1 Multinational Financial Management Alan Shapiro 10 th Edition John Wiley & Sons, Inc. PowerPoints by Joseph F. Greco, Ph.D. California State University, Fullerton

CHAPTER 20 Managing the Multinational Financial System

MANAGING THE MULTINATIONAL FINANCIAL SYSTEM I. THE VALUE OF THE MULTINATIONAL FINANCIAL SYSTEM Its value lies in its ability to arbitrage in the following areas: 1.Tax systems 2.Financial markets 3.Regulatory systems

TAX ARBITRAGE Tax Arbitrage is possible because we know: 1.Wide variations exist in global tax systems examples: Germany vs. Honk Kong 2.Firms want to reduce taxes paid especially the “triple-taxed” MNC move funds to low-tax jurisdiction

TAX ARBITRAGE 3. Tax Factors (triple taxation): a. Triple Taxes may be levied on 1.)corporate income 2.)personal income (includes dividends) 3.)subsidiary income b. U.S. Tax System Provision Offset: Foreign tax credit given on tax already paid abroad.

FINANCIAL MARKET ARBITRAGE Financial Market Arbitrage is possible if we 1. assume imperfect markets exist because a.Formal barriers to trade exist b.Informal barriers also exist c.Imperfections in domestic capital markets exist 2. agree parity conditions not in effect, namely a.interest rate parity b. International Fisher Effect

REGULATORY ARBITRAGE Regulatory Arbitrage: 1.Arises when subsidiary profits vary due to local regulations. 2.Examples of local regulations: a.Government price controls b.Union wage pressures: Firms may disguise true profits in order to gain better negotiations advantages 

INTERCOMPANY FUND-FLOW MECHANISMS II. INTERCOMPANY FUND-FLOWMECHANISMS: the name given to the methods used to move funds from one subsidiary to another.

INTERCOMPANY FUND-FLOW MECHANISMS COMMONLY USED MECHANISMS: A.Unbundling B.Transfer Pricing C.Reinvoicing Centers D.Royalties E.Leading and Lagging F.Mechanism: Dividends

UNBUNDLING A.Unbundling Mechanism breaks up a total international transfer of funds between pairs of affiliates into separate components Example: Headquarters breaks down charges for corporate overhead (wages, rent, utilities, etc.) by affiliate

TRANSFER PRICING B.Transfer Pricing Mechanism 1.Definition: pricing internally traded goods of the firm for the purpose of moving profits to a more tax-friendly nation.

TRANSFER PRICING 2.Uses of Transfer Pricing a.Reduces taxes paid b.Reduces tariffs c.Avoids exchange controls

TRANSFER PRICING: An Example Suppose that affiliate A produces 100,000 circuit boards for $10 apiece and sells them to affiliate B. Affiliate B, in turn, sells these boards for $22 apiece to an unrelated customer. Pretax profit for the consolidated company is $1 million regardless of the price at which the goods are transferred for A to B.

TRANSFER PRICING: An Example Basic rules: Between Affiliate A and B If tax rate A > tax rate B, set the transfer price and the mark-up policy as LOW as possible. If tax rate A < tax rate B, set the transfer price and the mark-up policy as HIGH as possible.

TRANSFER PRICING: An Example Without markup policy AB A+B Revenue 1,500 2,200 2,200 CGS Gross Profits ,200 Expenses Income b/t ,000 Taxes (30/50) Net Income

TRANSFER PRICING: An Example HIGH MARK-UP POLICY (unit price = $18) A B A+B Revenue 1,800 2,200 2,200 CGS Gross Profits ,200 Expenses Income b/t ,000 Taxes (30%/50%) Net Income

TRANSFER PRICING: An Example In effect: Profits are shifted from a higher to a lower tax jurisdiction

REINVOICING CENTERS C.Mechanism: Reinvoicing Centers 1.Set up in low-tax nations. 2.Center takes title to all gods. 3.Center pays seller/paid by buyer all within the MNC.

REINVOICING CENTERS 4.Advantages: a.Easier control on currency exposure b.Invoice currency other than local

REINVOICING CENTERS 5.Disadvantages of Reinvoicing a.Increased communications costs b.Suspicion of tax evasion by local governments.

FEES AND ROYALTIES D.Mechanism: Royalties 1.Firms have control of payment amounts. 2.Host governments less suspicious

LEADING AND LAGGING E.Leading and Lagging 1.Highly favored by MNCs 2.Often used instead of formal debt: may be prohibited by local government 3.Less chance of local government suspicion.

DIVIDENDS! F.Mechanism: Dividends most important method used by MNCs to transfer funds to parent

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