been implemented as of March 2006, that allow us to develop additional interconnection relationships and offer our interconnection customers new telecommunications services in the state of São Paulo.
I-Telefônica is a free Internet access service provider launched in September 2002 by our subsidiary A. Telecom S.A. (formerly Assist Telefônica). The product covers 620 cities in the State of São Paulo and over 1,000 cities in all of Brazil. The service delivers high quality, stable Internet access that is structured to ensure that our clients do not encounter a busy signal when connecting to the Internet. I-Telefônica permits us to increase the range of our services and better supplies our customers by offering an entry-level option to the Internet market. I-Telefônica also represents a strategic tool to protect us against the possible traffic imbalance that may be generated by Internet access service providers that do not use our network. Traffic imbalance (sumidouro) occurs when a certain telecommunications operator has a higher volume of incoming than outgoing traffic (with another operator). When the incoming/outgoing traffic relationship falls outside the 45%55% range, the operator with higher outgoing traffic must pay to the other the interconnection fees corresponding to the traffic that exceeds the range. Telecommunications operators that house internet service providers tend to have more incoming than outgoing traffic and thus receive interconnection revenues from other operators. I-Telefônica helps us keep our dial-up traffic on our own network, and thus reducing unfavorable traffic imbalance, thereby lowering our interconnection expenses.
IP Network Asset Acquisition
On December 10, 2002, after receiving the approval from ANATEL, our Board of Directors approved a proposal to acquire certain assets from T-Empresas, one of the companies of the Telefónica group, including the following services: (a) an Internet service which allows our customers to access our network through remote dial-up connection and (b) services that allow customers of Internet Service Providers, or ISPs, to have access to broadband Internet. The purpose of this asset acquisition was to capitalize on synergies that would assist in developing our network and provide a quick response to market competitors.
Authorization to Provide Multimedia Services
On January 29, 2003, ANATEL granted our Multimedia Communications Service (SCM) license nationwide, allowing A. Telecom S.A. (formerly Assist Telefônica), our wholly-owned subsidiary, to provide voice and data services through points-of-presence (POPs), which are comprised of private telecommunications networks and circuits.
On November 11, 2004, ANATEL granted us an experimental and scientific license to test Wi-Max technology, a multimedia service for a term of 12 months, renewable for one additional year. This license permits us to test new technologies and develop technical studies.
On December 14, 2005, ANATEL granted us a new experimental and scientific license to test technologies that would allow the transmission of digital video content via ADSL for a term of 6 months.
Corporate Customer Services
We offer our corporate clients comprehensive telecommunications solutions designed to address specific needs and requirements of companies operating in a number of different market segments such as manufacturing, services, financial institutions and government.
Our clients are assisted by our highly qualified professionals who offer specialized telecommunication support tailored to meet the specific needs of each company by delivering corporate internet access, voice and data solutions, and by consistently striving for greater service efficiency to preserve our competitiveness in our market.
Rates and Taxes
We generate revenues from (i) activation and monthly subscription charges; (ii) usage charges, which include measured service charges; and (iii) network usage charges.
Rates for telecommunications services are subject to comprehensive regulation by ANATEL. See Regulation of the Brazilian Telecommunications Industry. Since the relative stabilization of the Brazilian economy in mid-1994, there have been two major changes in rates for local and long-distance services. First, in January 1996, rates for all services were increased, primarily to compensate for accumulated effects of inflation. Then, in May 1997, the rate structure was modified through a fee rebalancing that resulted in higher charges for measured service and monthly subscription and lower charges for intraregional, interregional and international long-distance services. The purpose of the change was to eliminate the cross-subsidy between local and long-distance services.
Concession agreements, which are valid from 1998 until December 31, 2005, establish a price cap for annual rate adjustments, generally effected at June of each year. The annual rate adjustment is applied to the following categories of service rates:
Rates for international services are not required to follow the price cap established for other services and, therefore, we are free to negotiate our fees based on the international telecommunications market, where our main competitor is Embratel.
As of January 2006, with the renewal of our concession until December 31, 2025, the following readjustment rules for fees became effective.
We readjust charges based on baskets of fees, as follows:
Our revenue from local service consists principally of activation charges, monthly subscription charges, measured service charges and public telephone charges. Users of measured service, both residential and non-residential, pay for local calls depending on usage, which is measured in pulses. The first pulse is recorded at the moment a call is in fact connected to its destination. Afterwards, pulses occur system-wide every four minutes, regardless of the moment when a particular call was initiated. As a result, the time between the first pulse and the second (system-wide) pulse may vary between one second and four minutes. Thus, based upon when during a cycle a call is initiated, the charge for the call may vary significantly.
Local charges for weekday calls are determined by multiplying the number of pulses by the charge per pulse. For calls made at night and during selected weekend hours, callers are charged for only one pulse regardless of the duration of a call. Under current ANATEL regulations, residential customers receive 100 free pulses per month and commercial customers receive 90 free pulses per month.
On June 30, 2005, by means of the Act Nr. 51, 301, ANATEL ratified the new local fees for our concession areas, effective from July 3, 2005 onward. The average increase on the basis basket was 7.27%. The fees were applied to consumers as follows:
Intraregional and Interregional Long-Distance Rates
Intraregional long-distance service consists of all calls that originate in one local area or municipality of our concession region and terminate in another local area or municipality of our concession region. All other calls are denominated interregional long-distance calls. Rates for intraregional and interregional long-distance calls are computed on the basis of the time of day, day of the week, duration and distance of the call, and also may vary depending on whether special services, including operator assistance, are used.
On March 1, 2002, ANATEL acknowledged that we had reached its network expansion and universal service targets two years prior to the scheduled date. As a result, on April 25, 2002, ANATEL published an order that allowed us to be the first concessionaire to provide the full range of STFC services and expanded our concession to develop services in the local, intraregional, interregional and international markets throughout Brazil.
On April 29, 2002, certain provisions of ANATELs order were partially suspended as a result of certain legal proceedings brought by Embratel. The proceedings prevented us from commencing our interregional services that originated in our concession region, Region III, and terminated in other concession areas, namely Region I (Telemars concession region) and Region II (Brazil Telecoms concession region). However, our concession to provide local and interregional services in Regions I and II, Sector 33 of Region III, and international services in all three regions was not affected. On June 28, 2002, ANATEL dismissed the proceedings and allowed us to begin offering interregional services originating in our concession region.
On July 29, 2002, after we received the concession from ANATEL to provide interregional long-distance services throughout Brazil, we launched several new options of interregional calling plans relating to consumer Code 15, which is the selection code dialed by customers who may choose a long-distance provider with each call and may result in different prices based upon frequency of use and customer calling patterns.
International Long-Distance Rates
On May 7, 2002, we began operating international long-distance services. International long-distance calls are computed on the basis of the time of day, day of the week, duration and destination of the call, and also may vary depending on whether special services are used or not, including operator assistance.
We developed alternate rate plans for our residential and corporate customers.
Network Usage Charges
We earn revenues from any fixed-line or mobile service provider that either originates or terminates a call within our network. We also pay interconnection fees to other service providers when we use their network to place or receive a call. Under the General Telecommunications Law, all fixed-line telecommunications service providers must provide interconnection upon the request of any other fixed-line or mobile telecommunications service provider. We have interconnection agreements with other telephone service providers, including Embratel, Intelig and Telesp Celular. The interconnection agreements are freely negotiated among the service providers, subject to a price cap and in compliance with the regulations established by ANATEL, which includes not only the interconnection basic principles covering commercial, technical and legal aspects, but also the traffic capacity and interconnection infrastructure that must be made available to requesting parties. If a service provider offers to any party an interconnection fee below the price cap, it must offer the same fee to any other requesting party on a nondiscriminatory basis. If the parties cannot reach an agreement on the terms of interconnection, including the interconnection fee, ANATEL can establish the terms of the interconnection. See Regulation of the Brazilian Telecommunications IndustryObligations of Telecommunications Companies.
In accordance with ANATEL regulations, we must charge interconnection fees to the other telephone service providers based on the following fees:
Beginning in 2006, with the 20-year renewal of the Concession Contracts, the rules in respect of local network fees, or TU-RL, were changed. Beginning on January 1, 2008, local network fees will be calculated based on a long-term cost model (LRICLong Run Incremental Costs). For 2006 and 2007, ANATEL established the following rule:
(i) from January 1, 2006 to December 31, 2006, the local network fee will equal 50% of the per-minute value of a local call, in accordance with value promulgated by ANATEL, for the Basic Local Service Plan; and
(ii) from January 1, 2007 to December 31, 2007 the local network fee will equal 40% of the per-minute value of a local call, in accordance with value promulgated by ANATEL, for the Basic Local Service Plan. See the Local Concession Contracts included in the Annual Report as exhibits.
The usage fees for long-distance network (TU-RIU) will also be based on a long-term cost model (LRICLong Run Incremental Costs) starting on January 1, 2008. See the Local Concession Contracts included in the Annual Report as exhibits.
Cellular telecommunications service in Brazil, unlike in the United States, is offered on a calling party pays basis, under which the subscriber pays only for calls that he or she originates. Additionally, a subscriber pays roaming charges on calls originated and terminated outside his or her home registration area. Calls received by a subscriber are paid for by the party that places the call in accordance with a rate based on per minute charges. For example, a fixed-line service customer pays a rate based on per minute charges for calls made to a cellular service subscriber. The lowest base rate per minute, or VC1, applies to calls made by a subscriber in a registration area to persons in the same registration area. Calls to persons outside the registration area, but within our concession region, are charged at a higher rate, VC2. Calls to persons outside our concession region are billed at the highest rate, VC3. When a fixed line service customer calls a mobile subscriber, we charge fixed-line service customers per minute charges based on VC1, VC2 or VC3 rates. In turn, we pay the cellular service provider the cellular network usage charge.
Our revenue from network services also includes payments by other telecommunications service providers for the use of part of our network arranged on a contractual basis. Other telecommunications service providers, including providers of trunking and paging services, may use our network to connect a central switching office to our network. Some cellular service providers use our network to connect cellular central switching offices to the cellular radio-based stations. We also lease transmission lines, certain infrastructure and other equipment to other providers of telecommunications services.
We expect that the increase of our market share in long-distance, interregional and international services will reduce our revenues from interconnection services. We will invoice the client directly and therefore will not receive the interconnection charges from our competitors that otherwise would have to use our network to originate and terminate such client call. We have entered into several co-billing agreements in order to enable us to charge calls using the Code 15 in invoices from other providers.
Data Transmission Rates
Although we spun off most of our data transmission services to TDBH, we still receive revenues from the rental of dedicated analog and digital lines for privately leased circuits to corporations.
The cost of telecommunications services to each customer includes a variety of taxes. The principal tax is a state value-added tax, the Imposto sobre Circulação de Mercadorias e Serviços, or ICMS, which the Brazilian states impose at varying rates on revenues from the provision of telecommunications services. The rate in the State of São Paulo is 25% for domestic telecommunications services.
Other taxes on gross operating revenues include two federal taxes, the Contribuição para o Programa de Integração Social or PIS and Contribuição para o Financiamento da Seguridade Social or COFINS, imposed on gross operating revenues at a combined rate of 3.65% for telecommunications services and 9.25% for other services. PIS is a tax designed to share business profits with employees through a mandatory national savings program, and is financed by monthly deposits collected as a percentage of gross operating revenues. COFINS is a tax designed to finance special social programs created and administered by the Brazilian government. On February 2, 2004, the combined rate of PIS and COFINS imposed on gross operating revenues generated by services other than telecommunications services increased from 3.65% to 9.25%. However, revenues related to, among other things, equity, dividends and fixed asset sales are not subject to PIS and COFINS, except for hedging transactions and interest on shareholders equity (juros sobre o capital próprio).
In addition, the following contributions are imposed on certain telecommunications services revenues:
We must also pay the Contribution for the Fund of Telecommunications FiscalizationFISTEL. FISTEL is a fund supported by a tax applicable to telecommunications operators (the FISTEL Tax) and was established in 1966 to provide financial resources to the Brazilian government for the regulation and inspection of the telecommunications sector. The FISTEL Tax consists of two
types of fees: (i) an installation inspection fee assessed on telecommunications central offices upon the issuance of their authorization certificates and (ii) an annual operations inspection fee that is based on the number of authorized central offices in operation at the end of the previous calendar year. The amount of the installation inspection fee is a fixed value, depending upon the kind of equipment installed in the authorized telecommunications station. The operations inspection fee equals 50% of the total amount of the installation inspection fee that would have been paid with respect to existing equipment.
Billing and Collection
We send each customer a monthly bill covering all of the services provided during the prior period. Telephone service providers are required under Brazilian law to offer their customers the choice of at least six different payment dates within the monthly billing cycle. In our case, customers are divided into twelve different groups, and each group receives a bill according to a specific billing date within the monthly billing cycle.
We have a billing and collection system with respect to fixed-line-to-fixed-line and fixed-line-to-mobile for local, long-distance, subscription and receivables services. Payments of the bills are effected under agreements with various banks and other collection agencies (including lottery-playing facilities) either by debiting the customers checking account, by direct payment to a bank or through the Internet.
Brazilian telecommunications regulations require that we also offer a billing system known as co-billing. The co-billing system results in a third-party telephone service companys invoice being included within our own invoice. Our customers can receive and subsequently pay all of their bills (including the fees for the use of services of another telephone service provider) by using one invoice. In order to develop this co-billing system, we share our billing and collection infrastructure with the other telephone service companies and have developed a special system to facilitate this co-billing. We have co-billing agreements (i.e., co-billing in) with Intelig, Embratel, Telemar/TNL, GVT, CTBC Telecom and Brasil Telecom, each of which provides fixed-line services, and with TIM and Claro, each of which provides mobile services. Similarly, we employ the same co-billing system to bill for the use of our services by customers of other service providers. We have co-billing agreements of this nature (i.e., co-billing out) with Telemar, CTBC, Brasil Telecom, Sercomtel and GVT, each of which provides fixed-line services, and with Claro, Oi, Tim, Telemig Celular, Amazônia Celular, Sercomtel Celular, CTBC Celular, Brasil Telecom Celular and VIVO, each of which provides mobile services.
ANATEL regulations allow us to restrict a customer from making outgoing calls after a receivable has been outstanding for 30 daysa partial blockor restrict a customer from making outgoing or receiving incoming callsa total blockafter 60 days and to disconnect a customer upon failure to pay after 90 days. On December 31, 2005, we had 454,109 telephone lines partially blocked and 476,116 telephone lines totally blocked. We charge penalties of 2% plus interest at the rate of 1% per month on the overdue amounts. On December 31, 2005, 4.73% of all receivables had been outstanding between 30 and 90 days, and 15.47% of all receivables had been outstanding for more than 90 days. For a discussion of provisions for past due accounts, see Item 5Operating and Financial Review and Prospects.
In 2005, we operated for the second consecutive year having improved the system to control the revenue chain. This control was important for continual improvements in our billing and collections processes, as well as for the assurance of the non-occurrence of losses in the implementation of new systems and in roll-outs. The actions were followed closely by our Revenue Assurance Team, which measures every risk of loss of revenue detected along the billing and collection chain. These risks were managed to minimize revenue losses.
Network and Facilities
Our network includes installed lines and switches, a network of access lines connecting customers to switches and trunk lines connecting switches and long-distance transmission equipment. Intraregional long-distance transmission is provided by a microwave network and by fiber optic cable. Our network strategy is to develop a broadband integrated network that is compatible with several types of telecommunications services and multimedia applications.
As a telecommunications services provider, we do not physically build our own network and facilities. We purchase the equipment through which we provide our services from third-parties and, accordingly, do not buy the raw materials that comprise our network and facilities. The following table sets forth selected information about our network in aggregate, at the dates and for the years indicated:
We are incorporating new digital technology into our network in order to offer more integrated services. In 2002, we began to offer international and interregional long-distance telecommunications services known as Super 15. Since 1999, we have been heavily investing in the offering of broadband access through asymmetric digital subscriber line, or ADSL, technology under the brand Speedy. ADSL is a technology that allows more data to be sent over existing copper telephone lines. In 2005, we reached 1,206,799 broadband access connections. We introduced the innovative concept of a management portal in our ADSL network called Portal de Serviços through which our clients are able to select our services.
Our current Wi-Fi network consists of 599 hot spots which provide wireless Internet access and mobility to our Internet clients. These hot spots are installed mainly in major Brazilian airports, large hotel chains, certain restaurants and various coffee shops in the City of São Paulo.
Our development plan targets state of the art communication technology, focusing on the integration with the Internet and an increase in the number of multimedia transmission services.
As of December 31, 2005, our network was nearly 100.0% digital.
Companies seeking to operate in the telecommunications industry in Brazil are required to apply to ANATEL for a concession or an authorization. Concessions and authorizations are granted for services in the public or the private regime, respectively. The public regime differs from the private regime primarily in the obligations imposed on the companies rather than the type of services offered by such companies. We are one of four companies that operate within the public regime. All other telecommunications companies, including those that provide the same services as the four public regime companies, operate under the private regime.
In order to stimulate growth and increase competition, the Brazilian government issued new authorizations within our area of operations to Vésper Holdings S.A. and Vésper Holding São Paulo S.A., Embratel Participações S.A. and Intelig Telecomunicações Ltda. In April 1999, Vésper won the bid in connection with operating licenses for local and long-distance fixed-line services in Region III, our concession region. Vésper only started its operations in January 2000. In July 1999, Embratel and Intelig were also authorized to provide long-distance telecommunications services in our concession region. In addition, in July 1999, ANATEL introduced the operator selection code, so that customers may choose, at each call, the operator for their long-distance calls. Therefore, in 2000, competition in the long-distance service market increased, reducing our market share from previous years.
Vésper was formed by Qualcomm, VeloCom and Bell Canada International in 1999. According to the rules enacted by ANATEL, Vésper was required to quickly develop its local service business.
In 2002, Vésper started to offer portable telephones, which did not require physical installation in a customers premises and which could be operated remotely, similarly to cellular phones. However, the coverage of this device extended for several kilometers, and ANATEL prevented its sale based on the assumption that it violated the terms of Véspers wire line telecommunications license. Vésper modified the system and decreased its range and was thus allowed to resume the sale of its device. Based on the positive acceptance of this product when it did not present any range limits, Vésper tried to extend its operations to the wireless telecommunications business through the acquisition of licenses to operate in SMP (Personal Mobile Service), an authorization for a general mobile services operation, in the State of São Paulo (but not in the city). However, ANATEL did not authorize the use of the frequency in which Vésper operated to cellular telecommunications services and, subsequently, Véspers operations were offered for sale by its controlling shareholders in April 2003. In the third quarter of 2003, Vésper was sold to Embratel.
Embratel was acquired by MCI WorldCom in the privatization of the Telebrás System in 1998. In July 2001, MCI filed for bankruptcy under Chapter 11 in U.S. federal bankruptcy court. Since 2002, Embratel has been subject to long-distance service competition as a result of our operations and those of Telemar. During the second quarter of 2004, Embratel was sold to Telmex, the leading provider of fixed-line telecommunications services in Mexico.
Intelig was granted a license to provide long-distance services throughout Brazil and implemented its intraregional long-distance service in our region in July 1999. The shareholders of Intelig include National Grid, the owner and operator of the electricity transmission network in the United Kingdom, France Telecom, one of the worlds leading telecommunications carriers and Sprint, a global U.S. based communications company. Inteligs strategy has been characterized by extensive marketing efforts, including substantial discounts and attractive customer plans. However, Intelig has not managed to reach the same market penetration achieved by Embratel. In 2002, Inteligs partners expressed their intention to sell the company and received offers, but no sale was consummated.
In 2002, ANATEL certified that Telemar and we had achieved the universalization targets for 2003 and we were granted concessions to operate as interregional and international long-distance providers, thus starting to compete directly with Embratel and Intelig. Embratel and Intelig also achieved their targets and were granted concessions to operate as local telecommunications providers in the three Brazilian concession regions. Embratel started its local services operations in January 2003, and Intelig has been offering local services to its corporate clients since early 2003. Brasil Telecom announced that it achieved its targets in February 2003. ANATEL certified such achievement in January 2004 and Brasil Telecom started its long-distance operations in the second quarter of 2004.
For mobile operations, our concession region is divided into two sub-areas. In each sub-area there are currently three cellular service providers. We currently face competition from three cellular services providers in the State of São Paulo:
In 2002, the Brazilian government auctioned another license to operate cellular PCS (Personal Communications Systems) systems under the E Band frequency. In the City of São Paulo, Claro won the auction, while Vésper prevailed on E Band rights in the rest of the State of São Paulo. Despite the success of each company in the E Band auction, each announced the return of its respective
license for different reasons. Claro stated that it had already started operations in the São Paulo cellular market as a result of its acquisition of BCP. Vésper announced that it would return the license because it had been acquired by Embratel, the leading long-distance carrier and devoid of any interest in the cellular market. In September 2004, ANATEL again attempted to auction the E Band licenses for the City of São Paulo and the rest of the State of São Paulo. Despite Telemars request to delay the auction, the auction went forward with no company electing to submit a bid. The Brazilian government intends to auction the E Band licenses again at some point in the future in response to interest from two other telecommunications companies.
We currently face strong competition in the corporate and residential segments in respect of several types of services. In the corporate segment, we face strong competition in both voice services (local and long-distance) and data transmission, resulting in customer migration and the need for greater discounts to maximize client retention. Our main competitors in the corporate segment are Teléfonos de México, S.A. de C.V. (Telmex), Telemar and Intelig. In the high-income residential service segment, we compete for long-distance with Telmex and Intelig and for broadband services with cable TV providers, mainly NET Serviços de Comunicação S.A., TVA Sistema de Televisão S.A. and Vivax S.A. For the local voice and high-income segments, we also face increasing competition from cellular telecommunications services, which have lower rates for certain types of calls such as mobile-to-mobile calls. Such competition increases our advertising and marketing costs. In 2005, we also observed the appearance of small VOIP operators, focused on low and middle income corporate clients, the impact of which has not been significant through now, but which we expect to be more significant in the future. We are taking several steps to defend ourselves from increasing competition, including making improvements in our broadband products, offering bundled services that include voice and broadband and developing IPTV-related products. In addition, we are improving our market segmentation and developing more competitive and segment-oriented products intended to combat our competitors product offerings and to prevent our losing market share.
In the low-income, local fixed telecommunications segment, we face less direct competition because of the low profitability of this market. The most significant competition here is from pre-paid cellular telecommunications providers. Their services are relatively profitable because of the high fees they generate through the interconnection of fixed and cellular networks. In 2005, agreements were reached that revised such fees to levels that provided a positive impact for fixed operators. Further, there is an industry perception that the interconnection fees charged by fixed and mobile operators are imbalanced towards mobiles and should continue to be rebalanced, although the amount of time it would take for this to happen and the amount of rebalancing that would result is still uncertain.
In the second quarter of 2003, the number of cellular phones surpassed the number of fixed-line phones in Brazil, and, in the first quarter of 2004, the same phenomenon occurred in the State of São Paulo. At the end of 2004, there were approximately 17 million cellular telephones in the State of São Paulo. Despite this escalation suggesting, in part, a preference for cellular phones instead of fixed-line phones, the negative impact on our revenues from competition with cellular services providers is partially offset by interconnection fees we charge such providers for use of our network. See Item 5.AOperating and Financial Review and ProspectsOperating ResultsNet Operating RevenueNetwork Usage Services. However, subsidiaries of America Móvil operating under the brand name Claro and Embratel, each controlled by Carso Telecom Group, may begin a trend of combination offerings involving fixed-line and mobile services. In 2005, a few combination offerings were launched in the market, but until now they have not been highly significant. Telemar and its cellular company Oi launched one plan which bundles fixed-to-fixed and fixed-to-mobile minutes and Brasil Telecom and its cellular company BrT GSM launched an offer allowing the use of pre-paid credits in pay phones as well as in pre-paid cellular phones. We are also offering combinations of services for our customers with Vivo, one of the mobile companies indirectly controlled by the Telefónica group. The acquisition of AT&T Latin America by Carso Telecom Group-Controlled Telmex also represented an important development in the data transmission segment. In addition, Embratel announced in the first quarter of 2005 that it would concentrate on creating synergies with subscription television operator net and others to offer phone services with the objective of competing with us, Telemar and Brasil Telecom. Such combined offers and consolidations are likely to fuel additional competition in the marketplace.
Sales, Marketing and Customer Services
We employ the following different approaches to deliver our solutions to corporate customers:
We continuously monitor market trends in an effort to develop new products and services which may address future needs and tendencies of our customers.
We employ a differentiated approach in marketing whereby we use a mix of human and technological resources (a specialized team and business intelligence tools, respectively), in addition to specific studies that allow us to target each market segment according to the relevant customers specific needs.
We believe that the brand strength of Telefónica and its customer service, marketing and communication efforts will produce new business opportunities and attain and preserve customer loyalty.
One of our primary goals is to provide subscribers with excellent customer care. We continue to improve the quality of our services through network upgraded and the addition of automated operational support systems. The following table sets forth information on service quality for the periods indicated.
We are also required under the Brazilian telecommunications regulations to meet certain service quality targets relating to call completion rates, repair requests, response rates to repair requests and operator response periods. See Regulation of the Brazilian Telecommunications IndustryObligations of Telecommunications Companies.
In order to improve the quality of our services, we have undertaken several new measures and continued taking several previous measures to guarantee customer satisfaction including:
Our business and results of operations are not materially affected by seasonal fluctuations in the consumption of our services.
Regulation of the Brazilian Telecommunications Industry
Our business, including the services we provide and the rates we charge, is materially affected by comprehensive regulation under the General Telecommunications Law and various administrative rules thereunder. Our companies that operate under a concession are authorized to provide specified services and have certain obligations, according to the Plano Geral de Metas de Universalização, or General Plan on Universal Service Targets and the Plano Geral de Metas de Qualidade, or General Plan on Quality Targets.
ANATEL is the regulatory agency established by the General Telecommunications Law and the Regulamento da Agência Nacional de Telecomunicações, known as the ANATEL Decree issued on October 1997. ANATEL is administratively and financially independent from the Brazilian government. Any proposed regulation by ANATEL is subject to a period of public comment, including public hearings, and its decisions may be challenged in the Brazilian courts.
Concessions and Authorizations
Concessions are licenses to provide telecommunications services that are granted under the public regime, while authorizations are licenses to provide telecommunications services granted under the private regime. Companies that provide services under the public regime, known as the public regime companies, are subject to certain obligations as to quality of service, continuity of service, universality of service, network expansion and modernization. Companies that provide services under the private regime, known as the private regime companies, are generally not subject to the same requirements regarding continuity or universality of service; however, they are subject to certain network expansion and quality of service obligations set forth in their authorizations. Companies that operate under the public regime include us, Embratel, Telemar, Brasil Telecom and other local providers. The primary public regime companies provide fixed-line telecommunications services in Brazil that include local, intraregional, interregional and international long-distance services. All other telecommunications service providers, including the other companies authorized to provide fixed-line services in our concession region, operate under the private regime.
Public regime companies, including us, can also offer certain telecommunications services in the private regime, of which the most significant are data transmission services.
Fixed-line ServicesPublic Regime. Our current Concession Agreement was extended on December 22, 2005, for an additional period of 20 years. In accordance with the Concession Agreement before the renewal, we had notified ANATEL of our intention to renew such Concession Agreement on June 30, 2003.
On December 1, 2005, we sent to ANATEL the necessary evidence that we had attained our network expansion and universal service targets (requirements set forth by Presidential Decree 2,592, that telecommunications operators expand individual and public access to all places with a minimum determined number of inhabitants, among other targets, such as access in schools and hospitals) established by the Serviço Telefônico Fixo Comutado, or the STFC, of 2005. The evidence of our accomplishment was submitted by ANATEL to a public hearing on December 22, 2005, which was completed on February 6, 2006. ANATEL is in the process of issuing a certificate.
The renewed Concession Agreement contemplates possible changes to its terms by ANATEL in 2010, 2015 and 2020. This provision permits ANATEL to update the renewed Concession Agreement with respect to network expansion, modernization and quality of service targets in response to changes in technology, competition in the marketplace and domestic and international economic conditions.
ANATELs initial grant of our Concession did not require us to pay any concession fees. Under the renewed Concession Agreement and during the 20-year renewal period, we will be required to pay a biannual fee equal to 2% of our annual net revenue from the provision of fixed-line public telecommunications services in our concession area for the prior year (excluding taxes and social contributions). See Obligations of Telecommunications CompaniesPublic RegimeService Restrictions. Each of the foregoing regulatory terms and conditions affecting (or potentially affecting) the renewed Concession Agreement, as well as current obligations under the existing Concession Agreement, may impact our business plan and results of operations.
Other regional fixed-line companies and us were not permitted to offer interregional or international long-distance services or other specified telecommunications services until December 31, 2003, unless we attained the network expansion and universal service targets by December 31, 2001. We achieved the network expansion and universal service targets on September 30, 2001, which was acknowledged by ANATEL through Act No. 23.395 of March 1, 2002. Accordingly, on May 7, 2002, we began providing international long-distance services. A subsequent act, Act No. 26.880, allowed to operate interregional service originating in Sectors 31, 32 and 34 to other sectors, with the exception of Sector 33. See Obligations of Telecommunications CompaniesPublic Regime-Service Restrictions.
Act No. 25.120, enacted on April 25, 2002, allowed us to provide local and interregional services in Regions I and II and Sector 33 of Region III, and international long distance services in Regions I, II and III.
Fixed-line ServicesPrivate Regime. The Brazilian telecommunications regulations provide for the introduction of competition in telecommunications services by requiring ANATEL to authorize private regime companies to provide local and intraregional long-distance service in each of the three fixed-line regions and to provide intraregional, interregional and international long-distance services throughout Brazil. ANATEL has already granted authorizations to private regime operators to operate in Region III, our concession region. ANATEL also granted other private regime companies authorizations to operate in other fixed-line regions and authorizations to provide intraregional, interregional and international long-distance services throughout Brazil in competition with Embratel. Several companies have already applied for the authorization and ANATEL may authorize additional private regime companies to provide intraregional, interregional and international long-distance services. See Competition.
Obligations of Telecommunications Companies
We and other telecommunications service providers are subject to obligations concerning quality of service, network expansion and modernization. The four public regime companies are also subject to a set of special restrictions regarding the services they may offer, which are listed in the Plano Geral de Outorgas, or General Plan of Grants, and special obligations regarding network expansion and modernization contained in the General Plan on Universal Service Targets.
Public RegimeService Restrictions. The General Plan of Grants previously prohibited regional fixed-line service providers from offering cellular, interregional long-distance or international long-distance services and prohibited Embratel from offering local or cellular services until December 31, 2003. These service restrictions were lifted after December 31, 2001 for companies like us, which, within their respective regions, had collectively met the 2003 targets by December 31, 2001. ANATEL monitors the progress of regional fixed-line service providers in meeting their obligations. Each regional fixed-line provider was authorized to provide all other telecommunications services (except for fixed-line private services in the private regime within their own respective regions and cable TV services) if the company had already achieved the 2003 targets or had done so by the beginning of 2004.
Public regime companies are also subject to certain restrictions on alliances, joint ventures, mergers and acquisitions, including:
Network Expansion & Quality of Service. We are subject to the General Plan on Universal Service Targets (Plano Geral de Metas para a Universalização) and the General Plan on Quality Targets (Plano Geral de Metas de Qualidade), each of which respectively requires that we undertake certain network expansion activities with respect to our fixed-line services and meet specified quality of service targets. The timing for network expansion and benchmarks for quality of service are revised by ANATEL from time-to-time. No subsidies or other supplemental financings are anticipated to finance our network expansion obligations.
If a public regime company fails to meet its obligations in a particular fixed-line concession region, ANATEL may apply certain penalties set forth in the concessions and fines and penalties of up to R$50.0 million per event. Failure to meet the quality of services and modernization obligations may result in fines and penalties of up to R$40.0 million per event, as well as potential revocation of the concessions granted to the company. If a public regime company endangers the provision of basic telecommunications services to a concession region, and upon proof that the public regime company is incapable of providing such service, ANATEL may, after coordinating a regulatory process, decide there is a need to take back the concession temporarily until another auction takes place and a new concession is granted.
Interconnection. On July 2005, ANATEL published a new regulation for interconnection among providers of telecommunication services, with material changes compared to the prior regulation. Among the key changes, it became mandatory to make an interconnection public offer for all classes and types of services, which means that operators will have to issue a public document disclosing all the conditions for their establishment of interconnection. In addition to the offers that were already contained in the current model, such as the offer between STFC carriers or between STFC and SMP/SME carriers, Telesp will have to make offers to SCM authorized companies, in classes III and/or IV. Moreover, those offers are required to include criteria for treating fraudulent calls. These new regulations also contemplate the reduction of the period to fulfill the new interconnection requirements.
C. Organizational Structure
On December 31, 2005, our voting shares were controlled by two major shareholders: SP Telecomunicações Holding Ltda. with 50.23% and Telefónica Internacional S/A with 34.48%. Telefónica Internacional is the controlling shareholder of SP Telecomunicações and, consequently, holds directly and indirectly 84.71% of our common shares and 88.90% of our preferred shares. Telefónica Internacional is a wholly-owned subsidiary of Telefónica, S.A. of Spain.
A. Telecom S.A. (formerly Assist Telefônica) is our wholly owned subsidiary. Assist Telefônica, which was incorporated in Brazil on October 29, 1999, performs on-site technical assistance related to the installation, maintenance and management of telecommunication services under a Building Local Exchange Carrier (BLEC) model, and also provides free ISP service under the brand name I-Telefônica. In addition, on December 30, 2004, we entered into a transaction to acquire indirect control of Atrium Telecomunicações Ltda. The transaction was approved by our shareholders on January 19, 2005. The acquisition was carried out through the purchase of the total share capital of Santo Genovese Participações Ltda., which held 99.99% of the representative share capital of Atrium. See Item 4.BBusiness OverviewServices.
Since June 30, 2000, we have consolidated, under the Corporate Law Method, the operations of Aliança Atlântica Holding B.V., an investment company incorporated under the laws of the Netherlands. As of December 31, 2005, we held a 50% share ownership and Telefónica S.A. held the remaining 50%.
Furthermore, on December 31, 2003, we also consolidated, under the Corporate Law Method, our investment under proportional consolidation in Companhia AIX de Participações, or AIX. At December 31, 2005, we held a 50% share ownership in AIX and Telemar Participações S.A. held the remaining 50%. AIX was formed in 2001 to explore, directly and indirectly, activities related to the execution, conclusion and commercial exploitation of underground cables to optic fiber. See Note 1 and Note 33 to the consolidated financial statements included in this Annual Report starting at page F-1. We also consolidate, as required under the Corporate Law Method, Companhia ACT de Participações, in which we hold a 50% interest.
D. Property, Plants and Equipment
Our main physical properties include transmission equipment (including outside plant and trunk lines), switching equipment and various sites throughout the State of São Paulo. Our land and buildings primarily consist of telephone switches and other technical, administrative and commercial properties. Switches include local switches, toll switches that connect local switches to long-distance transmission facilities and tandem switches that connect local switches with each other and with toll switches.
Our properties are located throughout the State of São Paulo. At December 31, 2005, we used 2,072 properties in our operations, 1,475 of which we own, and we enter into standard leasing agreements to rent the remaining properties. We own a building in the City of São Paulo where the majority of our management activities are conducted.
As of December 31, 2005, property related to construction in progress represented 2.6% of the net book value of our total fixed assets, automatic switching equipment represented 28.5%, transmission and other equipment represented 26.9%, underground and marine cables, poles and towers represented 1.5%, subscriber and public booth equipment represented 6.2%, electronic data process equipment represented 0.8%, buildings and underground equipment represented 24.6%, land represented 2.1%, and other assets represented 6.8% of total fixed assets. As of December 31, 2005, the net book value of our property, plant and equipment was R$12.3 billion.
Pursuant to Brazilian legal procedures, liens have been attached to several properties pending the outcome of various legal proceedings to which we are a party. See Item 8.AFinancial InformationConsolidated Statements and Other Financial InformationLegal Proceedings.
ITEM 5. OPERATING AND FINANCIAL REVIEW AND PROSPECTS
A. Operating Results
The following discussion should be read in conjunction with our consolidated financial statements and accompanying notes and other information appearing elsewhere in this annual report and in conjunction with the financial statements included under Item 3.AKey InformationSelected Financial Data. Except as otherwise indicated, all financial information in this annual report has been prepared in accordance with the Brazilian Corporate Law and presented in reais. For certain purposes, such as providing reports to our Brazilian shareholders, filing financial statements with the CVM, and determining dividend payments and other distributions and tax liabilities in Brazil, we have prepared and will continue to be required to prepare financial statements in accordance with the Brazilian Corporate Law.
Our results of operations are principally affected by the following key factors.
Brazilian Political and Economic Environment
The Brazilian economy has experienced moderate growth this decade. According to the IBGE (Instituto Brasileiro de Geografia e Estatística), Brazils GDP expanded 0.5% in 2003 and 4.9% in 2004. In 2005, Brazilian GPD growth was approximately 2.0%.
Consumer prices, as measured by the Consumer Price Index, or the IPCA, published by the IBGE, reached their lowest point in five years and finished 2005 at 5.7% compared to 7.6% in 2004. Inflation, as measured by the General Price Index, or the IGP-DI, calculated by the Fundação Getúlio Vargas, which includes wholesale, retail and home-building prices, increased 1.2% in 2005 compared to 12.1% in 2004 due to real appreciation.
In early 2005, in an effort to curb inflation and achieve target rates, the Central Bank increased interest rates from 17.75% in December 2004 to 19.75% in May 2005. In response to the real appreciation, inflation decreased during the second semester. As a result, the Central Bank began to decrease interest rates in September 2005. At the end of the year, the Selic rate reached 18.0%.
Brazil finished 2005 with a trade balance surplus of US$44.8 billion, compared to US$33.7 billion in 2004. Exports went up by 23% to US$118.3 billion, while imports increased by 17% to US$73.5 billion. This trade surplus allowed the Brazilian Government to repay IMF debt in advance of its scheduled required payments and thereby reduce its external debt and increase international reserves.
Public finance surpassed government forecasts, and the initial target of 4.25% of GDP for primary surplus was increased. The net public sector debt, as a proportion of GDP, ended 2005 at 51%, close to the level reached in 2004.
The overall improvement in Brazils domestic economic indicators (external and fiscal accounts), together with an environment of greater liquidity in the international capital markets, led to a fall in country-risk. The JP Morgan Emerging Markets Bond Index Plus (EMBI + Brazil), which tracks total returns for traded external debt instruments in the emerging markets , fell to 305 basis points as at December 31, 2005, compared to 383 basis points as at December 31, 2004.
The Brazilian real appreciated during 2005 in the wake of increasingly promising economic indicators and falling country risk. The exchange rate was R$2.34 to US$1.00 on December 31, 2005 compared to R$2.65 to U.S.$1.00 as of December 31, 2004. The appreciation of the real in this context is also related to the devaluation of the U.S. dollar against other currencies.
Our business is directly affected by trends in the global economy and the Brazilian economy. If interest rates rise and the Brazilian economy enters a period of continued recession, then demand for telecommunications services is likely to decline. Similarly, depreciation of the Brazilian real against the U.S. dollar could reduce the purchasing power of Brazilian consumers and negatively affect the ability of our customers to pay for our telecommunications services. Real devaluations would also affect our
profit margins by increasing the carrying costs of our U.S. dollar and other foreign currency denominated debt, and our other costs and expenses based on the U.S. dollar and other foreign currencies.
Impact of Inflation on Our Results of Operations
Prior to 2005, the fees we charged our customers were periodically adjusted by ANATEL based on the inflation rates measured by the General Price Index (IGP-DI).
Starting in 2006, telephone fees will be indexed to the IST, which is a basket of national indexes that reflect the sectors operating costs. Such indexing will thus reduce inconsistencies between revenues and costs in our industry and therefore adverse effects of inflation on our business.
The table below shows the Brazilian general price inflation (according to the IGP-DI and the IPCA) for the years ended December 31, 1998 through 2005:
Regulatory and Competitive Factors
Our business, including the services we provide and the rates we charge, is subject to comprehensive regulation under the General Telecommunications Law. As a result, our business, results of operations and financial conditions could be impacted by the actions of the Brazilian authorities, including:
A series of new regulations were enacted in 2005 and will become effective in 2006:
There were also some public consultations that were completed, but rulings from which are still pending:
We believe that the following items will be submitted to public consultation:
In addition to regulatory considerations, our business is affected by competition from other telecommunications providers. We began to face competition in our region in July 1999 and anticipate that competition will contribute to declining prices for fixed-line
telecommunications services and increasing pressure on operating margins. Our future growth and results of operations will depend significantly on a variety of factors, including:
Revenue Increase as a Result of ANATELs Authorization to Provide Interregional and International Long-Distance Services
As we achieved our universal service targets before ANATELs deadline, we were authorized by ANATEL to launch long-distance services outside our concession region. We started our international long-distance services on May 7, 2002 and our interregional long-distance services on July 29, 2002. In 2005, our revenues from interregional and international long-distance services amounted to R$1.2 billion as compared to R$845.0 million in 2004. By the end of 2005, we had estimated market shares of approximately 50% in international service and approximately 60% in interregional long-distance services.
Foreign Exchange and Interest Rate Exposure
We face significant foreign exchange risk due to our foreign currency denominated indebtedness and our capital expenditures, particularly equipment. A real devaluation may increase the cost of certain of our capital expenditures. Our revenues are earned almost entirely in reais, and we have no material foreign currency denominated assets other than derivative instruments and corporate stakes in foreign companies.
On December 31, 2005, 36.5% of our R$2.4 billion of indebtedness was denominated in foreign currencies (U.S. dollar and Japanese yen). See Note 23 to the Consolidated Financial Statements. Devaluation of the real causes exchange losses on foreign currency denominated indebtedness and exchange gain on foreign currency denominated assets and corporate stakes in foreign companies.
We use derivative instruments that limit our exposure to exchange rate risk. Since September 1999, we have hedged virtually all of our foreign currency denominated debt, using swaps and options structures. However, we remain exposed to market risk deriving from changes in local interest rates (principally the Certificate for Interbank Deposits (Certificado de Depósito Interbancário), or CDI; CDI is an index based upon the average rate per cost of loans negotiated among the banks within Brazil).
Substantially all of our debt is exposed to interest rate risk. On December 31, 2005, we had R$2.4 billion in total loans and financing outstanding. From the total amount, R$478 million was subject to fixed rates, and the balance was subject to floating rates (TJLP, London Interbank Offered Rate, or LIBOR and CDI). However, virtually all of our foreign currency debt is swapped under hedging arrangements for variable rate real-denominated obligations based on CDI. As of December 31, 2005, we had no swap transactionsCDI against fixed rate to partially hedge against internal interest rate fluctuations. We invest our cash and cash equivalents mainly in short-term instruments that earn interest based on CDI. See Note 30 to the Consolidated Financial Statements and Item 11Quantitative and Qualitative Disclosures about Market Risk.
Since we have foreign currency derivatives substantially equivalent to our borrowings denominated in foreign currency, we do not have material exchange rate exposure with respect to these contracts. However, we could still continue to have exchange rate exposure with respect to our planned capital expenditures, approximately 14% of which are made in foreign currencies (mostly U.S. dollars). We systematically monitor the amounts and time of exposure to exchange rate fluctuations and may contract for hedging positions when appropriate at our discretion.
Discussion of Critical Accounting Estimates and Policies
The preparation of financial statements in accordance with Brazilian Corporate Law included in this annual report involves certain assumptions and estimates, which are based upon historical experience and various other factors that we deemed reasonable and relevant. Although we review these estimates and assumptions in the ordinary course of business, the portrayal of our financial
condition and results of operation often requires our management to make judgments regarding the effects on our financial condition and results of operations of matters that are inherently uncertain. Actual results may differ from those estimated under different variables, assumptions or conditions. Note 3 of our consolidated financial statements includes a summary of the significant accounting policies and methods used in the preparation of those statements. In order to provide an understanding of how we form the foregoing judgments and estimates, we have summarized certain critical accounting policies below.
Estimated useful lives of property, plant, equipment and intangible assets
We estimate the useful lives of property, plant and equipment in order to determine the amount of depreciation and amortization expense to be recorded during any reporting period. The useful lives are estimated at the time the asset is acquired and are based on historical experience with similar assets, as well as taking into account technological or other changes. If technological changes were to occur more rapidly than anticipated, the useful lives assigned to these assets may need to be shortened, resulting in the recognition of increased depreciation and amortization expenses in future periods. Alternatively, these types of technological changes could result in the recognition of an impairment loss to reflect the write-down in value of the asset. We review these types of assets for impairment losses annually, or when events or circumstances indicate that the carrying amount may not be recoverable over the remaining lives of the assets. In assessing impairment losses, we employ the cash flow method, which takes into account managements estimates of future operations.
As of December 31, 2005, we had R$12.4 billion recorded as property, plant and equipment under the Brazilian Corporate Law, accounting for approximately 66% of our total assets.
Revenue Recognition and Accounts Receivable
Under the Brazilian Corporate Law and U.S. GAAP, revenues from interconnection fees are calculated based on the duration of each call and, as determined by Brazilian law, recognized at the time the interconnection services are rendered. Under the Brazilian Corporate Law and U.S. GAAP, revenues from the sale of pre-paid phone cards to be used in public telephones are recognized at the time the card is used. Deferred revenues are determined based on estimates of outstanding credits of pre-paid phone cards that were sold but have not been used as of the date of each balance sheet. Under the Brazilian Corporate Law, revenues from activation or installation services are recognized upon the activation or installation of services to the customer. Under U.S. GAAP, revenues from activation and installation services are deferred and amortized over three years, which is the estimated average customer life.
We consider revenue recognition a critical accounting policy because of uncertainties caused by different factors such as the complex information technology required, the high volume of transactions, problems related to fraud and piracy, accounting regulations, managements determination of our ability to collect fees and uncertainties relating to our right to receive certain revenues (mainly revenues for use of our network). Significant changes in these factors could cause us to fail to recognize revenues or to recognize revenues that we may not be able to realize in the future, despite our internal controls and procedures. We have not identified any significant need to change our recognition policy for U.S. GAAP or the Brazilian Corporate Law.
Allowance for Doubtful Accounts
In preparing our financial statements, we must estimate our ability to collect payment for our accounts receivable. We constantly monitor our past due accounts receivable. If we become aware of a specific customers inability to meet its financial obligations, we record a specific allowance against amounts due in order to reduce the net recognized receivable to the amount we reasonably believe will be collected. For all other accounts receivable, we recognize allowances for doubtful accounts based on our past write-off experience (i.e., average percentage of receivables historically written-off, economic conditions and the length of time the receivables are past due). Our reserves have generally been adequate to cover our actual credit losses. However, because we cannot predict with certainty the future financial stability of our customers, we cannot guarantee that our reserves will continue to be adequate. Actual credit losses may be greater than the allowance we have established, which could have a significant negative impact on our selling expenses.
Provision for Contingencies
We are subject to legal and administrative proceedings related to tax, labor and civil matters. We are required to assess the likelihood of any adverse decision or outcome of these matters as well as the range of probable losses. A determination of the amount of reserves required, if any, for these contingencies is made after careful analysis of each individual matter and in consultation with our internal and external legal counsel. We record provisions for contingencies only when we believe that it is probable that we will incur loss in connection with the matter in dispute. We have recorded no provisions for a number of significant tax disputes with the Brazilian tax authorities because we do not believe we are likely to incur losses in connection therewith. Our required reserves for contingencies may change in the future based on new developments or changes in our approach to these proceedings (e.g., change in our settlement strategy). Such changes could result in a negative impact on future results and cash flows.
Future Liability for our Post-retirement Benefits (Pension Fund and Medical Health Care)
We provide various pension and medical benefits for our employees. We must make assumptions in connection with the provision of such benefits as to interest rates, investment returns, inflation, mortality rate and future employment rate levels in order to quantify our post-retirement liabilities. The accuracy of these assumptions will determine whether or not we have sufficient reserves for accrued pension and medical health care costs.
By recognizing our net deferred tax assets, we imply that we will generate sufficient future taxable income in certain tax jurisdictions, based on estimates and assumptions, and will continue operating under the current and future applicable provisional measures. If these estimates and related assumptions change in the future, we may be required to record additional provisions to be offset against our deferred tax assets, and thus be liable for an additional income tax expense in our financial statements. Management evaluates the reasonableness of the deferred tax assets and assesses the need for additional valuation allowances at the end of the year. As of December 31, 2005, we did not believe a provision to offset our net deferred tax assets was required.
Financial Instruments and Other Financing Activities
In order to manage foreign exchange transactions, we may from time to time invest in derivative financial instruments. Under the Corporate Law Method, foreign currency swap agreements are recorded in accordance with the contractual terms, plus interest and exchange variation incurred up to the balance sheet date. As of December 31, 2005, we recognized net losses of R$414.7 million (net losses of R$298.9 million as of December 31, 2004) on our hedge transactions and liabilities of R$294.3 million (liabilities of R$235.9 million as of December 31, 2004) in order to recognize existing temporary losses. The gains or losses on hedge transactions were calculated based on the notional amount plus interest and exchange variation incurred up to the balance sheet date, net of CDI rate variation on the notional amount.
We adopted SFAS 133, Accounting for Derivative Instruments and Hedging Activities, under U.S. GAAP, as of January 1, 2001. The accounting required under SFAS 133 is broader than the Corporate Law Method, especially with respect to the overall treatment and definition of a derivative, when to record derivatives, classification of derivatives, and when to designate a derivative as a hedge. All derivatives, whether or not related to a hedging transaction, must be recorded on the balance sheet at fair value. If the derivative is designated as a fair value hedge, the changes in the fair value of the derivative and the hedged item are recognized in earnings. If the derivative is designated as a cash flow hedge, changes in the fair value of the derivative are recorded in other comprehensive income, or OCI, a component of U.S. GAAP shareholders equity, and are recognized in the income statement when the hedged item results in earnings. Portions of ineffective changes in the fair value of cash flow hedges are recognized in earnings of the period.
On December 31, 2005, we had US$170.2 million and JPY19.8 billion of notional value swap contracts designated as fair value hedges of a portion of our foreign currency denominated debt.
On December 31, 2002, we recorded under SFAS 133 an adjustment in derivatives that were not designated as accounting hedges for the difference between the book value and the fair value of such derivatives. The fair value of derivatives on December 31, 2002 was impacted by the high interest rates used in the foreign interest rate swap market (basis of computation of derivatives fair value) mainly due to the uncertainties regarding the political and economical future of Brazil and the uncertainties about Brazilian foreign policy. The negative adjustment in our results of operations under U.S. GAAP was R$454.0 million for the year ended December 31, 2002.
Despite a period of instability in 2002, the Brazilian political and economic environment improved during 2003. As a consequence, we reverted the negative adjustments in the amount of R$454.0 million that had been registered in 2002 and recognized a gain in the amount of R$60.5 million on December 31, 2003 for U.S. GAAP purposes. In addition, the derivative operations contracted during 2003 gave rise to a positive adjustment of R$147.5 million in profit and loss under U.S. GAAP as at December 31, 2003. Therefore, the adjustment under SFAS 133 totaled R$662.0 million in 2003. For the period ended December 31, 2005, we recognized a loss of R$45.5 million (R$108.8 million as of December 31, 2004) for such transactions for the purposes of U.S. GAAP.
In applying generally accepted accounting principles in connection with these derivative instruments, management took into consideration interest rates, discount rates, foreign exchange rates, future cash flow, and the effectiveness of hedges. These judgments directly affect the value of derivative instruments recorded on the balance sheet, and the amount of gains and losses included in the calculation of operating income. Should actual interest rates, discount rates, foreign exchange rates, future cash flow and ultimate hedge effectiveness differ from our estimates, the amounts recorded within the period of realization will have to be revised.
Results of Operations
The following table sets forth certain components of our net income, as well as the percentage change of each component from the prior year, for each of the years in the three-year period ended December 31, 2005.
Results of Operations for Year Ended December 31, 2005 Compared to Year Ended December 31, 2004
Net Operating Revenue
Our revenues are derived primarily from the following:
Our gross operating revenues include value-added and other indirect taxes and discounts to customers in accordance with Brazilian GAAP. The composition of operating revenues by category of service is presented in our consolidated financial statements and discussed below. We have not calculated net operating revenues for each category of revenue.
The following table sets forth certain components of our operating revenues, as well as the percentage change of each component from the prior year, for 2005 and 2004.
Net Operating Revenue
Net operating revenue increased 8.2% to R$14.4 billion in 2005 from R$13.3 billion in 2004. The increase in net operating revenue is primarily a result of an increase in local, fixed-mobile and long distance fees that took place in June 2005, as well as growth in some of our services such as Speedy and the launch of a new pre-paid line called the Family Economy Line (Linha da Economia Família), whose subscription fee is less than conventional lines as it only permits local calls, that brought new subscribers into our network. This increase was partially offset by a general decrease in traffic during the same period.
Revenues from local services increased 11.8% to R$9.5 billion in 2005, from R$8.5 billion in 2004. The growth was mainly a result of the increase in local fees that took place in June 2005 and of the incorporation of new subscribers through the new Linha da Economia Família that was launched in March 2005.
Monthly subscription charges. Revenues from monthly subscription charges increased 14.3% to R$5.7 billion in 2005, from R$5.0 billion in 2004. The growth in 2005 was primarily due to the increase in local fees that took place in June 2005 and the new Linha da Economia Família that was launched in March 2005.
Activation fees. Revenues from monthly activation fees increased 42.0% to R$98.0 million in 2005 from R$69.0 million in 2004. The increase was principally due to the new Linha da Economia Família that was launched in March 2005.
Measured service charges. Revenues from measured service charges increased 6.0% to R$3.2 billion in 2005 from R$3.1 billion in 2004. The increase in 2005 was mainly a result of the increase in local fees that took place in June 2005, offset in part by decreases in measured services traffic of approximately 7.3% (surplus pulsespulsos excedentes).
Public telephones. Revenues from charges for the use of public telephones increased 20.7% to R$443.0 million in 2005 from R$367.0 million in 2004 as a result of the June 2005 fee increase, driven by an increase in sales of our telephone cards. Revenues from the sale of public phone cards are recognized at the moment the phone card is used in accordance with a change in an accounting methods introduced in December 2002.
Intraregional, interregional an international services. Revenues from long distance services increased 7.1% to R$3.4 billion in 2005 from R$3.2 billion in 2004. The increase was due to an increase in long-distance fees in June 2005, which offset the decrease in the traffic.
Revenues from data transmission services increased 44.4% to R$1.3 billion in 2005 from R$909.0 million in 2004. The increase in 2005 was principally due to the increase in subscriptions for our broadband services called Speedy.
Network Usage Services
Revenues from network usage services increased by 4.5% to R$4.2 billion in 2005 from R$4.0 billion in 2004 due to an increase in fixed-mobile fees that occurred in June 2005 but was expected in February 2005, partially offset by a decrease in traffic.
Revenues from interconnection services decreased by 6.8% to R$755 million in 2005 from R$809 million in 2004 due to a decrease in fees, that accompanied in the general adjustment of fees in June 2005.
The revenues derived from network access increased 5.6% amounting to R$415.0 million in 2005 against R$393.0 million in 2004 which were mainly due to the growth of our average utilized network dedicated for use by other telecommunication providers in our concession area.
Revenues from goods sold decreased 61.9% to R$8.0 million in 2005 from R$21.0 million in 2004 primarily due to a change in our strategy for providing equipment (modems) for our broadband service Speedy. We stopped selling them directly and instead began supplying them through partners.
Revenues from other services increased 26.4% to R$762.0 million in 2005 from R$603.0 million in 2004. The increase was due primarily to an increase in our revenues from Linha Inteligente (additional services to fixed lines) and revenues from the management of telecommunications services in commercial buildings rendered by our subsidiaries A. Telecom S.A. and Atrium.
Value Added and Other Indirect Taxes
Value added and other indirect taxes increased 9.6% to R$5.4 billion in 2005 from R$4.9 billion in 2004 in accordance with the increase in operating revenues.
Discounts increased 171.6% to R$584 million in 2005 from R$215 million in 2004. The increase was primarily due to the launch of Linha da Economia Família in March 2005.
Cost of Services
Cost of services primarily includes depreciation and amortization expenses, interconnection services, personnel expenses and costs of services provided by third parties. Cost of services increased 2.9% to R$7.7 billion in 2005 compared to R$7.5 billion in 2004, mainly due to an increase in expenses related to outsourced services and other costs.
The following table sets forth certain components of our cost of services, as well as the percentage change of each component from the prior year, for 2005 and 2004.
Depreciation and amortization
Depreciation and amortization expenses decreased totaling R$2.4 billion in 2005 and R$2.5 billion in 2004, driven primarily by a decrease in our capital expenditures after we attained ANATELs network expansion targets in 2002.
Expenses relating to services from third parties increased 13.2% to R$1.2 billion in 2005 from R$1.1 billion in 2004 primarily due to those services relating to maintenance of our network to meet some of ANATELs standards of quality and to reduce the level of customer complaints.
Expenses relating to interconnection services increased 1.9% to R$3.6 billion in 2005 from R$3.5 billion in 2004, primarily due to an increase in fees in June 2005 offset by a decrease in traffic for fixed-mobile services.
Operational personnel expenses consist of expenses relating to salaries, bonuses and other benefits of employees dedicated to operating and maintaining our services. Operational personnel expenses increased 10.6% to R$208.0 million in 2005 from R$188.0 million in 2004, primarily due to an increase in salaries and the implementation of a career plan for various employees.
The costs of materials increased 19.5% to R$49.0 million in 2005 from R$41.0 million in 2004 primarily due to the increase in cost of the materials used for the public telecommunications cards and the Economy line, as well as the materials used for the maintenance of our operational plants.
Costs associated with the sale of modems decreased 68.4% to R$6.0 million in 2005 from R$19.0 million in 2004, primarily due to the transfer of our direct modem sales to partner internet providers.
Other costs include costs associated with the lease of certain infrastructure equipment, poles and underground cables used to operate our telephone lines. Other costs increased 54.7% to R$280.0 million in 2005 from R$181.0 million in 2004, primarily due to a December 2005 settlement of a contract with an electric company for the passage of fiber optic cables through their network.
Operating expenses increased 11.7% to R$2.8 billion in 2005 from R$2.5 billion in 2004, primarily due to an increase in customer services to reduce complaints, salary increases in September 2005 and the implementation of a career plan for various employees, inclusion of Atriums personnel expenses in 2005 and an increase in legal services due to various proceedings involving the collection of monthly subscription fees.
Selling expenses increased 12.6% to R$1.8 billion in 2005 from R$1.6 billion in 2004, primarily due to increased customer services provided by Atento, an increase in the number of employees hired in connection with the verticalization of management of systems that had been previously rendered by third parties, a salary increase in September 2005 and the implementation of a career plan for various employees.
General and Administrative Expenses
General and administrative expenses increased by 15.7% to R$864.0 million in 2005 from R$747.0 million in 2004, primarily due to an increase of legal services related to collection of monthly subscription fees.
Other Net Operating Expense
Other net operating expense includes a variety of revenues and costs. See Note 7 to the consolidated financial statements. Other net operating expense decreased 11.0% to R$169 million in 2005 from R$190.0 million in 2004. This decrease was due to a reduction in expenses related to provisions for contingencies and reduction in goodwill amortization.
Financial Expense, Net
We recognized a net financial expense of R$460.0 million in 2005 compared to a net financial expense of R$404.0 million in 2004, representing the net effect of financial income, financial expense and exchange gains and losses. Such increase was a consequence of fluctuations of internal interest rates (CDI) because all of our loan and financing debt in foreign currency was hedged against exposure to the CDI.
Net Non-Operating Income (Expense)
Net non-operating income decreased 5.0% to R$37.8 million in 2005, compared to a net non-operating expense of R$40.0 million in 2004, primarily due to a write off of obsolete assets (modems) and the assignment of fiber optic cable pursuant to an agreement, as discussed in Other costs, offset by positive earnings from the sale of non-strategic public stock holdings in São Paulo Stock Exchange (BOVESPA).
Income and Social Contribution Taxes
Our income and social contribution tax expenses increased to R$871.3 million in 2005 from R$724.0 million in 2004 as a result of a confluence of factors, including overall improved financial performance and an absence of certain amortization of goodwill expenses that ended in 2004. Our effective tax rate in 2005 was 25.5%. See Note 10 to our consolidated financial statements.
As a result of the foregoing factors, net income increased to R$2.5 billion in 2005 from R$2.2 billion in 2004.
Results of Operations for Year Ended December 31, 2004 Compared to Year Ended December 31, 2003
Net Operating Revenue
Our revenues are derived primarily from the following:
Gross operating revenues are reduced by value-added and other indirect taxes and discounts to customers. The composition of operating revenues by category of service is presented in our consolidated financial statements and discussed below. We do not determine net operating revenues for each category of revenue.
The following table sets forth certain components of our operating revenues, as well as the percentage change of each component from the prior year, for 2004 and 2003.
Net Operating Revenue
Net operating revenue increased 12.7% to R$13.3 billion in 2004 from R$11.8 billion in 2003. The increase is primarily a result of an increase in local and intraregional long-distance fees that took place in June 2004, based on the accumulated IPCA of the previous 12 months and the increase in revenue from our data transmission services.
Revenues from local services increased 8.1% to R$8.5 billion in 2004 from R$7.8 billion in 2003. The growth is mainly a result of an increase in local and intraregional long-distance fees that took place in June 2004.
Monthly subscription charges. Revenues from monthly subscription charges increased 11.5% to R$5.0 billion in 2004 from R$4.5 billion in 2003. The growth in 2004 was due primarily an increase in local and intraregional long-distance fees that took place in June 2004, partially offset by a reduction in the average number of fixed lines in service.
Activation fees. Revenues from monthly activation fees decreased 34.3% to R$69.0 million in 2004 from R$105.0 million in 2003. The decrease is the result of the Companys low-income fixed-line service program, which began in July 2004, pursuant to which we did not charge activation fees for promotional reasons.
Measured service charges. Revenues from measured service charges increased 1.3% to R$3.1 billion in 2004 from R$3.0 billion in 2003. The increase in 2004 was mainly a result of an increase in local and intraregional long-distance fees that took place in June 2004, offset in part by decreases in measured service traffic of approximately 7.4% (surplus pulses pulsos excedentes).
Public telephones. Revenues from charges for the use of public telephones increased 48.6% to R$367.0 million in 2004 from R$247.0 million in 2003 as a result of the June 2004 fee increase, driven by an increase in sales of our telephone cards, primarily our alternative lower fee card programs (Bargain Line Linha Econômica and Super-Bargain Line Linha da Super Economia). Revenues from the sale of public phone cards are recognized at the moment the phone card is used, in accordance with a change in an accounting method introduced in December 2002.
Intraregional services. Revenues from intraregional services increased 28.4% to R$2.3 billion in 2004 from R$1.8 billion in 2003. The increase was mainly due to an increase in local and intraregional long-distance fees that took place in June 2004. However, an increase in revenue from SMP services and our growth in market share also contributed in part to the foregoing increase.
Interregional and international. We launched our long-distance interregional and international services in May and July 2002. Revenues from international and interregional services increased 14.2% to R$845.0 million in 2004 from R$740.0 million in 2003, driven primarily by an increase in revenue from SMP services and also, in part, by the fee adjustments that occurred in June 2004, as well as by our estimated growth in market share.
Revenues from data transmission services increased 73.8% to R$909.0 million in 2004 from R$523.0 million in 2003. The growth in 2004 was due to an approximately 62% increase in the use of our SPEEDY service.
Network Usage Services
Revenues from network services increased by 13.5% to R$4.0 billion in 2004 from R$3.6 billion in 2003 mainly due to an increase in fees for calls originating at fixed lines and terminating at mobile units that took place in February 2003, offset by a decrease in market share resulting from the implementation of the operator code selection for both interregional calls originating from fixed-lines (which took place in 2002) and interregional calls originating from mobile phones (which took place in July 2003).
Revenues from interconnection services increased by 0.4% to R$809 million in 2004 from R$806 million in 2003 due to an increase in fees in June 2004 and offset by a reduction in mobile-fixed traffic.
The revenues derived from network access increased 11.3% amounting to R$393.0 million in 2004 against R$354.0 million in 2003 which were mainly due to the revenues from the rents paid for the industrial use of dedicated lines and local access to networks.
Revenues from goods sold decreased 8.7% to R$21.0 million in 2004 from R$23.0 million in 2003 driven by increased costs associated with modems for SPEEDY broadband service and pricing pressures. The technology of the modems improved, making such equipment more expensive, and at the same time, the modems began selling in the open market placing pricing pressure on us to price such equipment more competitively.
Revenues from other services primarily include revenues from telecommunications services for the installation of phone lines, electronic mail and other local services including call waiting, call forwarding, voice and fax mailboxes, speed dialing and caller ID. Revenues from other services increased 6.9% to R$603.0 million in 2004 from R$563.0 million in 2003. The increase was due primarily to the increase in our revenues from Linha Inteligente, the brand name for our service package which includes call waiting, call forwarding, voice and fax mailboxes, speed dialing and caller ID, offset by a decrease in our digital access service known as 2M-ATB (2 Megabytes Basic Fee Area).
Cost of Services
Cost of services includes primarily depreciation and amortization expenses, interconnection services, personnel expenses and costs of services provided by third parties. Cost of services increased 11.6% to R$7.5 billion in 2004 compared to R$6.7 billion in 2003, mainly due to an increase in expenses related to interconnection services.
The following table sets forth certain components of our cost of services, as well as the percentage change of each component from the prior year, for 2004 and 2003.
Depreciation and amortization
Depreciation and amortization expenses decreased to R$2.5 billion in 2004 from R$2.6 billion in 2003, due primarily to capital expenditures in connection with ANATELs network expansion targets and reductions for obsolescence.
Expenses relating to services from third parties increased 34.7% to R$1.1 billion in 2004 from R$786.0 million in 2003 driven by a combination of factors, including payment for services relating to increased operational plant services, IP networking services and co-billing.
Expenses relating to interconnection services increased 23.8% to R$3.5 billion in 2004 from R$2.8 billion in 2003, as a result of an increase in traffic volume, especially from interregional and international long-distance services and an increase in fees that took place in June 2004. This increase also reflects expenses arising from SMP selections, which began in July 2003, and the resulting payments made to other telecommunications services providers.
Operational personnel expenses consist of expenses relating to salaries, bonuses and other employee benefits in connection with operating and maintaining our services. Operational personnel expenses decreased 26.6% to R$188.0 million in 2004 from R$256.0 million in 2003, due to a reorganization of personnel outsourcing services, offset in part by salary adjustments.
We include in materials, among other items, materials used for maintenance of our assets, replacement parts and automobile gas. The costs of materials decreased 2.4% to R$41.0 million in 2004 from R$42.0 million in 2003 as a function of a reduction in costs related to vehicles used in our operations, offset by an increase in costs for materials used in ordinary operations.
Expenses associated with the sale of telephone equipment increased 11.8% to R$19.0 million in 2004 from R$17.0 million in 2003 due, as noted above, to an increase in the costs associated with improved technology for modems used to access our SPEEDY broadband service.
Other costs relate to costs associated with the lease of certain infrastructure equipment, poles and underground cables used to operate our telephone lines. Other costs increased 11.1% to R$181.0 million in 2004 from R$162.0 million in 2003, primarily as a result of an increase in the rental cost for infrastructure, offset in part by a reduction in the rental cost for ducts housing various types of telephone cable.
Operating expenses decreased 3.7% to R$2.5 billion in 2004 from R$2.6 billion in 2003, primarily as a result of a reduction in provisions for contingencies and reduced personnel costs as a result of restructuring. These reductions were offset by an increase in expenses related to third-party services, primarily marketing services.
Selling expenses increased 25.0% to R$1.6 billion in 2004 from R$1.3 billion in 2003. Part of this increase resulted from the outsourcing of systems production (R$79.2 million), telemarketing (R$33.2 million), co-billing to other operators (R$31.8 million), traffic imbalance (R$25.9 million), advertising (R$21.1 million), Internet systems maintenance (R$23.8 million), mailing and administrative costs for billing (R$16.0 million) and other personnel expenses (R$48.7 million).
General and Administrative Expenses
General and administrative expenses decreased by 22.5% to R$747.0 million in 2004 from R$964.0 million in 2003. The decrease is attributable to a reduction in personnel expenses of R$85.8 million stemming from a reduction of expenses related to the PDI and a reduction in the outsourcing of systems production in the amount of R$126.5 million.
Other Net Operating Expense
Other net operating expense includes a variety of revenues and costs. See Note 7 to the consolidated financial statements. Other net operating expense decreased 51.7% to R$190.0 million in 2004 from R$393.0 million in 2003. This decrease was due to a reduction in expenses related to provisions for contingencies in the amount of R$182.6 million, comprised primarily of the provision made in 2003 in connection with INSS SAT and Plano Verão and Plano Bresser in the amount of R$174.1. See Item 8.AFinancial InformationConsolidated Statements and Other Financial InformationLegal ProceedingsLitigation with INSS.
Financial Expense, Net
We recognized a net financial expense of R$404.0 million in 2004 compared to a net financial expense of R$630.0 million in 2003, representing the net effect of financial income, financial expense and exchange gains and financial statements.
The decrease in net financial expenses recorded in 2004 versus 2003 was primarily driven by a decrease in interest rates of our loans and commitments. As of December 31, 2004, 44.6% of our debt was denominated in foreign currency (U.S. dollar, Canadian dollar and Japanese yen), and 98.6% of our debt was hedged by asset positions in foreign currency swap transactions. See Item 11Quantitative and Qualitative Disclosures about Market Risk.
Net Non-Operating Income (Expense)
We recorded a net non-operating income of R$40.0 million in 2004, compared to a net non-operating expense of R$50.0 million in 2003. This reduction was driven by gains associated with the restructuring of an affiliated company Companhia AIX de Participações in 2003 and by a positive result in 2004 in the sale of fixed assets.
Income and Social Contribution Taxes
Our income and social contribution tax expenses increased to R$724.0 million in 2004 as compared to R$279.0 million in 2003, as a result of a confluence of factors, including overall improved financial performance, a reduction in the payment of interest on shareholders equity (juros sobre capital próprio) and a reduction in certain amortization of goodwill expenses. Our effective tax rate in 2004 was 24.9%. See Note 24 to our consolidated financial statements.
As a result of the foregoing factors, net income increased to R$2.2 billion in 2004 from R$1.6 billion in 2003.
B. Liquidity and Capital Resources
We have funded our operations and capital expenditures mainly from operating cash flows and loans obtained from financial institutions. As of December 31, 2005, we had R$463.5 million in cash and cash equivalents. Our principal cash requirements include:
Sources of Funds
Our cash flow from operations was R$5.5 billion in 2005 compared to R$5.6 billion in 2004 and R$5.0 billion in 2003. Our decrease in cash flow from operating activities of 1.2% in 2005 compared to 2004 was primarily due to increased income tax and social contribution payments that resulted from (i) the end of the amortization period of a goodwill expense and tax loss carryforwards in 2004 and (ii) a legally imposed limitation on the deductibility of distributions of interest on shareholders equity. The increase in cash flows of 12.6% in 2004 compared to 2003 was due to an increase in sales of our telecommunications services, with our Speedy and other data transmission services being important drivers for such gains, as well as the increase in fees.
Our future cash flow is subject to the rates approved by ANATEL and the impact of competition on our revenues. We expect to continue to experience a reliable and steady source of internal cash flow from operations for the foreseeable future from on our base of customers and installed network.
Uses of Funds
Our cash flow used in investing activities was R$1.7 billion in 2005 compared to R$1.4 billion in 2004 and R$1.3 billion in 2003. The increase in 2005 from 2004 was due to our program of expansion and modernization of our telecommunications services, particularly broadband services.
Our cash flow used in financing activities was R$3.6 billion in 2005 compared to R$4.2 billion in 2004 and R$4.0 billion used in 2003. The decrease in cash flow used in financing activities in 2005 was due mainly to the payment of R$3.1 billion in dividends which was less than the previous year and the repurchase of R$59 million in shares of treasury stock. The increase in 2004 was due mainly to dividends paid in the amount of R$3.7 billion which was higher than the previous year and payments on derivative contracts maturing in 2004 that were used to hedge our foreign currency indebtedness.
As of December 31, 2005, our total debt was as follows:
Interest and principal payments on our indebtedness as of December 31, 2005 due in 2006 and 2007 totaled R$247.0 million and R$1,605 billion, respectively.
The agreements that govern the majority of our outstanding loans and financings contain certain standard restrictive covenants, which provide for the acceleration of the full balance of our obligations in the event of any default. As of December 31, 2005, we were not in default of any of our obligations and therefore none of our liabilities were subject to acceleration.
Capital Expenditures and Payment of Dividends
Our principal capital requirements are for capital expenditures and payments of dividends to shareholders. Additions to property, plant and equipment totaled R$1.7 billion, R$1.3 billion and R$1.3 billion for the years ended December 31, 2005, 2004, and 2003, respectively. Our capital expenditures for the year ended 2006 are expected to be approximately R$1.8 billion. These expenditures relate primarily to expansion of our network. We expect to seek financing for part of our capital expenditures either from equipment suppliers and Brazilian government agencies (from local or foreign Capital Markets) or from local and foreign Bank Institutions. See Item 4.AHistory and Development of the CompanyCapital Expenditures.
Pursuant to our bylaws and Brazilian Corporate Law, we are required to distribute a mandatory minimum dividend of 25% of adjusted net income (as defined below) in respect of each fiscal year, to the extent earnings are available for distribution. Holders of preferred shares are assured priority in the reimbursement of capital, without a premium, and entitled to receive cash dividends 10% higher than those attributable to common shares.
Adjusted net income, as determined by Brazilian Corporate Law, is an amount equal to our net income adjusted to reflect allocations to or from (i) legal reserve, (ii) statutory reserve and (iii) a contingency reserve for anticipated losses, if any.
We may also make additional distributions to the extent that we have available profits and reserves to distribute. All of the above distributions may be made as dividends or as tax-deductible interest on shareholders equity. We paid dividends of R$3.1 billion, R$3.7 billion and R$3.1 billion in 2005, 2004, and 2003, respectively.
Our management expects to meet 2006 capital requirements primarily from cash provided by our operations. Net cash provided by operations was R$5.5 billion, R$5.6 billion and R$5.0 billion in 2005, 2004, and 2003, respectively.
C. Research and Development, Patents and Licenses
Research and Development
We conduct independent research and development on telecommunications services; however, we do not independently develop new telecommunications hardware. We primarily depend on several manufacturers of telecommunications products for the purposes of such development.
In connection with the breakup of Telebrás, we were required to enter into a five-year agreement with the Center for Research and Development (Centro de Pesquisa e Desenvolvimento da Telebrás), or CPQD, under which we were required to contribute R$112.0 million to CPQD. This agreement, which we refer to as Contract 7000, terminated in December 2004.
In 2005, we entered into a new agreement with the Center for Research and Development or CPQD, so as to assure the life cycle, support and maintenance of the systems implemented by CPQD for Telesp during the term of the Agreement 7000.
The agreement was negotiated for R$11.8 million and, during its term, we had access to telecom software development, technological services of research and development, equipment maintenance, consulting and training.
CPQD has within its portfolio a tool used by Telefónica for management, planning, engineering and maintenance of terminals of the external network. This tool has data related to the wires, fiber optics and usage of the external network, among others.
Telefónica also uses other product from CPQD which control terminals and manage the analogical plant.
Our research and development expenses, including our monetary contributions to CPQD, were R$10.5 million for 2004 and R$11.6 million for 2003. For 2005, there were no expenses in respect of Research and Development with CPQD.
Patents and Licenses
Our principal intellectual property assets include:
D. Trend Information
We expect increased competition and rapid technological changes which may negatively affect our market share and profit margins. See Item 3.ERisk Factors-Risks Relating to the Brazilian Telecommunications Industry and Us and Item 4.BInformation on the Company Business OverviewCompetition.
We also expect to continue to make capital expenditures to improve the quality of our services and network and to launch new services. See Liquidity and Capital ResourcesCapital Expenditures and Payment of Dividends.
While the Brazilian economy continues to experience growth, we do not anticipate a material increase in fixed lines in Brazil. We remain committed, however, to innovating and adapting our business to the changing environment and finding markets for our services. For example, in 2004, we implemented successful operations geared towards providing telephone service for low-income families. Given that ANATEL is studying a regulated product in this area, we expect that this type of service and market will have an important role in the future. One of our competitors currently offers a similar product, but faces limitations on its ability to offer the services to all clients. Other providers do not yet have a product with the same characteristics. In sum, we believe that while the growth of fixed lines will not markedly increase, we and our competitors will have to offer new services, penetrate alternative markets in Brazil and find new methods of meeting our customers needs.
We do, however, expect another year of growth for broadband lines in Brazil and corresponding growth for current and new providers of broadband services. We anticipate that current providers will be investing to expand network capacity. We have seen this trend not only in Brazil, but in other parts of the world such as Spain and Italy. We also anticipate investments in web content that should help Internet operators increase their value-added service (VAS) revenues. Telefónica is a market leader in this area, and we are putting efforts in order to acquire new customers and to promote the broadband market growth.
In the long distance market we expect competition from VoIP (Voice over Internet Protocoltechnology for transmitting voice using the internet) providers to be more substantial in the future. In 2005, we experienced the entrance of many VoIP players in the market, but due to Brazils low broadband penetration and the players limited marketing efforts, VoIP has not substantially affected the traditional long distance market yet. We believe that in 2006 VoIP may play a more expansive role. We believe the first impact would be a decline in traditional long distance prices.
We also expect to see an increasing movement towards convergence, with the beginning of triple play offers (bundled offers consisting of TV, broadband internet access and phone, usually VoIP) of Embratel (telecommunications operator) and Net (cable operator), both companies of Telmex, which may affect our local market share in broadband and local telephony, and more fixed and mobile offers from Telemar/Oi and Brasil Telecom/BrT GSM.
Moreover, the appearance of commercial solutions using Wi-Max technology (emerging technology of wireless high-speed multi user access) is expected for 2006. This new technology tends to increase competition in the fixed line market since it will eliminate the dependence of a physical-metallic cable network for new entrants.
We are taking several actions to keep up with market trends and to compete by taking advantage of new technologies. We are closely monitoring the evolution of VoIP usage and developing bundled services that include voice and broadband, and we are developing IPTV-related products. In addition, we are following technological developments and performing tests on Wi-Max technology, preparing the company to take advantage of such technology in areas in which our conventional network coverage is currently limited.
E. Off-balance-Sheet Arrangements
F. Tabular Disclosure of Contractual Obligations
Our contractual obligations and commercial commitments are as follows:
ITEM 6. DIRECTORS, SENIOR MANAGEMENT AND EMPLOYEES
A. Directors and Senior Management
We are managed by a Board of Directors (Conselho de Administração) and an Executive Committee (Diretoria).
Board of Directors
Our Board of Directors is comprised of a minimum of five and a maximum of fifteen members, all shareholders, serving for a term of three years. The following is a list of the current members of the Board of Directors, their respective positions and dates of their election.
Set forth below are brief biographies of our directors:
Fernando Xavier Ferreira is 57 years old and serves as our Chief Executive Officer. Mr. Ferreira also currently serves as chief executive officer of SP Telecomunicações Holding Ltda. He also serves as vice-chairman of the Board of Directors and chief executive officer of TDBH. He is president of Supervisory Board of Brasilcel N.V., president of the boards of directors of Vivo Participações S/A, Telefônica Factoring do Brasil Ltda., Fundação Telefônica and chairman of the Control Committee for Telefônica Gestão de Serviços Compartilhados do Brasil Ltda. (T-Gestiona). He is also a member of the Board of Directors of Telefónica Internacional S.A., Norte Brasil Telecom S/A, and of Aliança Atlântica Holding BV. Mr. Ferreira has served as president of Telecomunicações Brasileiras S.A. Telebrás, executive secretary in the Brazilian Ministry of Communications, chairman of the Board of Directors of Embratel S.A., president of Nortel do Brasil S.A., president of Telecomunicações do Paraná S.A. Telepar and as member of ANATELs consulting committee and member of the Board of Directors of Empresa Brasileira de Correios e Telégrafos ECT and Portugal Telecom. He holds a degree in electrical engineering from Faculdade de Engenharia Elétrica da Universidade Católica do Rio de Janeiro, the Electric Engineering Faculty of the Catholic University of Rio de Janeiro, Brazil, which he received in 1971. He attended a business administration course at Western Ontario University, Canada, in 1982.
José María Álvarez-Pallete Lopez is 42 years old and has been the executive president of Telefónica Internacional S.A. since July 2002. He is also a member of the Board of Directors of each of Telefónica de España, Telefónica Móviles, Telefónica Móviles España, Telefónica Data, Telefónica Internacional S.A., representative of Telefónica S/A as director of TPI, Telefónica de Argentina, Telefónica de Peru, Telefónica CTC Chile, Telefónica Larga Distância Puerto Rico, Cointel y Compañía de Telefonos de Chile Transmisiones Regionales. In 1999, Mr. Álvarez-Pallete Lopez served as the chief financial officer of Telefónica Internacional S.A. and the chief corporate finance officer of Telefónica S.A. He holds economics degrees from the Universidad Complutense de Madrid, the Complutense University of Madrid, Spain, and the Université Libre de Bruxelles, Belgium.
Manoel Luiz Ferrão de Amorim is 47 years old and served as our General Executive Officer until December 31, 2005. He is a member of our Board of Directors and serves as a member of the boards of directors of TDBH and of the Câmara Americana de Comércio de São Paulo, or the American Chamber of Commerce of São Paulo. From February 1, 2001 to May 5, 2001, Mr. Amorim was the president of our wholly owned subsidiary Assist Telefônica S.A. From January to November of 2000, he served as president of America Online Brasil. From 1990 to 2000, he performed several functions at Proctor & Gamble in the United States, Brazil and Venezuela, including marketing manager, marketing director and general manager for Latin America. Mr. Amorim also worked at McKinsey, Petrobrás and F.I. Indústria e Comércio. He holds a degree in chemical engineering from IMEInstituto Militar de Engenharia, the Military Engineering Institute, Brazil, and a masters degree in business administration from Harvard University, United States.
Fernando Abril-Martorel Hernández is 44 years old. He was the chief operating officer of Credit Suisse Group in Spain and is a member of the Board of Directors of Companhia de Infraestruturas del Transporte S.A. (CINTRA). From 1987 to 1997, Mr. Abril-Martorel performed several functions at JP Morgan, in New York, London and Madrid, including treasury department manager and member of the managing committee. Mr. Abril-Martorel Hernández joined the Telefónica group in January of 1997, as corporate finance general manager, having represented the groups interests in the Brazilian telecommunications industry privatization process. From December 1998 to June 2000, he served as chief executive officer and chief financial officer of Telefónica Publicidade e Información (TPI). He was a member of the Board of Directors of the Telefónica Group from August 2000 to September 2003. Mr. Abril-Martorel Hernández holds a degree in law and business sciences from ICAI-ICADE Instituto de Postgrado y Formación Continua, Spain.
Juan Carlos Ros Brugueras is 44 years old and serves on our Board of Directors and that of TDBH. In 2005, he was appointed as the General Counsel of Telefónica S.A. Since May 1998, Mr. Ros Brugueras has been a Secretary General to the Board of
Directors and General Counsel of Telefónica Internacional S.A. and also a director of Telefónica de Argentina S.A. (Argentina), Telefónica Larga Distância de Porto Rico Inc. (Porto Rico), Companhia de Telecomunicações do Chile S.A. (Chile) and Telefónica do Peru S.A. (Peru). He served on our board and that of Companhia Telefônica da Borda do Campo from December 1998 through November 1999, and also on the boards of Companhia Riograndense de Telecomunicações CRT, Tele Sudeste Celular Participações S/A, Telerj Celular S/A and Telest Celular S/A. From 1985 to 1997, he was a partner in a law firm in Barcelona, and, during such time, he served as Secretary on the boards of directors of various Spanish and foreign companies. Mr. Ros holds a law degree from Universidad Central de Barcelona, the Central University of Barcelona, Spain.
Enrique Used Aznar is 64 years old. He is also the chief executive officer of Amper, S.A., in Madrid, a member of the boards of directors of Telefónica Peru, the chief executive officer of Amperprogramas and the vice-chairman of the Board of Directors of Mediadata Brasil. He is also a member of the Board of Directors of Telefónica S.A., member of the Assembléia Directiva of IESE of Madrid and patron of Fundação Científica contra o Câncer. He has also served as chief executive officer of Telefónica Internacional S.A., Telefónica Servicios Móviles and Telefónica I+D, as vice-chairman of the delegate committees of TPI Páginas Amarelas, Telefónica do Chile and Telintar (investor from Argentina), and as member of the boards of directors of Telefónica da Argentina, AT&T Network System International and of Ericsson in Spain. He holds a degree in telecommunications engineering from the Universidad de Madrid, the University of Madrid. He also holds a degree from IESE (Alta Direção de Empresas).
Javier Nadal Ariño is 56 years old and serves as General Director of Institutional Relations of Telefónica S/A. and Executive Vice President of Telefónica S.A. Foundation. He served as Executive President of Telefónica do Peru (2003 to 2004), Regulation Director of Telefónica International (1998 to 2002) and served as President of Telefónica da Argentina (March 1995 to December 1997), served as Telecommunications General Director and President of Retevisión. He has also collaborated with the United Nations as an expert in data transmission programs for activities support and participated in the development of affairs for Telettra Española in Vimercate (Italy) and Torrejón de Ardoz . He also served as General Secretary of the Telecommunications Engineers Association of Spain. He has written various articles on the telecommunications sector and has collaborated in certain books related to the sector and the information society. Mr. Nadal Ariño holds a degree in telecommunications engineering from Universidad Politécnica de Madrid, the Technical University of Madrid, Spain.
Luciano Carvalho Ventura is 59 years old. He is a member of our Board of Directors and is the officer responsible for LCV Governança Corporativa. He is a member of the board of auditors of Perdigão, Indústrias Bardella, Globex (Ponto Frio) and Iochpe Maxion. He serves as member of the Board of Directors of Grupo Tavares de Melo, Gtmprevi Sociedade Previdenciária, Agrofertil from Grupo Fertibrás and Y. Takaoka Empreendimentos. Since 1980, he has been dedicated to corporate governance consulting and in serving as member of corporate boards. He is the founding member of the Board of Directors of Instituto Brasileiro de Governança Corporativa IBGC Brasil. He is a member of the International Corporate Governance Network England and National Association of Corporate Directors USA. He is professor of the course for formation of directors of Brazilian Corporate Governance Institute and speaker at various masters courses and seminars. He holds an MBA from Escola de Administração de Empresas de São PauloFundação Getúlio Vargas, a post-graduate degree in finance from Escola de Administração de Empresas de São Paulo da Fundação Getúlio Vargas, a degree in business management from Escola de Administração de Empresas da Universidade Federal de Pernambuco, and a degree in economics from Faculdade de Ciências Econômicas da Universidade Federal de Pernambuco.
José Fernando de Almansa Moreno-Barreda is 57 years old. He is a member of the Board of Directors of Telefónica and chairman of the boards international affairs committee. He is also a member of the boards of directors of Telefónica de Peru S.A., Telecomunicações de São Paulo S.A., Telefónica Móviles S.A., Telefónica de Argentina S.A. Telefónica Internacional S.A. and BBVA Bancomer. He is currently a sponsor of the foundations Reina Sofía, Conde de Barcelona, Diputación de San Andrés de los Flamencos Fundação Carlos de Amberes, Padre Arrupe-Activa, Príncipe de Astúrias, Fundação Euroamérica and Fundação MMA. Mr. Almansa initiated his diplomatic career in 1974 and served as the Secretary of the Spanish Embassy in Belgium in 1976. In 1979 he was appointed as the Cultural Counselor for the Spanish Delegation in Mexico and, in 1982, he was named as embassy advisor to the Spanish Ministry of Foreign Relations. During the same year, he was appointed as chief director to the coordination section of the Spanish diplomatic office in Eastern Europe and as a director for Atlantic matters for the Spanish foreign policy office
for Europe and Atlantic matters. In 1983, Mr. Almansa served as a press and political advisor for the Spanish diplomatic mission at the North Atlantic Council in Brussels. In April 1988, he was assigned to the Spanish Embassy in the Soviet Union, where he served as a minister advisor, and in August of the same year he became a plenipotentiary minister. In 1990, Mr. Almansa was appointed as general secretary for the National Commission of the V Centennial of the Discovery of America, and, in 1991, he served as the general sub-director for Eastern Europe under the Spanish general office of foreign policy for Europe. In 1993, His Majesty the King of Spain named Mr. Almansa as chief of the Royal House, with ministerial status, where he served until December 2002. Mr. Almansa holds a law degree from the Universidad de Deusto, the University of Deusto, Spain.
Miguel Àngel Gutiérrez Méndez is 47 years old and a member of our Board of Directors, and a director of Telefónica Internacional, S.A., where he is responsible for Institutional and Public Policy for Grupo Telefónica in Latin America. He also served a director for Telefónica de Argentina S.A. (where he also served as President and Chief Operating Officer from February 2002 through June 2003); president of the Board of Directors for Autopistas Del Oeste S.A and president of the Board of Directors of ABERTIS of Spain Group (controlled by La Caixa de Barcelona). He is also a member of the consulting committee to The Rohatyn Group Asset Management in New York. From December 2003 to December 2004, he served as Chief Executive Officer of the Association of Public Service Businesses of Argentina (Asociación de Empresas de Servicios Públicos ArgentinosADESPA), and from January 2002 to October 2004, he served as Vice-President of the Chamber of Commerce of Spain (Fundación Cámara Española de Comercio). He is also a member of the Executive Committee of the Chamber of Commerce of Argentina (Cámara Argentina de Comercio), a member of the Business Development Institute for Argentina (Instituto Para El Desarrollo Empresarial de La Argentina IDEA) and a member of the Consulting Committee of the Center for the Implementation of Public Policy for Equity and Growth (Centro de Implementación de Políticas Públicas para la Equidad el CrecimentoCIPEC). Until October 2001, Mr. Mendez was employed by J.P. Morgan where he spent over twenty-one years as a Managing Director responsible for Global Emerging Markets. He is a certified public accountant with a degree from the University of Buenos Aires, and an MBA from IAE Universidad Austral (Argentina).
Luis Bastida Ibarguen is 60 years old and is a member of our Board of Directors. He serves as a director for various companies, and is an independent consultant, author and lecturer on business economics. From 2000 to 2001, he served as general director for global asset administration and member of the steering committee for Banco Bilbao Viscaya Argentaria. From 1988 to 2000, he held various posts at Banco Bilbao Viscaya, and in 2000, became General Finance Director, reporting directly to the President. From 1976 to 1987, he worked generally in finance at Banco Bilbao. From 1971 to 1976, he worked in various capacities at General Electrics International Division in New York and General Electric Española, including accounting, management and strategic planning. He holds degrees in International Management Program, Financial Management Program and is licensed in business sciences by E.S.T.E. He also holds an MBA from Columbia University.
Narcís Serra Serra is 62 years old and serves as a member of our Board of Directors. From 1991 to 1995, he was Vice President of the Government of Spain, and from 1982 to 1989, served as Minister of Defense. From 1979 to 1982, he was the Mayor of Barcelona. Mr. Serra holds a doctorate in political science from the Universidad Autónoma de Barcelona and is a professor of economic theory at the Universidad Autónoma de Barcelona.
Eduardo Navarro de Carvalho is 43 years old and serves as a member of our Board of Directors and Strategy and Planning, Regulation and Corporate Development Director of Telefónica Internacional S/A. He previously served as our Vice President of Regulation and Operator Business, Vice President of Telefônica Data Brasil Holding S.A., SP Telecomunicações Holding Ltda., Sudestecel Participações S.A., Iberoleste Participações S.A. and TBS Celular Participações S.A. Mr. Navarro served as regulatory and corporate strategist of Tele Sudeste Celular Participações S.A., Tele Leste Celular Participações S.A. and Celular CRT Participações S.A. and as a member of the Board of Directors of Ceterp Centrais Telefônicas de Ribeirão Preto S.A., senior project director of McKinsey & Company, Inc., and factory manager of Belgo-Mineira (Arbed Group). He holds a degree in metallurgy engineering from Universidade de Minas Gerais (the University of Minas Gerais), Brazil.
Juan Vicente Revilla Vergara is 44 years old and serves on our Board of Directors and as the General Director of Operations of Telefónica Internacional S/A. Previously, he served as the General Manager of Telefónica del Peru, our Director of Financial Planning and the General Director of Administrative Control at Telefónica del Peru. He was also formerly a Senior Analyst of Issuances at CNMV, a Control Manager at Banesto S.A., a Risk Analyst in the credit department at Caja de Madri, a Credit Assistant
in the large client division at Caja de Ahorros and a Junior Consultant at Andersen Consulting Perú. He is an Economic and Business Sciences graduate of the Universiadade Del Pacífico in Lima, Perú.
Manuel Alfredo Alvarez Trongé Zinder is 48 years old and serves on our Board of Directors. Currently, he is General Secretary of Telefónica Internacional, S.A. He served as the General Secretary of Grupo Telefónica in Argentina, General Counsel at Perez Companc S.A., General Counsel at PASA Petroquímica Argentina, Superintendent of Security at NaçãoFinance Ministry. He is a graduate in law of Facultad de Derecho U.B.A (Business University of Buenos Aires, Argentina), a professor at the University of Buenos Aires and of the Catholic University of Argentina, President of the Commission for Business Law of the League of Lawyers of the city of Buenos Aires.
The executive committee consists of at least three and no more than ten members, who may or may not be our shareholders, all of them appointed by our Board of Directors for a period of three years and may remain in office until reappointed or replaced. Any of our executive officers may be removed at any time by a decision of the Board of Directors.
The following are the current members of the executive committee, their respective positions and the date of their appointment.
Set forth below are brief biographies of our executive officers:
Pedro Lucas Antón Lázaro is 45 years old and has served as Vice President of Administrative Control and Finance and Director of Investor Relations (CFO) since October 2004. Previously he was named General Corporate Subdirector of Economic Processes-Finance in Telefónica S.A. He led the creation of the Share Services Centers (Centro de Serviços Compartilhados) of Telefónica Group and served as its Global Manager and Administrator of Telefónica Gestión de Servicios Compartidos (t-gestiona) of Spain SAU through July 2004. In November 1998, he was named Vice President of Finance, Control and Resources for Telesp and TeleSudeste Participações, and CFO of Telefónica in Brazil, overseeing all financial and corporate operations, such as the merger of Grupo Telesp. In 1997, he served as General Subdirector of Accounting and Consolidation at Telefónica, reporting to the CFO of Grupo Telefónica. Once having segregated the business of fixed telephone service in Spain, he began to report to the CEO of Telefónica de España S.A. as General Subdirector of Economy and Finance and member of the Management Committee. In 1987, he moved to JP Morgan and, after serving in various capacities, was named, in 1995, Chief Operating Officer of JP Morgan in Madrid with direct responsibilities for Systems and Operations, indirect oversight of all support areas in that branch and as a member of the Management Committee. From 1981 to 1987, he worked for Telefónica in the areas of network and systems. He holds degree in naval engineering from Universidade Politécnica de Madrid and an MBA in Economics and Management from IESE Business School.
Stael Prata Silva Filho is 54 years old and serves as General Executive Officer. He is currently also a director, since December 20, 2004, of Visão Prev Sociedade de Previdência Complementar, a pension fund. Since 1972, he has held several titles in our company, including Executive Vice President of Strategic Planning and Regulation and previously Vice President of Public Relations, Vice President Business Services and Vice President of Special Clients and Small Business, as well as positions as Director in Planning, Data Processing and Business Affairs. In 1997, Mr. Prata was appointed as a consultant for Sistel, and, from January 2000 to December 2000, Mr. Prata was the chief executive officer and commercial manager of Ceterp Centrais Telefônicas de Ribeirão Preto S.A. and Ceterp Celular S.A., businesses now controlled by Telesp. He has also held the titles of Director and President of Business Affairs at Assist Telefónica S.A. (another Telesp subsidiary, currently named A. Telecom S.A.). He was involved in the coordination of the management committee of Telefônica da Borda do Campo, also a Telesp subsidiary, and he participated in the coordination of the Management Committee and in the planning of Information Technology and as Business Director. Mr. Prata holds a degree in business administration from Faculdade Luzwell- Brazil and an MBA from the Instituto IESE de Barcelona- Espanha.
Gilmar Roberto Pereira Camurra is 50 years old and serves as Vice President of Financial Planning. He has twenty-eight years of working experience in the financial system. He served for a year as member of the Board of Directors of Grupo Paranapanema (tin exporter). Among his experiences in the banking system, he was vice-president of Citibank N.A., performing various activities for 18 years with a focus on the international and treasury areas; founding partner of Banco ABC Roma, performing activities relating to treasury, international and controlling areas; and executive officer of BCN-Barclays, performing activities relating to the treasury, asset management and corporate finance in the last three years before the transfer to the Telefônica Group served as foreign exchange director and deputy treasurer for HSBC Bank. He has been Chief Financial Officer of Telefônica Group in Brazil since November 1999. He also serves as President of the Board of Directors of Fundação Sistel, President of the Board of Directors of Fundação Visão, Vice President of the Board of Directors of Telefônica Factoring and Vice President of Telefônica Data Brasil Holding. He holds a business management and accounting science degree with a specialization course in finance from Berkeley University, University of California.
Françoise Trapenard is 42 years old and serves as Vice President of Human Resources. She has been in the Telefônica Group since 1999 and has served as human resources development supervisor (from May 1999 to October 2000), human resources director of T-Empresas (from October 2000 to December 2001), corporate human resources director of Telefónica S.A. in Madrid (January 2002 to February 2004) and human resources director of the Company (from February 2004 to February 2006). She has also worked as a trainee at Citibank, N.A. from 1987 to 1988, Job and Salary Analyst at Editions Gallimard, in Paris, from 1989 to 1990, as Export Manager at International Paper do Brasil from October 1992 to December 1996, as Human Resources Director at Asea Brown Boveri, from February 1997 to November 1998, as Human Resources Manager at Companhia Paulista de Força e Luz, from November 1998 to May 1999. She holds a Masters degree in Philosophy from Université de Paris I Panthéon Sorbone and a Business Administration degree from Faculdade de Economia e Administração USP and a post-graduate degree in Business Administration from ESSEC (Ecole Superieure de Sciences Economiques et Commerciales) in Paris.
Fábio Silvestre Micheli is 43 years old and serves as Vice President of Network Services. He previously served as the operation officer and resources officer of our subsidiary A. Telecom S.A. Mr. Micheli has been working with us for twenty-five years (seventeen in managerial functions) and previously served in the following positions: operational district manager, customer service manager, technical assistance supervisor, technical assistance officer, operational vice president and residential commercial vice president. He holds a business administration masters degree from IESE (Barcelona).
Odmar Geraldo Almeida Filho is 42 years old and serves as Vice President of Residential Services. He previously served as officer for residential business in traffic and services from August 2001 to January 2004; marketing director for Proctor & Gamble in the division of baby care products, Latin America in Caracas from 1988 to 2001 and brand/marketing manager feminine care in Cincinnati, Ohio from 1991 to 1993. He also served for Johnson & Johnson as management trainee in manufacturing in the city of São José dos Campos from 1988 to 1989 and for Elebra/Nortel as Software Engineer in the city of Campinas from 1986 to 1988. He holds a degree in electronic engineering from UNICAMP (from 1982 to 1986) and an MBA from the University of Southern
California (from 1989 to 1991) and attended the senior executive management program IESE from Universidade de Navarra Barcelona (from 2003 to 2004).
Bento José de Orduña Viegas Louro is 50 years old and serves as Vice President of Wholesale and Regulation. He has served as Vice President of our long-distance and interconnection business since May 2002. From 1979 to 1984, Mr. Louro managed the telecommunications and electronic areas for The Chase Manhattan Bank. From 1985 to 1998, he served as general manager for AT&T, where he managed internal operations in Venezuela, Florida; Rio de Janeiro and New Jersey. From 1998 to 2001, Mr. Louro served as area director for Northern Brazil for Nextel International, where he was responsible for direct and indirect sales channels, corporate accounts, supply operations, post-sale support, marketing, training, international engineering, finance, and human resources. From May 2001 to May 2002, Mr. Louro served as our general director for long-distance business. He holds a degree in economic sciences from the Universidade de Economia e Ciências Políticas do Rio de Janeiro, or the Economics and Political Sciences University of Rio de Janeiro, Brazil, and a masters degree in international administration and finance from the American Graduate School of International Management at Thunderbird School, United States.
Manuel José Benazet Wilkens is 42 years old and serves as Vice President of Commercial and Administrative Services. From March 2002 to March 2004, he served as our officer of development of residential businesses, responsible for the business development of our residential segment, he served as general officer of technology, planning and investment programs and worked on the advancement of the 2003 universal targets and design of the access service ADSL Speedy. Mr. Wilkens also served as officer of network management and new services and worked on the implementation of CEOS (Centro Estadual de Operação e Supervisão or state center of operation and supervision). He has also served as our superintendent of network systems and participated in the initial take over in the area of network system OSL. His experience in Telefónica de Espanha S/A includes service as national administrator of JDS transmission network, administrator of management and networking system in the region of Barcelona North, and technical quality inspector with oversight of the technical courses of the Escola de Formação Telefônica. He also has experience in external network engineering and operation and maintenance of the commuting internal plant. He holds degrees in telecommunications engineering I.C. from ETSETB from Barcelona; economic and financial management of non-governmental entities from IPT Barcelona and attended the advance management program 2001 of IESE Barcelona and INSEAD Sênior Leadership Program in 2004.
José Antonio Gallego García is 51 years old and serves as Vice President of Small and Medium-sized Business Services. He entered into Telefónica (Telefónica de Espana) in July 1974. Mr. García also held important management positions at Telefónica de Espanha until he was designated, in 1989, Sub-officer of Technology of Public Telephone Usage. In April, 1994 he was designated officer of control and development at CANTV (Venezuela). Between August 1997 and March 1999, he was designated Executive Director of Public Relations (Residential Market) and CRT (Rio Grande do Sul). He also acted as officer responsible for special projects at Telesp (São Paulo) between March 1999 and June 2002. In July 2002, he was nominated commercial officer responsible for long residential distance services at Telesp. Since January 2004 until now he has served as interconnection services officer at Telesp. He holds a degree in information and technology sciences from the Universidad Complutense in Madrid.
For a biography of Fernando Xavier Ferreira, see Board of Directors.
For the year ended December 31, 2005, the aggregate amount of compensation paid to all our Directors and Executive Officers was approximately R$23.6 million, of which R$16.1 million corresponded to salaries and R$7.5 million corresponded to bonuses.
For the year ended December 31, 2005, our Directors and Officers did not receive any pension, retirement or similar benefits.
C. Board Practices
Board of Directors
Our Board of Directors typically meets once every three months and the Chairman may call special meetings. Our Board takes action by majority vote, provided the majority of its members in office are present, with the Chairman having, in addition to his or her regular vote, the deciding vote in the event of a tie. The specific responsibilities of the Chairman include representing the Board in the General Shareholders Meetings, chairing the General Shareholders Meetings and selecting the Secretary from among those present, and calling and chairing meetings of the Board.
Our Board of Directors is responsible, among other things, for:
The members of our Board of Directors are all shareholders: one of them being elected by the preferred shareholders in a separate voting process and the others being elected by the holders of common shares. The members of the Board of Directors are elected for a period of three years and may be reelected.
Our Executive Committee is responsible for our day-to-day management and for representing us in our business with third parties. Each of our current Executive Officers has been appointed by our Board of Directors for a three-year term and may remain in office until reappointed or replaced.
Brazilian Corporate Law and our bylaws each require that we maintain a statutory Fiscal Board (Conselho Fiscal). Our statutory Fiscal Board, which is a separate and distinct entity from our outside auditors, is primarily charged with certain advisory, reporting, oversight and review functions with respect to the companys financial statements. Our statutory Fiscal Board is also responsible for rendering opinions on managements annual report and management proposals to be submitted at shareholders meetings relating to a change in the companys capital composition, budget, payment of dividends and consolidations, mergers and spin-offs. However, the statutory Fiscal Board, as required by Brazilian Corporate Law and our bylaws, has only an advisory role and does not participate in the management of the company. Indeed, decisions of the statutory Fiscal Board are not binding on the company under Brazilian Corporate Law.
In accordance with Brazilian Corporate Law and our bylaws, the Fiscal Board consists of a minimum of three and a maximum of five members and an equal number of alternates.
One member of the Fiscal Board and his or her alternate must be elected by holders of preferred shares in a separate voting process. The following are the current members of the Fiscal Board:
Brazilian Corporate Law does not require a corporation to maintain committees responsible for ethics, corporate governance or compensation. Nevertheless, our Board of Directors has created the following committees:
Control and Audit Committee
Our Control and Audit Committee was created by our Board of Directors in December 2002 and is comprised of a minimum of three and a maximum of five directors, who are not members of our executive committee, appointed by the Board of Directors to serve as members of the Control and Audit Committee for the duration of their respective terms as members of the Board of Directors. The Committee has its own charter, which was approved by the Board of Directors. The Committee provides support to the Board of Directors.
According to its charter, the Control and Audit Committee shall meet four times per year and report its conclusions to the Board of Directors. We anticipate that there will be some similar functions between the Control and Audit Committee and our statutory Fiscal Board (Conselho Fiscal).
The Control and Audit Committee, among other responsibilities that may be required by the Board of Directors, is charged with informing and providing recommendations to the Board of Directors regarding the following:
The following are the current members of the Control and Audit Committee:
Nominations, Compensation and Corporate Governance Committee
Our Nominations, Compensation and Corporate Governance Committee was established in December 1998 and consists of three to five directors appointed by the Board of Directors to serve for the duration of their respective terms as members of the Board of Directors. Except for our Chief Executive Officer, Mr. Fernando Xavier Ferreira, the other three members of our Nominations, Compensation and Corporate Governance Committee are non-management directors. The Nominations, Compensation and Corporate Governance Committee, among other responsibilities that may be required by the Board of Directors, is charged with informing and providing recommendations to the Board of Directors regarding the following:
The following individuals are the current members of the Nominations, Compensation and Corporate Governance Committee:
Service Quality and Marketing Committee
The Service Quality and Marketing Committee was created on December 16, 2004 and provides assistance to our Board of Directors. The Committee consists of, at least 3 and at most 5, members of our Board selected periodically. The Committee meets from time to time, depending on the availability of its members and when called by its chair. The Committee is responsible for review and analysis of quality indices measuring our principal services and to ensure that the requisite degree of commercial assistance is furnished to our clients.
As of December 31, 2005, we had 7,770 employees. All of our employees are on a full-time basis, divided into the following categories: 47% in our network plant operation, maintenance, expansion and modernization; 36% in sales and marketing; and 17% in administration, finance and investor relations, human resources, inventory, technology, legal and strategic planning and management control.
We, in conjunction with other sponsors (the companies resulting from the breakup of Telebrás), sponsored private pension benefits and health care plans for retirees in order to supplement the salaries of retired employees. The plans PBS Telesp and Visão Telesp, previously managed by Fundação Sistel de Seguridade Social, or the Sistel, were transferred to another closed social security entity called Visão PREV Sociedade de Previdência Complementar on February 18, 2005. The Visão PREV Sociedade de Previdência Complementar manages the following social security plans: Visão Telesp, Visão Telefonica Empresas, Visão Assist e Visão T-Gestiona. The plans, Planos de Assistência Médica aos Aposentados PAMA, or the PAMA, and PBS-A Plano de Benefícios Sistel Assistidos, or the PBS-A, are still managed by Fundação Sistel de Seguridade Social. Until December 1999, all sponsors of the plans managed by Sistel were jointly and severally liable for all existing benefit plans. After December 1999, a single-employer sponsored pension plan for active employees was created, the PBS Telesp Plan, or PBS plan. See Note 26 to our consolidated financial statements for a more detailed description of the PBS plan. Retired employees (PBS-A) and post-retirement health care benefits, or PAMA, remained as multi-employer benefit plans. The restructuring of the benefit plans took place in January 2000.
Due to the withdrawal of other active participants in December 1999, we individually sponsored the PBS plan, which covers less than 1.0% of our employees. In addition to the PBS plan, the multi-sponsored health care plan, or PAMA, is provided to retired employees and their dependents. Contributions to the PBS plan are determined based on actuarial valuations prepared by independent actuaries, in accordance with standards applicable in Brazil.
On August 2000, we established the Visão plan, offered to participants in our PBS plan, as well as to employees who did not qualify for participation. Unlike the PBS plan, which is a defined benefits plan, the Visão plan is financed for contributions by participating employees, as well as by us as sponsor, which are credited to the individual accounts of the participants. We are responsible for all management and maintenance expenses of the Visão plan, including the risks of death and permanent injury of the participants. The employees participating in the plan were granted the option to migrate to the Visão plan, which was also offered to those who did not participate in the PBS plan and to all newly hired employees. Our contributions to the Visão plan are equal to those of the individual participants, ranging from 2% to 9% of the participants salary, depending on the percentage chosen by the participant. The aggregate costs under the Visão plan equal approximately 12.0% of the total amount of salaries paid to participating employees. Currently 86% of our employees are covered under the Visão plan.
In 2005, we had 904 retirees covered by PAMA, from which only 21 were transferred to PAMA-PCE and as a result 2.3% of our current retirees changed to PAMA-PCE. In the end of 2005, PAMA remained as a multi-financed plan.
Approximately 32% of our employees are members of the main telecommunications industry labor union, Sindicato dos Trabalhadores em Empresas de Telecomunicações e Operadores de Mesas Telefônicas no Estado de São Paulo, the Labor Union of
Employees of Telecommunications Companies and Telecommunications Desk Operators in the State of São Paulo, or SINTETEL, which is associated with the Federação Nacional dos Trabalhadores em Telecomunicações, the National Federation of Telecommunications Workers or FENATTEL. Our collective labor agreements will expire on August 31, 2006. Our management considers relations with our work force to be satisfactory. We have never experienced a work stoppage that had a material effect on our operations. The collective labor agreement was renewed on September 1, 2005.
E. Share Ownership
None of our directors or executive officers beneficially owns, on an individual basis, 1% or more of our common or preferred shares (including ADSs representing preferred shares) or of our total equity share capital.
We do not provide any stock incentive plans to our management or employees; however, our controlling shareholder, Telefónica S.A. offers stock incentive plans relating to its own shares (the Telefónica Stock Option Plans). The Telefónica Stock Option Plans implemented in 2001 are designed to retain the services of our officers and to obtain highly qualified employees.
The Telefónica Stock Option Plans are managed by the Telefónica stock option committee (the Committee), which is comprised of members who are elected by Telefónica S.As Board of Directors. The Committee periodically grants and sets the terms of the share options and determines which officers and employees will be included in the plans. The Telefónica Stock Option Plans relating to us are divided into two programs, TOP and TIES.
In April 2001, we approved an incentive program (the TOP Program) following the guidelines of a plan designed by Telefónica S.A. for certain of its key executives. The TOP Program consists of granting stock options of Telefónica S.A to 22 of our key executives who are bound to hold these stock options for the entire term of the TOP Program. Each stock option under the TOP Program gives the holder the right to acquire shares of Telefónica S.A. linked to either Telefónica S.A. common shares, Telefónica S.A. ADRs or Telefónica S.A. BDRs (Brazilian Depositary Receipts). The term of the TOP Program was three years during which the stock options could be exercised no more than three times.
The TOP Program ended on September 25, 2003. Under the programs regulations, Telefónica S.A. was required to settle all exercised options. However, since the market price of the shares on the subsequent five days after the end of the program was lower than the option price, no option was exercised. The beneficiaries became able to freely trade the shares they acquired over the course of the program.
In February 2000, Telefónica S.A approved a program (the TIES Program) whereby all of our employees who choose to participate in the TIES Program are able to acquire a number of Telefónica S.A. common shares. Under the TIES Program, the number of shares employees are able to acquire is based on their annual compensation, for an amount equivalent to five euros per share. In addition, Telefónica S.A. granted the participants 26 stock options for every Telefónica S.A. share purchased at five euros per option. The actual number of stock options eligible for exercise depends on the appreciation, if any, of the share price of Telefónica S.A. over the reference value established at 20.50 euros. The term of the TIES Program is four years and participating employees may exercise the stock options granted on three different occasions during the four-year term. The exercise dates for the stock options were in January 2003, 2004 and 2005. No option was exercised on such dates because the market price of the shares was lower than the option price. The TIES Program ended in February 2005 and the beneficiaries were granted to the right to freely trade the shares they acquired over the course of the TIES Program.
ITEM 7. MAJOR SHAREHOLDERS AND RELATED PARTY TRANSACTIONS
A. Major Shareholders
In accordance with our bylaws, we have two classes of capital stock authorized and outstanding, common shares (ações ordinárias) and preferred shares (ações preferenciais). Our common shares have full voting rights. Our preferred shares have voting rights only under limited circumstances. At December 31, 2005 and for at least the past three years, Telefónica Internacional owned 34.48% of our common shares and SP Telecomunicações, formerly Tele Brasil Sul Participações S.A. and a wholly owned subsidiary
of Telefónica International, owned 50.23% of our common shares. Since Telefónica International owns 100% of the equity share capital of SP Telecomunicações, it has effective control over 84.71% of our outstanding common shares. Accordingly, Telefónica Internacional has the ability to control the election of our Board of Directors and to determine the direction of our strategy and corporate policies. Neither Telefónica Internacional nor SP Telecomunicações has any special voting rights beyond those ordinarily accompanying the ownership of our common or preferred shares.
The following tables set forth information relating to the ownership of common and preferred shares by SP Telecomunicações, its parent company Telefónica Internacional and our officers and directors. We are not aware of any other shareholder that beneficially owns more than 5% of our common shares.
Telefónica Internacional is a wholly owned subsidiary of Telefónica S.A., or Telefónica. Telefónicas shares are traded on various stock exchanges, including Madrid, Barcelona, Bilbao, Valencia, London, Paris, Frankfurt, New York, Lima, Buenos Aires and São Paulo. Telefónicas business operations are concentrated in a number of sectors, including fixed and mobile telecommunications services, data communications, integrated business solutions, e-commerce, Internet, telephone book publishing and marketing, marketing information and services, media content creation, production, distribution and marketing and call center services.
B. Related Party Transactions
Note 28 to our consolidated financial statements presents, in tabular format, more detailed financial information with respect to transactions and balances with related parties. We provide below a summary description of transactions with related parties.
We entered into a consulting service agreement, known as the Consulting Agreement, with Telefónica Internacional, on May 17, 1999, pursuant to which Telefónica Internacional provides advice regarding our management, operations and business. Under the Consulting Agreement, we paid Telefónica Internacional in 2000, for its consulting services, an amount equal to one percent of our 2000 net operating income. In 2001 and 2002 under the same agreement we paid one half of one percent of our net operating income in each of 2001 and 2002, and since 2003 we have been paying Telefónica Internacional two-tenths of one percent of our net operating income per year. The expiration of this contract was originally August 3, 2003, but it was automatically extended for another 5-year term.
In February 1999, we entered into a service agreement with Atento Brasil S.A , an indirect majority owned subsidiary of Telefónica S.A. (Telefónica controls 91.35% of Atento Brasils equity), for the provision of certain customer services, principally services related to our call center. Transactions under this service agreement with Atento Brasil involved approximately R$238 million in 2005 (R$208 million in 2004).
In April 2001, we entered into a service agreement for the provision of administrative, accounting and other services with Telefônica Gestão de Serviços Compartilhados do Brasil Ltda., or T-Gestiona, an indirect wholly owned subsidiary of Telefónica. Transactions with T-Gestiona under this service agreement involved approximately R$67 million in 2005 (R$79 million in 2004).
We also entered into certain agreements for the provision of telecommunications services to several of our affiliates, each under the indirect control of Telefónica, including T-Empresas, Terra Networks Brasil S.A., Telefónica Publicidade e Informação Ltda., Emergia Brasil Ltda. and Grupo Brasilcel (Vivo) and others listed in Note 28 to our consolidated financial statements. Transactions pursuant to these various service agreements, in the aggregate, involved approximately R$2.1 billion in 2005 (R$2.2 billion in 2004).
CVM Administrative Proceeding Relating to Agreement with Atento
There is a CVM administrative proceeding arising out of a certain service agreement with an affiliate of Telefónica Group, Atento Brasil S/A (Atento). The CVM initiated an administrative proceeding with respect to the execution of the service contract between Telesp and Atento (the Atento Agreement). On October 2, 2003, the CVM held that although the terms and conditions of the Atento Agreement were equivalent to those normally applied in agreements of the same nature and that are considered arms-length conditions, the Atento Agreement had not obtained the required approvals. The CVM, therefore, fined one of our current officers and three of our former officers each in the amount of R$75,000.00. The company disagreed with the CVMs administrative resolution and filed an appeal to the Treasury Departments Appeals Council for the National Finance System (Conselho de Recursos do Sistema Financeiro Nacional), which currently remains pending.
C. Interests of Experts and Counsel
ITEM 8. FINANCIAL INFORMATION
A. Consolidated Statements and Other Financial Information
See Note 18 of our consolidated financial statements.
We are party to legal proceedings incidental to the normal course of our business. The main categories of such proceedings include:
Our policy with respect to provisioning for contingencies classifies the various legal proceedings to which we are party as probable, possible and remote. In general, 100% of the total claim value for legal proceedings classified as probable are provisioned. Senior management classifies each legal proceeding into one of these three categories (probable, possible and remote) based upon the advice of internal and external counsel and specialized technical advisors in charge of each matter. Due to the level of provisioning and based on its analysis of the individual cases, our management believes that no liabilities related to any legal proceedings will have a material effect on our financial condition or results of operations.
Litigation with INSS
We are defendants in several lawsuits filed by the INSS, in the federal courts of São Paulo, including:
While we await the outcome of the foregoing lawsuits, depending on the case and respective procedural situation we have pledged, for judicial attachment purposes, real property owned by us, and offered bank guarantees and cash deposits, in accordance with Brazilian legal procedures. If we prevail in the foregoing lawsuits, such attachments will be cancelled, guarantees released and deposits returned.
Litigation Relating to FINSOCIAL, COFINS, PASEP and PIS
Litigation Relating to ICMS
We are a named defendant in several ICMS proceedings pertaining to
Based on the Brazilian federal constitution, we are of the opinion that (i) the treasury secretaries acted beyond the scope of their authority; (ii) their interpretation would subject certain services to taxation, which are not considered telecommunications services; and (iii) new taxes may not be applied retroactively.
There can be no assurance that we will prevail in our claim that the treasury secretarys new interpretation of the ICMS tax is unconstitutional. The retroactive application of the ICMS tax to activation fees would give rise to a maximum liability estimated to be R$278.9 million. However, since our management and consultants have estimated that the probability of loss in connection with this case is remote, we have made no provision for these taxes.
Litigation Relating to Fust
We are also a defendant in several legal proceedings filed by former employees and third parties employees (the latter alleging joint and several liability), who claim, among other things, deficient overtime payment, unequal compensation, retirement wage supplements, and health and security hazard compensation.
The following lawsuits are pending:
As of December 31, 2005, the total costs of the labor lawsuits filed against us amounted to R$2.4 billion, of which we provisioned R$320.9 million, corresponding to the aggregate amount of liability for which an unfavorable outcome has been deemed probable.
We have several civil contingencies in the total amount of R$1.8 billion, for which R$56.5 million has been deemed probable and provisioned, including:
Regulatory and Antitrust Litigation
We are a defendant in each of the following administrative proceedings, which have been filed by long-distance service providers alleging anticompetitive practices:
In addition to the two antitrust-related claims mentioned above, we are a defendant in the following proceedings:
Litigation Arising Out of Events Prior to the Telebrás Breakup
Telebrás, our legal predecessor, is a defendant in a number of legal proceedings and subject to certain claims and contingencies. Under the terms of the Telebrás breakup, the liability for any claims arising out of acts committed by Telebrás prior to the effective date of the breakup remains with Telebrás, except for labor and tax claims (for which Telebrás and the resulting companies incorporated as a result of the breakup are jointly and severally liable by operation of law) and any liability for which specific accounting provisions have been assigned to us or one of the other resulting companies incorporated as a result of the breakup of Telebrás. Our management believes that the chances of any of these claims materializing and having a material adverse financial effect on us are remote.
Litigation Related to the Breakup of Telebrás
The legality of the breakup of Telebrás was challenged in numerous legal proceedings, some of which remain pending. Our management believes that the final outcome of these proceedings will not have a material adverse effect on our business or financial condition.
See Item 7.BMajor Shareholders and Related Party TransactionsCVM Administrative Proceeding Relating to Agreement with Atento.
Dividends and Dividend Distribution Policy
Priority and Amount of Preferred Dividends
The Brazilian Corporate Law generally requires that the bylaws of each Brazilian corporation specify a minimum percentage of the distributable profits comprising dividends and/or interest on shareholders equity, or distributable amount, of the corporation for each fiscal year that must be distributed to shareholders as dividends. See Item 10.BAdditional InformationMemorandum and Articles of Association. Moreover, each Brazilian company may only issue new preferred shares for public distribution if one of the following terms applies to the preferred shares: (i) right to receive dividends equivalent to at least 25% of the net profit for the fiscal year, to be calculated in accordance with Article 202 of the Brazilian Corporate Law as follows: (a) priority in the receipt of dividends corresponding to at least 3% of the book value per share and (b) the right to an equal share of the profits attributable to the holders of common shares, after the holders of common shares have received a dividend equal to a minimum of 3% of the book value per share; or (ii) dividends at least 10% higher than those paid for common shares; or (iii) tag along rights of at least 80% of the price paid in the sale of control to be paid by the controlling shareholder and also including the right to receive dividends at least equal to the dividend paid to common shares.
According to our bylaws, we are required to distribute as dividends in respect of each fiscal year ending on December 31, to the extent amounts are available, an aggregate amount equal to at least 25% of adjusted net income as a mandatory dividend. The annual dividend distributed to holders of our preferred shares is 10% higher than the dividend distributed to our common shareholders.
Under the Brazilian Corporate Law, a company is allowed to withhold payment of the mandatory dividend in respect of common shares and preferred shares if:
We may pay dividends out of our retained earnings or accumulated profits in any given fiscal year.
For the purposes of the Brazilian Corporate Law, net profits are defined as net income after income tax and social contribution for the fiscal year, net of any accumulated losses from prior fiscal years and any amounts allocated to beneficiary parties, employees and managements participation in a companys profits and founders shares.
Under Brazilian Corporate Law, and in accordance with our bylaws, adjusted net income is an amount equal to our net income adjusted to reflect allocations to or from (i) legal reserves, (ii) statutory reserves, and (iii) contingency reserves for anticipated losses, if any.
At each annual shareholders meeting, the Board of Directors is required to suggest the allocation of net profits obtained during the preceding fiscal year. Under the Brazilian Corporate Law, we are required to maintain the legal reserve, to which 5% of our net profits must be allocated for each fiscal year, until the reserve amounts to 20% of our paid-in capital. Net losses, if any, shall be charged against the accumulated profits, profits reserves and legal reserve, following this order.
The Brazilian Corporate Law also provides for an additional discretionary allocation of net profits to special accounts, which is also suggested by management and subject to approval by shareholders at the annual shareholders meeting, including the amount of net profits that may be allocated to the contingency reserve for anticipated losses that are deemed probable in future years. Any amount so allocated in a previous year must be either:
Net profits may also be allocated to the unrealized income reserve in case the total amount of mandatory dividends exceeds the amount of realized income. Such allocation should also be suggested by management and subject to approval by shareholders at the shareholders meeting. For such purpose, realized income is the balance of net profits exceeding the sum of:
The amounts available for distribution are determined on the basis of financial statements prepared in accordance with the Brazilian Corporate Law.
If the minimum dividend to be paid to the holders of preferred shares is not paid for the period set forth in our bylaws, which in no event shall be longer than three years, the holders of preferred shares will be entitled to full voting rights until such dividend is paid in full.
Payment of Dividends
We are required by law and our bylaws to hold an annual shareholders meeting before April 30 of each year at which, among other issues, the allocation of net profits obtained during the preceding fiscal year and the declaration of dividends by decision of common shareholders are decided, acting on the recommendation of the executive officers, as approved by the Board of Directors. The payment of annual dividends is based on the financial statements prepared for each fiscal year ending December 31. Under the Brazilian Corporate Law, dividends are required to be paid within 60 days following the date the dividend is declared to shareholders of record on the declaration date, unless a shareholders resolution sets forth another date of payment, which must occur prior to the end of the fiscal year.
A shareholder has a three-year period from the dividend payment date to claim dividends in respect of its shares, after which we have no liability for the payment. Because our shares are issued in book-entry form, dividends with respect to any share are automatically credited to the account holding the share and no action is required on part of the shareholder. We are not required to adjust the amount of paid-in capital for inflation.
If a shareholder is not a resident of Brazil, he or she must register with the Central Bank of Brazil in order to be eligible to receive dividends, sales proceeds or other amounts with respect to his or her shares outside of Brazil. Our preferred shares underlying ADSs are held in Brazil by a Brazilian custodian, Banco Itaú S.A., as the agent for the depositary, which is the registered owner of our shares.
Payments of cash dividends and distributions, if any, will be made in Brazilian currency to the custodian on behalf of the depositary, which will then convert those proceeds into U.S. dollars and will cause U.S. dollars to be delivered to the depositary for distribution to holders of ADRs. In the event that the custodian is unable to immediately convert the Brazilian currency received as dividends into U.S. dollars, the amount of U.S. dollars payable to holders of ADRs may be adversely affected by devaluations of the Brazilian currency that occur before dividends are converted and remitted. Dividends in respect of the preferred shares paid to resident and non-resident shareholders, including holders of ADRs, are not currently subject to Brazilian withholding tax.
We are in compliance with all the amendments of the Brazilian Corporate Law, as resolved by our general shareholders meeting and our special preferred shareholders meeting held on December 30, 2002.
Additional Payments on Shareholders Equity
Law No. 9,249, dated December 26, 1995, as amended, provides for distribution to shareholders of interest on shareholders equity, which may be computed against the amount of dividends to be distributed to the shareholders. A company may treat these payments as financial expenses for income tax and social contribution purposes. This interest is limited to the daily pro rata variation of the Taxa de Juros de Longo Prazo, or TJLP, a nominal long-term interest rate determined by the federal government that includes an inflation factor and cannot exceed the greater of:
Any payment of interest in respect of preferred shares to shareholders (including the holders of ADSs) is subject to Brazilian withholding tax at a rate of 15%, or 25% in the case of a shareholder domiciled in a tax haven, and these payments may be included, at their net value, as part of any mandatory dividend. Payments to persons who are exempt from taxation in Brazil are not subject to withholding tax. See Item 10.ETaxationBrazilian Tax ConsiderationsDistributions of Interest on Capital.
We declare and pay dividends and/or interest on shareholders equity as required by Brazilian Corporate Law and our bylaws. The declaration of annual dividends, including dividends in excess of the mandatory distribution, requires approval by the vote of the majority of the holders of common shares, and depends on many factors. These factors include our results of operations, financial condition, cash requirements, future prospects and other factors deemed relevant by shareholders. Our shareholders have historically acted on these matters based on recommendation of the Board of Directors. Within the context of tax planning, we may determine in the future that it is to our benefit to distribute interest on shareholders equity.
The following table sets forth the dividends or interest on shareholders equity paid to holders of our common and preferred shares since 2003 in reais.
Interim Dividends and Interest on Shareholders Equity
At the Board meetings held on April 1, 2005 and September 19, 2005, distributions of intermediary dividends for our common and preferred shareholders was approved in the amount of R$1.5 billion from accumulated earnings as of December 31, 2004 and R$1.29 billion from June 20, 2005. The dividends were paid on April 20, 2005 and October 24, 2005, respectively.
At the Board meetings held on April 1, 2005 and September 19, 2005, payments of interest on own shareholders equity for our common and preferred shareholders was approved in the amount of R$305.2 million and R$204.9 million from retained earnings from 2005. These payments were paid from October 24, 2005.
On December 12, 2005, the board approved, subject to the approval of the shareholders, a credit of interest paid on own shareholders equity, regarding 2005 operations, in the amount of R$323 million to be paid from retained earnings. Payment will be made until December 30, 2006.
According to the sole paragraph of Article 28 of our bylaws, the interim dividends mentioned above will be charged to the mandatory minimum dividend for the year 2005.
According to Article 29 of our bylaws, the interest on shareholders equity mentioned above may be charged to the mandatory minimum dividends for 2005.
Reverse Stock Split
In a special shareholders general meeting held on May 11, 2005, our shareholders approved the reverse stock split of all of our shares, under the terms of Article 12 of the Brazilian Corporate Law, at the ratio of 1,000 existing shares per one share of the same type and class. As the result of the reverse stock split, our capital stock was represented by 493,592,278 total shares without par value, of which 165,320,206 were common shares and 328,272,072 were preferred shares. The main objectives of the reverse stock split were (i) to reduce the administrative and operating costs of our shareholder structure, (ii) to confer greater visibility on the quotation price of our shares as they started to be negotiated in unitary form and (iii) to meet the requirements of BOVESPA. The fractional shares resulting from the reverse share split were sold to the public on BOVESPA on July 15, 2005. Upon settlement of the public bid, the net proceeds from the sale of fractional shares was credited to individual selling shareholders, as stated in the notice to shareholders published on July 21, 2005. When the shares started to be traded on BOVESPA in unitary form on June 27, 2005, each of our ADRs, which previously represented 1,000 preferred shares, became one preferred share.
Cancellation of Treasury Stock
On March 9, 2006, a special meeting of the shareholders approved the cancelation of 1,562,387 shares of treasury stock, being 1,258,508 common shares and 303,879 preferred shares. These treasury shares had been acquired through an action at the São Paulo Stock Exchange BOVESPA on July, 2005, as a result of a reverse stock split.
B. Significant Changes
ITEM 9. THE OFFER AND LISTING
A. Offer and Listing Details
The trading market for our common and preferred shares is BOVESPA.
Our preferred shares began trading on BOVESPA, on September 21, 1998. Our preferred shares trade on BOVESPA under the symbol TLPP4 and our common shares trade under the symbol TLPP3. At December 31, 2005, we had approximately 493.6 million common and preferred shares held by approximately 2.0 million common and preferred shareholders. The following table sets forth the reported high and low closing sale prices for the preferred shares on BOVESPA, for the periods indicated.
In the United States, the preferred shares trade in the form of ADSs, each representing 1,000 preferred shares, issued by The Bank of New York, as depositary, pursuant to a Deposit Agreement, among us, the depositary and the registered holders and beneficial owners from time to time of ADSs. The ADSs commenced trading on the NYSE on November 16, 1998 under the symbol
TDSP. At December 31, 2005, there were approximately 203 institutional owners of ADSs (registered holders). The following table sets forth the reported high and low closing sales prices for ADSs on the NYSE for the periods indicated.
B. Plan of Distribution
Trading on the Brazilian Stock Exchanges
BOVESPA is a non-profit entity owned by its member brokerage firms. Trading on this exchange is limited to member brokerage firms and a limited number of authorized nonmembers.
BOVESPA has open outcry trading sessions each day, from 10:00 a.m. to 1:00 p.m. and from 2:00 p.m. to 5:00 p.m. Trading is also conducted from 10:00 a.m. to 5:00 p.m. on an automated system on BOVESPA. On September 20, 1999, BOVESPA launched the After-Market, with the objective of expanding business opportunities and offering investors a more flexible trading schedule. After-Market trading takes place from 5:30 p.m. to 7:00 p.m. All stocks traded during the regular trading session of the day may be traded on the After-Market. However, only cash market trading via BOVESPAs electronic trading system is allowed. The maximum variation allowed for stock prices, whether positive or negative, corresponds to 2% in relation to the closing price at the regular trading session.
In order to better control volatility, BOVESPA has adopted a circuit breaker system pursuant to which trading sessions may be suspended for a period of 30 minutes or one hour whenever the indices of these stock exchanges fall below the limits of 10% and 15%, respectively, in relation to the index registered in the previous trading session.
Settlement of transactions is effected three business days after the trade date without adjustment of the purchase price for inflation. Payment for shares is made through the facilities of a separate clearinghouse, which maintains accounts for member brokerage firms. The seller is ordinarily required to deliver the shares to the exchange on the second business day following the trade date. The clearinghouse for BOVESPA is Companhia Brasileira de Liquidação e Custódia S.A. CBLC, which is wholly owned by the exchange.
At December 31, 2005, the aggregate market capitalization of the 343 companies listed on BOVESPA was approximately US$482.1 billion. Although all the outstanding shares of an exchange-listed company may trade on a Brazilian stock exchange, in most cases, less than half of the listed shares are actually available for trading by the public, the remainder being held by small groups of controlling entities or persons that rarely trade their shares. For this reason, data showing the total market capitalization of Brazilian stock exchanges tend to overstate the liquidity of the Brazilian equity securities market.
The Brazilian equity securities market is relatively small and illiquid compared to major world markets. In 2005, the combined monthly trading volumes on BOVESPA averaged approximately US$13.8 billion. In 2005, the ten most actively traded issues represented approximately 51.3% of the total trading in the cash market on BOVESPA. Trading on Brazilian stock exchanges by nonresidents of Brazil is subject to certain limitations under Brazilian foreign investment legislation.
The institution of a securities market maker was introduced in the Brazilian market through CVM Directive No. 384/2003 and São Paulo Stock Exchange Resolution No. 293/2003-CA. The market maker is a liquidity agent or specialist that guarantees minimum liquidity and price reference for specific assets, thus promoting the efficiency of the Brazilian capital markets. At the end of 2004, there were five market makers operating on BOVESPA.
Regulation of Brazilian Securities Markets
The Brazilian securities markets are regulated by the CVM, which has authority over stock exchanges and the securities markets generally, the CMN and the Central Bank, which has, among other powers, licensing authority over brokerage firms and regulates foreign investment and foreign exchange transactions. The Brazilian securities market is governed by Law No. 6,385, as amended, known as the Brazilian Securities Law, and by the Brazilian Corporate Law.
Law No. 10,303 of December 31, 2001 amended the Brazilian Corporate Law and the Brazilian Securities Law. Consequently, some major modifications resulted for the businesses of the publicly traded companies. Among the changes, Law No. 10,303, along with Executive Order No. 8 and Decree No. 3.995, all dated as of October 31, 2001, established that the CVM would have the scope of its authority altered and expanded. Additionally, the CVMs positioning in the regulatory hierarchy, as well as its autonomy, was modified. The modifications include changes in the proportions of common and preferred shares, new rules for the issuance of Debentures, other parameters governing the exercise of the right of withdrawal, duties and powers of the members of the audit committee and the Board of Directors, and the ability of publicly traded companies to make publications available over the Internet. Also provided is the pooling agreement, the block voting system by which the shareholders agree during a prior meeting on the direction of the votes that will be cast at the general meetings. The purpose of this type of vote is to prevent any possible individual dissidents or interests from harming corporate interests.
The period established for companies to adapt their bylaws is one year starting from the publication of the law on November 1, 2001. Our shareholders held a general shareholders meeting on December 30, 2002, at which they addressed these modifications in our bylaws.
The CVM, which is the agency in charge of regulating the market, now handles some functions that were reserved to the Central Bank, including the regulation and organization of the futures and commodities markets.
Under the Brazilian Corporate Law, a company may be a listed company, a companhia aberta, as we are, or a non-listed company, a companhia fechada. All listed companies are registered with the CVM and are subject to reporting requirements. A company registered with the CVM may have its securities traded either on BOVESPA or on the Brazilian over-the-counter market. The shares of a listed company may also be traded privately, subject to certain limitations. In order to be listed on the BOVESPA, a company must apply for registration with the CVM and the stock exchange. Once the stock exchange lists a company and the CVM accepts its registration as a listed company, its securities may start to be traded.
Trading in securities on the stock exchange may be suspended under a request from a company in anticipation of a material announcement. Trading in the securities of a particular company may also be suspended under the initiative of BOVESPA or the CVM, among other reasons, due to the belief that the company has provided inadequate information regarding a material event or has provided inadequate responses to inquiries by the CVM or the stock exchange.
The Brazilian securities law; the Brazilian Corporate Law and the regulations issued by the CVM; the CMN and the Central Bank provide, among other things, disclosure requirements and restrictions on insider trading, price manipulation and protection of minority shareholders.
Corporate Governance Practices
We are a sociedade anônima, a corporation incorporated under the laws of Brazil, and are subject to the corporate governance provisions of Brazilian Corporate Law. We comply with the regulatory requirements of the Brazilian Corporate Law regarding the independence of our Board of Directors, the establishment and composition of certain board committees and the adoption and disclosure of corporate governance guidelines.
We comply with several requirements of Brazilian and international laws in order to promote strong corporate governance, reduce investor uncertainties and enhance disclosure of material and other information.
With the approval of our Board of Directors, we concluded the implementation along the last years of several measures designed to improve our transparency and disclosure practices. We believe these measures will benefit our shareholders, current and future investors as well as the marketplace in general. Among the measures we have implemented, we have:
As determined by the Brazilian Corporate Law, the aggregate annual compensation of senior management is approved by our shareholders at an annual shareholders meeting. The Nominations, Compensation and Corporate Governance Committee provides information and recommendations to the Board of Directors regarding the criteria for compensation.
Our internal rules relating to insider trading are determined in our internal rules and the corporate laws. Senior management and members of our Board of Directors and any other employee exposed to sensitive information are subject to the restrictions imposed by such charter. In addition to the prohibition on trading of our shares by such individuals when in possession of insider information, the charter establishes blackout trading periods for those periods when insider information is available. As an example, the month before the formulation and approval of our annual income statements by our Board of Directors is considered a blackout period under the charter. In addition, the charter sets forth instructions for dealing with conflicts of interest and mandates disclosure of any such situation.
Principal Differences between U.S. and Brazilian Corporate Governance Practices
On November 4, 2003, the SEC approved new corporate governance rules established by the NYSE. Pursuant to these rules, foreign private issuers that are listed on the NYSE, such as our company, must disclose any significant ways in which its corporate governance practices differ from those followed by U.S. companies under the listing rules of the NYSE.
The significant differences between our corporate governance practices and the NYSE corporate governance standards are as follows:
Independence of Directors and Independence Tests
The Brazilian Corporate Law and our bylaws require that our directors be elected by our shareholders at a general shareholders meeting. Fourteen of our directors were appointed by our common shareholders, and one director is appointed by representatives of our minority preferred shareholders. Six of our directors are independent in accordance with rules generally accepted in Brazil.
Both the Brazilian Corporate Law and CVM establish rules in relation to certain qualification requirements and restrictions, investiture, compensation, duties and responsibilities of the companies executives and directors. We believe these rules provide adequate assurances that our directors are independent and such rules would permit us to have directors that would not otherwise pass the independence tests established by the NYSE.
According to the Brazilian Corporate Law, up to one-third of the members of the Board of Directors can be elected to executive positions. The remaining non-management directors are not expressly empowered to serve as a check on management, and there is no requirement that those directors meet regularly without management. Notwithstanding, our Board of Directors consists of fourteen non-management directors, six of which are independent directors in accordance with rules generally accepted in Brazil, and as such we believe we are in compliance with this standard.
Control and Audit Committee/Additional Requirements
Brazilian Corporate Law and our bylaws each require that we have a statutory Fiscal Board (Conselho Fiscal). See Item 6.CDirectors, Senior Management and EmployeesBoard PracticesFiscal Board. Our statutory Fiscal Board meets the requirements of the general exemption from the listing standards for audit committees set forth in Exchange Act Rule 10A-3(c)(3). See Item 16D.Exemptions from the Listing Standards for Audit Committees. Our statutory Fiscal Board is primarily charged with certain advisory, oversight and review functions with respect to the companys financial statements. However, the statutory Fiscal Board, as required by Brazilian Corporate Law, has only an advisory role and does not participate in the management of the company. Indeed, decisions of the statutory Fiscal Board are not binding on the company under Brazilian Corporate Law. See Item 6.CDirectors, Senior Management and EmployeesBoard PracticesFiscal Board.
In addition to our statutory Fiscal Board, we have established a Control and Audit committee as a best corporate governance practice in order to comply with the requirements of the Sarbanes-Oxley Act as described in Item 6C. We anticipate that there will be some similar functions between the Control and Audit Committee and our statutory Fiscal Board.
Code of Business Conduct and Ethics
Although adoption of a code of ethics is not required by Brazilian Corporate Law, we implemented a code of ethics regulating the conduct of our managers in connection with the registration and control of financial and accounting information and their access to privileged and non-public information and data in order to comply with the requirements of the Sarbanes-Oxley Act and NYSE rules. See Item 16B.Code of Ethics.
In addition to complying with the rules of corporate governance applicable to us under Brazilian law, we intend to gradually comply with substantially all of the new rules established by the NYSE and the SEC applicable to domestic U.S. companies.
D. Selling Shareholders
F. Expenses of the Issue
ITEM 10. ADDITIONAL INFORMATION
A. Share Capital
B. Memorandum and Articles of Association
Set forth below is certain information relating to our capital stock and a summary of certain significant provisions of our bylaws and the Brazilian Corporate Law.
We are registered with the Junta Comercial de São Paulo, the Board of Trade of São Paulo, or JUCESP, under no. 35.3.001588-14. According to Section 2 of our bylaws, our main corporate purpose is to provide telecommunications services and to develop those activities necessary or useful for the performance of these services, in accordance with the concessions, authorizations and permits granted to us.
There are no provisions in our bylaws with respect to:
Brazilian Corporate Law forbids a director to interfere in any business of the company when there is any conflicting interest between him and the Company.
Brazilian Corporate Law requires ownership of shares in order for a person to qualify as a member of the Board of Directors (conselho de administração) of a corporation (sociedade por ações).
Issuance of commercial paper and incurrence of certain debt shall be preceded by approval from our Board of Directors, according to the provisions set forth in section 17 of our bylaws.
Our capital stock is comprised of preferred shares and common shares, all without par value. At December 31, 2005, there were 327,968,193 outstanding preferred shares and 164,061,698 outstanding common shares. Our share capital may be increased by resolution of the Board of Directors, up to the limit authorized by our bylaws. Any increase above the authorized capital must be approved by a general shareholders meeting.
The preferred shares are non-voting, except under limited circumstances. They are given priority in the reimbursement of capital, without premium, and are entitled to receive a dividend 10% higher than that attributable to common shares.
Pursuant to Law 10,303/01, the following changes were introduced to the Brazilian Corporate Law:
Each common share entitles the holder to one vote at general shareholders meetings. Preferred shares do not entitle the holder to vote at shareholders meetings, except under specific circumstances and with respect to certain matters, as specified below. Holders of preferred shares are only entitled to attend and to discuss, but not to vote on, the issues discussed at our general shareholders meetings.
The appointment of one member of our statutory Fiscal Board, including the alternate member, takes place at the annual ordinary general shareholders meeting, upon separate vote of the holders of preferred shares, for the position available at the Fiscal Board. The election of a member of the Board of Directors by preferred shareholders also occurs on a separate vote, with no participation of the controlling shareholder.
Brazilian Corporate Law provides that certain non-voting shares, such as our preferred shares, shall be entitled to voting rights in the event a corporation fails for three consecutive fiscal years to pay any fixed or minimum dividends to which non-voting shares are entitled. In this case, the voting rights of these shares shall extend until the date on which the payment of the accrued and unpaid dividend is made.
Preferred shares are entitled to full voting rights with respect to
Any change in the preference, benefits, conditions of redemption and amortization of preferred shares or the creation of a more favored class would require the approval or ratification by holders of a majority of the preferred shares at a special meeting of the preferred shareholders. This meeting would be called by publication of a notice in two Brazilian newspapers during three days, at least thirty days prior to the meeting; however, it would not generally require any other form of notice.
In any circumstances in which holders of preferred shares are entitled to vote, each preferred share will entitle the holder to one vote.
Each shareholder has a general preemptive right to subscribe for shares of the same class in any capital increase, in an amount sufficient to keep the same proportional participation of each shareholder in the total capital of the corporation. A minimum period of 30 days following the publication of the capital increase notice shall be observed by the corporation for the exercise of the preemptive right by the shareholder. The right of participation in capital increases is assignable under Brazilian Corporate Law. However, the bylaws of a publicly held company that allows capital increases may provide for the issuance, without granting any preemptive rights to prior shareholders, of stocks, Debentures convertible into stocks, or subscription bonuses, the placement of which shall be made:
In the event of a capital increase, which would maintain or increase the proportion of capital represented by preferred shares, holders of ADSs, or of preferred shares, would have preemptive rights to subscribe only to our newly issued preferred shares. In the event of a capital increase, which would reduce the proportion of capital represented by preferred shares, holders of ADSs, or of preferred shares, would have preemptive rights to subscribe to our new preferred shares, in proportion to their shareholdings and to our new common shares only to the extent necessary to prevent dilution of their interest.
Redemption and Right of Withdrawal
According to the Brazilian Corporate Law, dissenting shareholders in a shareholders meeting shall have a right of redemption, with reimbursement of the value of their shares, in case the following matters are approved:
It is important to point out that (a) in items (i) and (ii), only the holders of shares of the affected type or class will be entitled to redemption; (b) in items (iv) and (v), the holders of shares of a type or class with liquidity and dispersion in the market will not have the right; and (c) in item (vii), the dissenting shareholders shall only have a right of redemption if the split-up implies a change in the corporate purpose, a reduction of the compulsory dividend or the participation in a group of companies.
The reimbursement must be required by the dissenting shareholders within 30 days after the publication of the minutes of the general shareholders meeting or special meeting, as the case may be. Within 10 days after the expiration of the period, management is authorized to call a general shareholders meeting to ratify or reconsider the decision, if management understands that the payment of reimbursement to the dissenting shareholders who have exercised their redemption right may jeopardize the financial stability of the company. A shareholder who fails to exercise the right within the assign term shall no longer be entitled to redemption.
According to the Brazilian Corporate Law, the amount to be reimbursed may only be lower than the share net value ascertained in the last balance sheet approved by the general shareholders meeting if this amount is based on the economic value of the corporation, to be duly appraised. If the decision of the general shareholders meeting takes place more than 60 days after the issuance of the last approved balance sheet, the shareholder shall be entitled to demand, together with the reimbursement, the preparation of a special balance sheet that complies with the time frame previously described.
C. Material Contracts
We have six material contracts related to the concession of public telecommunications service granted by ANATEL (each filed as an Exhibit to this Annual Report). These contract were renewed on December 22, 2005 and expire on December 31, 2025. Three of the contracts relate to local telephone services (Sectors 31, 32 and 34) and the others are relate to long distance services (Sectors 31, 32 and 34).
D. Exchange Controls
There are no restrictions on ownership of preferred shares or common shares by individuals or legal entities domiciled outside of Brazil.
The right to convert dividend or interest payments and proceeds from the sale of shares into foreign currency and to remit such amounts outside Brazil is subject to restrictions under foreign investment legislation which generally requires, among other things, that the relevant investments have been registered with the Central Bank and the CVM. The restrictions on the remittance of foreign capital abroad may hinder or prevent the custodian for the preferred shares represented by ADSs or holders of preferred shares from converting dividends, distributions or the proceeds from any sale of these preferred shares into U.S. dollars and remitting the U.S. dollars abroad. Holders of ADSs could be adversely affected by delays in, or refusal to grant any, required government approval to convert Brazilian currency payments on the preferred shares underlying the ADSs and to remit the proceeds abroad.
Resolution No. 1,927 of the CMN provides for the issuance of depositary receipts in foreign markets in respect of shares of Brazilian issuers. It restates and amends Annex V to Resolution No. 1,289 of the National Monetary Council, known as the Annex V Regulations. The ADS program was approved under the Annex V Regulations by the Central Bank and the CVM prior to the issuance
of the ADSs. Accordingly, the proceeds from the sale of ADSs by ADR holders outside Brazil are free of Brazilian foreign investment controls, and holders of the ADSs are entitled to favorable tax treatment. See TaxationBrazilian Tax Considerations.
Under Resolution 2,689 of the CMN, foreign investors registered with the CVM may buy and sell Brazilian securities, including the preferred shares, on Brazilian stock exchanges without obtaining separate certificates of registration for each transaction. Registration is available to qualified foreign investors, which principally include foreign financial institutions, insurance companies, pension and investment funds, charitable foreign institutions and other institutions that meet certain minimum capital and other requirements. Resolution 2,689 also extends favorable tax treatment to registered investors. See TaxationBrazilian Tax Considerations.
Pursuant to Resolution 2,689 foreign investors must (i) appoint at least one representative in Brazil with the ability to perform actions regarding the foreign investment; (ii) complete the appropriate foreign investor registration form; (iii) obtain registration as a foreign investor with the CVM; and (iv) register the foreign investment with the Central Bank.
The securities and other financial assets held by a foreign investor pursuant to Resolution 2,689 must be registered or maintained in deposit accounts or under the custody of an entity duly licensed by the Central Bank or by the CVM or be registered in register, clearing and custody systems authorized by the Central Bank or by the CVM. In addition, the trading of securities is restricted to transactions carried out on the stock exchanges or over-the-counter markets licensed by the CVM.
Amounts invested in preferred shares by a non-Brazilian holder who qualifies under Resolution 2,689 and obtains registration with the CVM, or by the depositary representing an ADS holder are eligible for registration with the Central Bank. Such registration (the amount so registered is referred to as registered capital) allows the remittance outside Brazil of foreign currency, converted at the commercial market rate, acquired with the proceeds of distributions on, and amounts realized through, dispositions of such preferred shares. The registered capital per preferred share purchased in the form of an ADS, or purchased in Brazil and deposited with the depositary in exchange for an ADS, will be equal to its purchase price (stated in U.S. dollars). The registered capital per preferred share withdrawn upon cancellation of an ADS will be the U.S. dollar equivalent of (i) the average price of a preferred share on the Brazilian stock exchange on which the most preferred shares were traded on the day of withdrawal or (ii) if no preferred shares were traded on that day, the average price on the Brazilian stock exchange on which the most preferred shares were traded in the fifteen trading sessions immediately preceding such withdrawal. The U.S. dollar equivalent will be determined on the basis of the average commercial market rates quoted by the Central Bank on such date or dates.
An electronic registration has been issued in the name of the depositary with respect to the ADSs and is maintained by the custodian on behalf of the depositary. Pursuant to the registration, the custodian and the depositary are able to convert dividends and other distributions with respect to the preferred shares represented by ADSs into foreign currency and remit the proceeds outside Brazil. In the event that a holder of ADSs exchanges such ADSs for preferred shares, such holder will be entitled to continue to rely on the depositarys registration for five business days after such exchange, following which such holder must seek to obtain its own electronic registration with the Central Bank. Thereafter, any holder of preferred shares may not be able to convert into foreign currency and remit outside Brazil the proceeds from the disposition of, or distributions with respect to, such preferred shares, unless such holder is a duly qualified investor under Resolution 2,689 and obtains its own electronic registration.
If the holder appoints a representative in Brazil to act directly in the Brazilian market to acquire preferred shares, the holder will be subject to a less favorable Brazilian tax treatment than a holder of ADSs. Regardless of registration under Resolution 2,689, residents in tax havens are subject to less favorable tax treatment than other foreign investors. See TaxationBrazilian Tax Considerations.
Under current Brazilian legislation, the federal government may impose temporary restrictions on remittances of foreign capital abroad in the event of a serious imbalance or an anticipated serious imbalance of Brazils balance of payments. For approximately six
months in 1989 and early 1990, the federal government froze all dividend and capital repatriations held by the Central Bank that were owed to foreign equity investors, in order to conserve Brazils foreign currency reserves. These amounts were subsequently released in accordance with federal government directives. There can be no assurance that the federal government will not impose similar restrictions on foreign repatriations in the future.
The following discussion contains a description of the material Brazilian and U.S. federal income tax consequences of the acquisition, ownership and disposition of preferred shares or ADSs by certain holders. This summary is based upon the tax laws of Brazil and the United States as in effect on the date of this annual report, which are subject to change, possibly with retroactive effect, and to differing interpretations. You should consult your own tax advisors as to the Brazilian, U.S. federal or other tax consequences of the acquisition, ownership and disposition of preferred shares or ADSs, including, in particular, the effect of any state, local or non-U.S., non-Brazilian tax laws.
Although there is presently no income tax treaty between Brazil and the United States, the tax authorities of the two countries have had discussions that may culminate in such a treaty. No assurance can be given, however, as to whether or when a treaty will enter into force or how it will affect the U.S. holders of preferred shares or ADSs.
Brazilian Tax Considerations
The following discussion mainly summarizes the principal Brazilian tax consequences of the acquisition, ownership and disposition of preferred shares or ADSs by a U.S. holder not deemed to be domiciled in Brazil for Brazilian tax purposes (a U.S. holder). This discussion does not address all the Brazilian tax considerations that may be applicable to any particular non-Brazilian holder, and each non-Brazilian holder should consult its own tax advisor about the Brazilian tax consequences of investing in preferred shares or ADSs.
Taxation of Dividends
Dividends paid by us in cash or in kind from profits generated on or after January 1, 1996 (i) to the depositary in respect of preferred shares underlying ADSs or (ii) to a U.S. holder or non-Brazilian holder in respect of preferred shares will generally not be subject to Brazilian withholding tax. We do not have any undistributed profits generated before January 1, 1996.
Distributions of Interest on Capital
Brazilian corporations may make payments to shareholders characterized as interest on capital as an alternative form of making dividend distributions. The rate of interest may not be higher than the federal governments long-term interest rate, or the TJLP, as determined by the Central Bank from time to time (10% per annum for the three month period beginning January 2004). The total amount distributed as interest on capital may not exceed the greater of (i) 50% of net income (before taking the distribution and any deductions for income taxes into account) for the year in respect of which the payment is made or (ii) 50% of retained earnings for the year prior to the year in respect of which the payment is made. Payments of interest on capital are decided by the shareholders on the basis of recommendations of the companys Board of Directors.
Distributions of interest on capital paid to Brazilian and non-Brazilian holders of preferred shares, including payments to the depositary in respect of preferred shares underlying ADSs, are deductible by us for Brazilian corporate income tax purposes. These payments to U.S. holders or non-Brazilian holders are subject to Brazilian withholding tax at the rate of 15%. If the recipient of the payment is domiciled in a tax haven jurisdiction (i.e., a country that does not impose any income tax or that imposes tax at a rate of less than 20%), the rate will be 25%.
No assurance can be given that our Board of Directors will not recommend that future distributions of profits will be made by means of interest on capital instead of by means of dividends.
Amounts paid as interest on capital (net of applicable withholding tax) may be treated as payments in respect of the dividends we are obligated to distribute to our shareholders in accordance with our bylaws (estatuto social) and Brazilian Corporate Law.
Distributions of interest on capital in respect of the preferred shares, including distributions to the depositary in respect of preferred shares underlying ADSs, may be converted into U.S. dollars and remitted outside of Brazil, subject to applicable exchange controls.
Taxation of Gains
Gains realized outside Brazil by a U.S. holder or a non-Brazilian holder on the disposition of property located in Brazil, including preferred shares, to another U.S. holder or non-Brazilian holder are subject to Brazilian tax, as of February 2004. In this case, gains would be subject to a 15% withholding tax rate, except if the beneficiary is located in a low-tax jurisdiction, as defined by Brazilian law, in which case the applicable rate would be 25%.
Our understanding is that ADSs do not qualify as property located in Brazil and, therefore, are not subject to Brazilian taxes upon disposition to other non-Brazilian or U.S. holders. Insofar as the regulatory norm referred to in Article 26 is recent and generic and has not been tested through the administrative or judicial courts, we are unable to evaluate what the final ruling on the matter will be.
Gains realized by a U.S. holder or a non-Brazilian holder on dispositions of preferred shares in Brazil or in transactions with Brazilian residents may be free of Brazilian tax, taxed at a rate of 25% or taxed at a rate of 15%, depending on the circumstances:
Resolution 2,689, which as of March 31, 2000 superseded the Annex IV Regulations that previously provided tax benefits to foreign investors, extends favorable tax treatment to a U.S. holder or non-Brazilian holder of preferred shares who has (i) appointed a representative in Brazil with power to take action relating to the investment in preferred shares, (ii) registered as a foreign investor with the CVM and (iii) registered its investment in preferred shares with the Central Bank. Under Resolution 2,689 securities held by foreign investors must be maintained under the custody of, or in deposit accounts with, financial institutions duly authorized by the Central Bank and the CVM. In addition, the trading of securities is restricted under Resolution 2,689 to transactions on Brazilian stock exchanges or qualified over-the-counter markets. The preferential treatment generally afforded under Resolution 2,689 to investors in ADSs is not available to residents of tax havens. All preferred shares underlying ADSs qualify under Resolution 2,689.
There can be no assurance that the current preferential treatment for U.S. holders and non-Brazilian holders of ADSs and U.S. holders and non-Brazilian holders of preferred shares under Resolution 2,689 will be maintained.
Gain on the disposition of preferred shares is measured by the difference between the amount in Brazilian currency realized on the sale or exchange and the acquisition cost of the shares sold, measured in Brazilian currency, without any correction for inflation. Although there is controversy surrounding this issue, there are arguments to sustain the position that the acquisition cost of shares registered as an investment with the Central Bank is calculated on the basis of the foreign currency amount registered with the Central Bank. See Registered Capital.
Gains realized by a U.S. holder and non-Brazilian holder upon the redemption of preferred shares will be treated as gains from the disposition of such preferred shares to a Brazilian resident occurring off of a stock exchange and will accordingly be subject to tax at a rate of 15%. In case the non-Brazilian holder is domiciled in a tax haven jurisdiction, the applicable rate would be 25%.
As of January 1, 2005, the purchase price of preferred shares sold on the Brazilian stock exchange is subject to withholding tax at a rate of 0.005%, except in the case of non-Brazilian holders that invest through Resolution No. 2,689. This tax may be offset against the 15% income tax due on the gains realized upon the sale of the shares.
Any exercise of preemptive rights relating to the preferred shares or ADSs will not be subject to Brazilian taxation. Gains on the sale or assignment of preemptive rights relating to the preferred shares will be treated differently for Brazilian tax purposes depending on (i) whether the sale or assignment is made by the depositary or the investor and (ii) whether the transaction takes place on a Brazilian stock exchange. Gains on sales or assignments made by the depositary on a Brazilian stock exchange are not taxed in Brazil, but gains on other sales or assignments may be subject to tax at rates up to 15%.
The deposit of preferred shares in exchange for the ADSs is not subject to Brazilian income tax if the preferred shares are registered under Resolution 2,689 and the respective holder is not in a tax haven jurisdiction. If the preferred shares are not so registered or the holder is in a tax haven jurisdiction, the deposit of preferred shares in exchange for ADSs may be subject to Brazilian capital gains tax at a rate of 15%.
The withdrawal of preferred shares in exchange for ADSs is not subject to Brazilian tax. On receipt of the underlying preferred shares, a U.S. holder or non-Brazilian holder entitled to benefits under Resolution 2,689 will be entitled to register the U.S. dollar value of such shares with the Central Bank as described above, under Registered Capital. If a U.S. holder or non-Brazilian holder does not qualify under Resolution 2,689, he will be subject to the less favorable tax treatment described above in respect of exchanges of preferred shares. Brazils tax treaties do not grant relief from taxes on gains realized on sales or exchanges of preferred shares.
Beneficiaries Residing or Domiciled in Tax Havens or Low-Tax Jurisdictions
Law No. 9,779, dated as of January 19, 1999, states that, with the exception of limited circumstances, any income derived from operations by a beneficiary that resides or is domiciled in a country considered to be a tax haven is subject to income tax to be withheld by the source at a rate of 25%. Accordingly, if the distribution of interest attributed to shareholders equity is made to a beneficiary residing or domiciled in a tax haven, the applicable income tax will be at a rate of 25% instead of 15%. The increased rate also applies for capital gains paid to residents of low-tax jurisdictions as of February 2004.
In accordance with Law No. 9,959, non-Brazilian holders of ADSs or preferred shares who are residents of tax havens have been excluded from the tax incentives granted to holders of ADSs and investors under Resolution No. 2,689 since January 1, 2000 and are subject to the same tax treatment applicable to holders that are residents of or domiciled in Brazil.
Other Brazilian Taxes
There are no Brazilian inheritance, gift or succession taxes applicable to the ownership, transfer or disposition of preferred shares or ADSs by a non-Brazilian holder except for gift and inheritance taxes levied by some states in Brazil on gifts made or inheritances bestowed by individuals or entities not resident or domiciled in Brazil or in the relevant state to individuals or entities that are resident or domiciled within this state in Brazil. There are no Brazilian stamp, issue, registration, or similar taxes or duties payable by holders of preferred shares or ADSs.
A financial transaction tax, or the IOF tax, may be imposed on a variety of transactions, including the conversion of Brazilian currency into foreign currency (e.g., for purposes of paying dividends and interest). The IOF tax rate on such conversions is currently 0%, but the Minister of Finance has the legal power to increase the rate to a maximum of 25%. Any increase will be applicable only prospectively.
The IOF may also be levied on transactions involving bonds or securities, or IOF/Títulos, even if the transactions are effected on Brazilian stock, futures or commodities exchanges. The rate of the IOF/Títulos with respect to preferred shares and ADSs is currently 0%. The minister of finance, however, has the legal power to increase the rate to a maximum of 1.5% of the amount of the taxed transaction per each day of the investors holding period, but only to the extent of gain realized on the transaction and only on a prospective basis.
In addition to the IOF tax, a second, temporary tax that applies to the removal of funds from accounts at banks and other financial institutions, the CPMF tax, will be imposed on distributions in respect of ADSs at the time these distributions are converted into U.S. dollars and remitted abroad by the Custodian. The CPMF tax is due to expire on December 31, 2007. It is currently imposed at a rate of 0.38%. Transactions conducted through the Brazilian stock exchanges in current accounts specified for stock exchange transactions have been exempt from the CPMF tax since July 13, 2002. Additionally, as of August 2004, Brazilian holders may elect to make investments through a special investment account, which is exempt from CPMF. In this case, the tax only applies upon the transfer of funds from the banking account to the investment account. Once deposited in this account, funds may be withdrawn without the CPMF. However, funds deposited in the investment account must only be used for investments.
U.S. Federal Income Tax Considerations
The following discussion is a summary of the material U.S. federal income tax consequences of the acquisition, ownership and disposition of our preferred shares or our ADSs by U.S. Holders, as defined below. This summary is based on the Internal Revenue Code of 1986, as amended (referred to herein as the Code), final, temporary and proposed Treasury regulations, administrative pronouncements of the U.S. Internal Revenue Service (the IRS) and judicial decisions, all as currently in effect and all of which are subject to change (possibly with retroactive effect), and to different interpretations. It is also based in part on representations by the depositary and assumes that each obligation under the Deposit Agreement and any related agreement will be performed in accordance with its terms. This discussion deals only with preferred shares and ADSs held as capital assets (generally, for investment purposes). It does not discuss all of the tax consequences that may be relevant to a U.S. Holder in light of the U.S. Holders particular circumstances or to U.S. Holders subject to special rules