13. VAT Tax Issue in Brazil

From early in 2004 to April 2009, Lakeland Brasil, S.A. (“Qualytextil,” “QT”) imported its raw materials through the port of Recife (in the state of Pernambuco, neighboring the state of Bahia where the QT plant is located). QT paid an import broker in Recife the proper taxes and then trucked the goods to Salvador, Bahia, Brazil. QT obtained a legal opinion at the time and relied on this in good faith.

In October 2009, QT received an audit notice from Bahia claiming the taxes paid to Recife/Pernambuco should have been paid to Bahia in the amount of R$4.8 million and assessed fines and interest of an additional R$5.9 million for a total of R$10.7 million (approximately US$2.9 million, $3.7 million and $6.7 million, respectively).

Bahia had announced an amnesty for this tax whereby the taxes claimed were paid by the end of the month of May 2010, and the interest and penalties were forgiven. According to fiscal regulation of Brazil, this amnesty payment has been partially recouped as credits against future taxes due. Since the amounts were paid as tax on the import of goods, Bahia has allowed this amnesty payment to be recouped as credits against future taxes due.

Of these claims, our attorney informs us that R$1.0 (US$0.6) million will be successfully defended based on a lapse of statute of limitations and R$0.3 (US$0.2) million based on state auditor misunderstanding. A small amount of R$0.2 million (US$0.1 million) was paid by amnesty defended by another attorney. This amount is already included in the total amnesty program (R$3.5 million) (US$2.2 million).

The total taxes paid into the amnesty program on May 31st were R$3.5 (US$2.2) million.

Amounts from Preacquisition Period; Escrow

The initially asserted tax claims of R$4.8 million (R$10.7 million with penalty and interest) (US$3.0 million and $6.7 million, respectively) all relate to imports during the period 2004-2006, prior to the QT acquisition by the Company in May 2008. At the closing, there were several escrow funds established to protect Lakeland Industries, Inc. (Lakeland) from contingencies as discussed herein. The remaining funds in escrow have a total current balance of R$2.1 (US$1.3) million. One seller has released his escrow with a balance of R$1.0 (US$0.6) million. Lakeland has filed a claim against the remaining funds in escrow.

Future Accounting for Funds

Following payment into the amnesty program, the taxes will be or have already been partially recouped via credits against future taxes due. The Company does not expect any further charges to expense other than interest and legal fees as described below:

	(R$ millions)		(US$ millions )
1) Interest costs		0.4		0.2
2) Legal fees		0.5		0.3
TOTAL	$	0.9	$	0.5

These costs will be assessed or already have been assessed against the credits and should serve to recoup these costs or lost incentives back to QT Lakeland Industries, Inc. from the escrow but are considered opportunity costs or future costs and have not been charged to expense currently.

Additional VAT Claim for 2007/2009 Period

An audit for the 2007-2009 period has been completed by the State of Bahia. In October 2010, the Company received a claim from the State of Bahia for taxes of R$6.2 (US$3.9) million and fines and penalties of R$4.9 (US$3.1) million, for a total of R$11.1 (US$6.9) million, which had been expected per above. The Company intends to defend and wait for the next amnesty period. Of these claims, our attorney informs us that R$0.48 (US$0.3) million will be successfully defended based on state auditor misunderstanding.

Company counsel advises the Company that in his opinion the next amnesty will come before the end of the judicial process. There has been a long history in Bahia of the state declaring such amnesty periods every two to three years going back 25 years. The litigation process begins as two separate administrative proceedings and, after a period of time, must be switched to a formal court judicial proceeding. If the next amnesty does not arrive prior to the commencement of the formal court proceedings, the Company will have to remit a “judicial deposit” covering the exposure from 2007-2009 in taxes of approximately R$6.2 (US$3.9) million plus assessed fines and interest bringing the judicial deposit needed to approximately R$11.1 (US$6.9) million. The initial estimated time period to Judicial Court deposit was 1.5-2 years. This does not necessarily have to be all cash. The Court will accept a pledge of real estate (approximately R$4.2 (US$2.6 million)).

Summary of Cash Flow Requirements: (R$ millions and US$ millions)

Claim period/description

Taxes

Fines and

Penalties

Maximum Judicial

deposit

2004-2006 not paid into amnesty and being defended. Management does not plan to pay this into amnesty

1.3

1.8

3.1

US$

1.9

2007-2009 claim by State of Bahia (1)

6.2

4.9

11.1

US$

6.9

TOTAL

7.5

6.7

14.2

US$

8.8

(1) Our attorney informs us that based on the slow progress so far in the administrative proceedings for the 2007-2009 claim, that he believes it is now more likely than not that the next amnesty will arrive prior to the need to pay the R$11.1 judicial deposit. Therefore, the most likely cash flow outlook in management’s opinion is as follows:

R$3.1 (US$1.9) million 2004-2006 Judicial deposit	Q4 FY12
R$6.2 (US$3.9) million 2007-2009 claim into amnesty	Q4 FY12 to Q2 FY13

Further, management believes it will be able to satisfy the R$3.1 (US$1.9) million judicial deposit by pledging real estate owned rather than paying cash.

At the next amnesty period:

If before judicial process - still administration proceeding - the Company would pay just the taxes with no penalty or interest. This would then be recouped via credits against future taxes on future imports. As before, the Company would lose desenvolve and interest.

If after judicial process commences - the amount of the judicial deposit previously remitted would be reclassified to the taxes at issue, and the excess submitted to cover fines and interest would be refunded to QT. As above, the taxes would be recouped via credits against future taxes on future imports but we would lose desenvolve and interest.

The desenvolve is scheduled to expire on February 2013 and will be partially phased out starting February 2011. Based on the anticipated timing of the next amnesty, there may be little amounts of lost desenvolve since it would largely expire on its own terms in any case.

Statement of Operations Treatment

There is a R$2.9 million (US$1.6 million) charge to expense in Q1FY11 as a result of this issue determined as follows (based on exchange rates in effect at the time):

	Millions
	R$			US$
Total to be paid not available for:
Asserted claims	$	1.4		$	0.8
Unasserted claims		2.5			1.3
		3.9			2.1
Escrow funds released		(1.0	)		(0.5	)
Charge to expense in Q1FY11	$	2.9		$	1.6
Escrow funds available:
Total escrow funds	$	2.8		$	1.6
Escrow released in May		(1.0	)		(0.5	)
Remaining funds in escrow as of May 31, 2010	$	1.8		$	1.1
There has been an additional R$0.3 million (US$0.2 million) additional interest earned through August 2011.

The claim for the 2007-2009 is in the amount of approximately R$6.2 (US$3.9) million. Lakeland intends to apply for amnesty and make any necessary payments upon the forthcoming amnesty periods imposed by the local Brazilian authorities. Of this R$6.2 (US$3.9) million exposure, R$3.4 (US$2.1) million is eligible for future credit. The R$3.5 (US$2.2) million balance is subject to indemnification from the Seller, and the Company is in the process of pursuing this claim through an arbitration proceeding in progress. Also, there is $0.1 million our attorney informs us is a mistake made by the state auditor, which he believes will be successfully defended.

Possible Recourse Actions

The Company’s counsel has reviewed potential actions against sellers under indemnification proceedings, including possible claims on postacquisition exposure resulting from misrepresentations and has begun arbitration proceedings against two of the selling stockholders. The Company is also evaluating potential action for recourse against other parties involved in the original transactions.

When the Company receives the remaining funds from escrow, this will be recorded as a gain at such time. Any further indemnifications from the sellers and potential other parties will also be recorded as a gain at such time as received.

The Company has also asserted indemnification rights under its Share Purchase Agreement with the sellers and has other legal avenues for recoupment of these monies against both the sellers and will in the future against negligent third parties. Such recoupment, if successful, will be reported as profits over future periods when and if collected.

Balance Sheet Treatment

The Company has reflected the above items on its July 31, 2011, balance sheet as follows:

		(R$ millions)			US$ millions
Current assets	Prepaid taxes	$	0.2	(a)	$	0.1
Noncurrent assets	VAT taxes payable	$	3.5		$	2.2
Long-term liabilities	Taxes payable	$	6.0		$	3.8

(a)

Originally recorded at $R2.1 million and US$1.1 million when paid into amnesty in May 2010. Balances remaining and included on July 31, 2011, balance sheet are R$0.2 million and US$0.1 million. The reduction represents credits offset against current VAT taxes due for current purchases .