The Breakup. The Breakup of Telebrás is subject to several lawsuits in which the plaintiffs have requested, and in certain cases obtained, preliminary injunctions against the Breakup. All of these preliminary injunctions have been quashed by decisions of the relevant Federal Court, although several of such decisions are currently on appeal. If any such appeal is successful, the shareholders of Telebrás will be required to reapprove the Breakup or other legislative actions may be required.
The lawsuits to which the Breakup has been subjected are based on a number of legal theories, the principal among which are that:

  · the Brazilian Constitution requires that the creation of the twelve New Holding Companies be specifically authorized by the Telecommunications Law;

· the shareholders' meeting of Telebrás held on May 22, 1998 which approved the Breakup was not properly convened;

· national sovereignty will be threatened if the country's telecommunications companies are controlled by foreign entities; and

· the Telecommunications Law requires that certain matters, such as the entry of new competitors and the administration of development and technology funds, be regulated prior to the Breakup and privatization either by an executive order of the President or by an act of Congress.

If any of the plaintiffs in the these lawsuits ultimately prevails, the Breakup may have to be reinitiated. This could require, depending upon the prevailing plaintiff's theory, any combination of the following:

  · amendment of the Telecommunications Law;

· reconvening the May 22, 1998 Telebrás shareholders' meeting; and

· the passing of additional laws by Congress or issuance of executive orders by the President.

It is theoretically possible under Brazilian law for a court to require that the Breakup be unwound, although we believe that this would not be likely to occur.

We are a party in a public civil action brought by the Federal Department of Justice initially to impede the privatization auction. This lawsuit, filed before the First Federal Circuit of Rio de Janeiro on July 27, 1998, is about to move from the first procedural phase, that is, the pleading phase, to the discovery phase.

Foreign source operating income. In March 1999, we received from the Federal Revenue Agency a tax assessment in the amount of R$287.2 million for failing to pay income tax on net foreign source operating income for the years 1996 and 1997. Foreign source operating income consists of payments made to us by foreign companies for connecting incoming international calls to Brazil. In late April 1999, we filed our response to the tax assessment with the administrative level of the courts. In June 1999, we were further assessed for non-payment of income tax on net foreign source income for the year 1998 in the amount of R$111.1 million. However, of this total, approximately R$46.7 million related to the period from August to December 1998 for which we had already recorded and paid in full the income tax and related interest during 1999. We intend to continue to pay income tax on net foreign sources income until this tax controversy is resolved. In February 2001, we appealed to the third level of the tax administrative court against a decision by the lower tax administrative court that maintained the assessment from June 1999. The tax assessment from March 1999 is still pending in the lower administrative level. We expect to continue to dispute the assessment and to discuss this issue with the appropriate authorities. See note 20 to the consolidated financial statements.

Withholding tax on remittances to foreign telecommunications companies. We regularly make payments to foreign telecommunications companies for completing international calls that originate in Brazil and terminate in a foreign country. Brazilian income tax law generally requires Brazilian recipients of services from foreign companies to withhold 25% from payments to foreign companies for such services. However, based on decisions in 1952 of both the Brazilian Finance Ministry and the Taxpayers' Council, we have never withheld Brazilian income tax from such payments. See note 20 to our consolidated financial statements.

On December 23, 1999, we received a tax assessment in the amount of R$410.7 million for failing to pay the related withholding tax on outbound revenue for the period from December 1994 to October 1998. The Federal Revenue Agency has concluded that starting October 1998, we are exempt from any such withholding requirement. We believe that other double taxation treaties should also apply to remittances made to countries that are parties to such treaties. We filed a lawsuit to contest the date of applicability of the Melbourne treaty, which exempts us from this withholding requirement, and we intend to demonstrate that it is applicable prior to 1992, and not limited to the period beginning October 1998.

In order to avoid the collection and imposition of penalties by the tax authorities while the courts are reviewing the matter, we filed an injunction. The injunction was overturned in May 2000 after an appeal by the Federal Revenue Agency's Attorney Officer. We appealed the judge's order and the injunction was reinstated in July 2000, conditioned on a financial guarantee, which was immediately provided by Embratel. We continue to believe that the application of this tax to us is inappropriate and plan to continue the process of administrative and judicial appeals.

In response to a request from the Ministry of Communications, the Federal Attorney General's office issued a legal opinion on October 31, 2000, confirming the government's position with respect to the foreign source operating income issue and the withholding tax on remittances to foreign telecommunications companies. Based on our management's review and the advice of our legal counsel, we believe that the attorney general has not presented any new arguments that could change the evaluation of this matter when the final decision is issued by the judicial authorities.

We have also notified Telebrás, our legal predecessor, of both issues concerning the foreign sources operating income and the withholding tax on remittances to foreign administrations.

COFINS. We are presently challenging in court a legislation which mandates that:

  · taxable revenues for purposes of PIS (0.65%) and COFINS (3%) be broadened to include financial revenues and exchange rate variation; and

· COFINS be raised to 3%.


Regulatory sanctions. When the carrier selection code, or PIC code, was introduced in July 1999, the telephony system throughout Brazil experienced an unusually high rate of busy circuits. Domestic and international long-distance calls could not be completed. As a result, Anatel established an administrative hearing process and imposed on us a penalty of R$55 million. Embratel filed a lawsuit to void Anatel's administrative procedure and received an injunction and a favorable opinion from the State Attorney Officer, and thus we avoided the collection of the penalty. With respect to such lawsuit filed against the Anatel administrative procedure, on April 24, 2001, the lower court issued a decision in favor of Anatel. However, the judge decided to reduce the penalty from R$55 million to R$50 million due to a partial violation of the administrative procedures by Anatel. We intend to appeal this decision and, in addition, will pursue all legal remedies to avoid the collection of this penalty amount.

In April 2000, the state of São Paulo imposed a fine of R$30 million on us and a local fixed-line operator, and ordered us to refund our customers an amount equivalent to the value of all calls made between July 3 and July 12, 1999. We appealed and requested that the lower court decision be vacated due to the violation of our right to defense.

ICMS on international outbound traffic and bundled services. Until the enactment of Complementary Law No. 87 of September 13, 1996, known as the Complementary Law, local telecommunications companies invoiced and collected state value-added tax, or ICMS, on fixed-line telecommunications services at an effective rate of 13% in accordance with ICMS Convention No. 27 of March 29, 1994. When the Complementary Law went into effect, Telebrás instructed its telecommunications operating companies to stop collecting ICMS on international outbound telephone traffic. However, certain state tax agencies fined local telecommunications companies for not collecting and paying ICMS on international outbound traffic from 1996 to 1999. As a precautionary measure, we began collecting ICMS on international traffic in January 2000. We were also assessed for nonpayment of ICMS on certain services (bundled services) considered to be exempt or non-taxable for ICMS purpose. Management and our legal counsels believe that there is a sound basis for defending the position that ICMS is not payable on revenues derived from international outbound traffic and from certain exempt and non-taxable services (bundled services) as well. Based on the facts currently available and on advice from legal counsel, we consider the probability of loss on these issues as possible. The possible losses amount to approximately R$115 million. This amount already includes assessments received after December 2000 from the states of Para, Espirito Santo and Rio de Janeiro; and a partial favorable decision to us from Rio de Janeiro Administrative Tax Court as well.
In addition, our management is considering challenging in court the ICMS on international outbound traffic. Accordingly, no provision has been recorded. Meanwhile, we are taking an active role in the telecommunications industry's effort to inform the tax authorities about the detrimental effect of the high ICMS rate.

Telebrás. Telebrás, the legal predecessor of the registrant, is a defendant in a number of legal proceedings and subject to other claims and contingencies. Under the terms of the Breakup, 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 New Holding Companies are jointly and severally liable by operation of law) and any liability for which specific accounting provisions have been assigned to the registrant or one of the other New Holding Companies. Creditors of Telebrás could challenge this allocation of liability until September 14, 1998. We are not aware of any such challenge having been made.

Although we are considered to be the surviving entity of Telebrás for financial reporting purposes under U.S. GAAP, we will not be liable for any claims arising out of acts committed by Telebrás except for such claims as have been assigned to it under the terms of the Breakup and except for labor and tax claims as discussed above.

We are a party to certain other legal proceedings arising in the normal course of business. We have provided for or deposited in court amounts to cover estimated losses due to adverse legal judgments. In the opinion of our management, such actions, if decided adversely to us, would not have a material adverse impact on our business, financial condition or results of operations.