Managing the Multinational Financial System Chapter 16

MANAGING THE MULTINATIONAL FINANCIAL SYSTEM I. THE VALUE OF THE MULTINATIONAL FINANCIAL SYSTEM A. 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, Hong 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. Taxes may be levied on 1.) corporate income 2.) personal income (includes dividends) 3.) subsidiary income b. U.S. Tax System Provisions 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. The following parity conditions may not be in effect: a. interest rate parity b. International Fisher Effect

REGULATORY ARBITRAGE Regulatory Arbitrage 1. Regulations on environmental pollution 2. Arises when subsidiary profits vary due to local regulations. 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-FLOW MECHANISMS: 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 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 from A to B.

TRANSFER PRICING: An Example Basic rules: If tA > tB , set the transfer price and the mark-up policy as LOW as possible. If tA < tB , set the transfer price and the mark-up policy as HIGH as possible.

TRANSFER PRICING: An Example Without markup policy A B A+B Revenue 1,500 2,200 2,200 CGS <1,000> <1,500> <1,000> Gross Profits 500 700 1,200 Expenses <100> <100> <200> Income b/t 400 600 1,000 Taxes (30/50) <120> <300> <420> Net Income 280 300 580

TRANSFER PRICING: An Example HIGH MARK-UP POLICY (unit price = $18) A B A+B Revenue 1,800 2,200 2,200 CGS <1,000> <1,800> <1,000> Gross Profits 800 400 1,200 Expenses <100> <100> <200> Income b/t 700 300 1,000 Taxes (30/50) <210> <150> <360> Net Income 490 150 640

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 goods. 3. Center pays seller/paid by buyer all within the MNC.

REINVOICING CENTERS d. Advantages: 1.) Easier control on currency exposure 2.) Invoice currency other than local

REINVOICING CENTERS e. Disadvantages of Reinvoicing 1.) Increased communications costs *2.) 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

Suppose Navistar’s Canadian subsidiary sells 1,500 trucks monthly to the French affiliate at a transfer price of $27,000 per unit. Assume that the Canadian and French marginal tax rates on corporate income equal 45% and 50%, respectively. a. Suppose the transfer price can be set at any level between $25,000 and $30,000. At what transfer price will corporate taxes paid be minimized? Explain. b. Suppose the transfer price is increased from $27,000 to $30,000 and credit terms are extended from 90 to 180 days. What are the fund-flow implications of these adjustments?