Brazil has provided investors with some of the best returns in the world this year but investment funds based in Ireland have been forced to adopt new strategies to get their money's worth.
Brazil blacklisted Ireland as a tax haven in September 2016 because of its low corporate tax rates, so investment funds in Dublin now pay higher tax on returns from Brazilian bonds and shares than funds in some rival centres such as Luxembourg.
In a fiercely competitive industry, Dublin-based investment funds have been faced with having to accept lower returns from Brazil, reducing their exposure to the country, or finding ways to keep pace with rival funds elsewhere subject to lower taxes.
"It is an important issue because for some reason Luxembourg is not treated in the same way, so the asset managers who are set up there are advantaged over Dublin, in principle," said Rob Drijkoningen, head of emerging debt at Neuberger Berman, an investment manager with more than 30 funds listed in Dublin.
Brazil is the world's ninth biggest economy, after Italy and ahead of Canada, so it typically accounts for a significant chunk of global or emerging market investment portfolios.
The country's debt makes up a 10th of the local currency debt benchmark, the JPMorgan Government Bond Index-Emerging Markets. Brazilian shares account for 7.6% of the MSCI Emerging Markets equity index.
So far this year, bonds denominated in the Brazilian real have returned 20% while the local Bovespa stock market index has surged almost 30%, making it hard for investors searching for higher yields to ignore.
But since the tax haven ruling, Brazilian transactions by Dublin-based funds have been subject to 25% withholding tax on interest, royalties and capital gains - up from 15% previously.
Steve O'Hanlon, chief investment officer at Rubrics Asset Management, which has its six fixed-income funds domiciled in Dublin, said following the tax change he was using similar strategies to those used in 2010 when Brazil slapped a levy on foreign purchases of domestic securities to curb so-called hot money flows.
Then, many investors turned to securities listed offshore, such as American Depositary Receipts, that mirrored a direct exposure to Brazil but sidestepped the tax.
O'Hanlon said this time he was buying instruments such as total return swaps which offered exposure to Brazilian assets, and any gains, without having to own the underlying securities.
Neuberger Berman's Drijkoningen said he was now investing in Brazil using derivative instruments such as interest rate swaps, credit default swaps and currency forwards, and his emerging market debt portfolio had not suffered from the tax changes.
The derivative trades effectively replicate an investment in an actual bond but are not usually subject to local taxes because they are done offshore, he said.
For Ireland, losing any tax advantage is a major blow and the government has been lobbying Brazil for more than a year to reverse its decision, but with little success.
At the end of 2016, funds based in Ireland managed almost 3 trillion euros ($3.5 trillion) of assets, according to research house Monterey Insight, making it the second most popular home for investment funds in Europe after Luxembourg.
Out of that total, emerging market funds managed $121 billion and another $1.3 billion was held in Latin America products, Monterey estimated.
Some fund managers said the Brazilian tax issue had been little more than a headache so far.
Greg Saichin, head of emerging debt at Allianz Global Investors, said some clients might be more exposed to higher taxation, especially those with segregated accounts buying local bonds. But despite having some funds based in Ireland, he has not changed tack on investing in Brazil.
"In our global portfolios, Brazil may not be more than a 4 to 5 percent allocation overall, and the investment umbrella families have been set up on the back of multiple considerations - management, administration, taxation," Saichin said.
Ireland's fund industry body said the impact on Dublin as a centre for asset management had been minimal so far.
"We are not aware of any fund which has redomiciled from Ireland as a result and understand that managers are taking appropriate action to manage and mitigate any impact on their investments," Irish Funds said in an emailed statement.
Along with Ireland, Brazil added Austria and Caribbean island nations Curacao and Saint Martin to its tax haven blacklist, which already included well-known low-tax jurisdictions such as the Isle of Man, Monaco and Panama.
An Irish finance ministry spokesman said a formal request last year from Ireland's ambassador to reverse the decision was accompanied by a detailed explanation of the Irish corporate tax system, outlining why the country should not be on the list.
Brazil's move was originally designed to stop domestic firms taking advantage of Ireland's 12.5 percent corporation tax. It was announced soon after Brazilian meatpacking giant JBS said it planned to move some global operations to Ireland. A Brazilian state agency later vetoed the plan.
The Irish finance ministry spokesman said the appeal was still being considered by Brazil's revenue secretary.
Brazil is carefully analysing the issue, its Finance Minister Henrique Meirelles said in September. But the fact so many international funds were located in Dublin because of tax rates "indicates something", he said.
Ireland has also faced pressure from Washington and Brussels over its pro-business tax structures, a key part of its economic policy since the 1960s that has attracted multinationals such as Google, Microsoft, Apple and Facebook.
Some investment managers said the derivative strategies used to limit the impact of higher taxes meant funds had to watch the risks associated with trading with other financial houses.
"Any time you play with derivatives you have the counterparty risk element," said O'Hanlon at Rubrics. "Prior to 2008 no one cared about these things, but since then there are limits to how much counterparty risk you can take."
Drijkoningen also said Brazil's move could ultimately backfire if investors demanded higher returns to compensate for the additional tax liability.
"It has a downside ... to compensate for a higher withholding tax, interest rates on Brazilian debt have to increase in a commensurate way," he said. "The trade-off for owning local bonds became less attractive." (Reuters)