Investor Presentaiton

industry, and that Totvs' business model has shown competence in grasping the opportunities available in this segment. Ultrapar Ipiranga Law No. 9.900, which reduced to zero the rate of these taxes on distribution, and concentrated their payment in the refineries. At the time, the consumption of fuel ethanol was not so important and the authorities efforts concentrated on gasoline and diesel oil. With the advent of flexible fuel vehicles, the ethanol market grew very sharply, bringing with it the old famil- iar tax evasion and adulteration practices. Besides that, while gasoline production is concentrated in no more than a dozen refineries controlled by Petrobras, ethanol production occurs in around 350 plants. This fragmentation of interests adds further challenges to legality. Hence, the market share of the distribu- tion companies represented by Sindicom reaches only 60% in the ethanol market, comparing to 77% of the gasoline market and 84% of the diesel market. This also explains the fact that the bulk of ethanol tax substitution is still an obligation due to the distributor (60%) and only a smaller portion (40%) is the responsibility of the ethanol mills, while, for the gasoline market, 100% of the ST is a refinery liability. Furthermore, the installation of flow meters (device enabling the production flow count and which significantly contributed to putting an end to tax evasion in the beer industry) is still pending specific regulation for its installation in ethanol mills. The fuel distribution market has co-existed for many years with practices such as product adulteration (dilution us- ing solvents or water) and tax evasion. With the opening of the market in the nineteen-nineties, the number of distributors rapidly multiplied from ten to four hundred companies, most of them operating irregularly. At the end of the decade, the volume of fuel drawn from the Paulínia refinery by companies not associated with the Sindicom amounted to over 70% of the total volume sold 7. This problem was addressed by tax substitution when the refineries became liable for paying the taxes due along the supply chain, specifically ICMS (value-added tax) and PIS-Cofins (labor and social security taxes). But even then, no solution was immediately forthcoming. A number of companies resorted to legal action to challenge the new tax system, a practice that, at the time, was dubbed "the injunction industry". The contention surrounding the ICMS was partially reduced in 1998, when the State of São Paulo Justice Tribunal suspended all injunctions then in force. The PIS-Cofins problem endured and, in 2000, was settled by Provisional Measure No. 2.037/00 and, later, by 7 Sindicom is the association sheltering the ten largest fuel and lubricant companies active in Brazil. Sindicom companies comply with legitimate market practices. Chart I Gross Margin of Fuel Distribution 0,25 0,20 0,15 0,10 0,05 0,00 (0,05) (0,10) (0,15) (0,20) in São Paulo - R$/liter jan-05 jun-05 nov-05 abr-06 Source: ANP, Esalq and Dynamo sep-06 Ethanol Gasoline feb-07 jul-07 dec-07 mai-08 Oct-08 mar-09 Taxes are a major stake of consumer price of fuels. In the case of gasoline, for example, taxes represent around 40-50% of the pump price. Tax evasion represents a significant competitive edge in this market. The PIS-Cofins payable on distribution is equivalent to approximately eight cents (in R$ terms) per liter of ethanol, while the gross margin for this fuel is around four or five cents per liter. Distributors that do not pay these taxes can charge, say, six cents per liter less than a taxpaying competitor obliging it to operate under a negative margin and still record a margin of six to seven cents per liter. As a rule, these tax evasion and adulteration practices are associated with the suppliers and retailers 'private label' service stations, in other words, gas stations that have no fuel supply agreement with the leading brand name distributors. Just as an example, in December 2008, of Brazil's almost 36 thousand service stations, no fewer than 15.8 thousand were 'private label' establishments (44%). Moreover, most of these gas stations are in the State of São Paulo, the country's biggest producer and distributor of ethanol. It is no coincidence that the ethanol operating margins of São Paulo market distributors have historically been consideraly lower than gasoline margins, as shown in the chart below. Threatening tax evasion represents a combination of opportunities for the fuel distribution business: i) it eliminates the advantage held by unfair competition; ii) it undermines the business model of the majority of service stations not operating under a brand name, thereby enabling free access by legitimate 4

View entire presentation