International Finance FIN456 Michael Dimond

Michael Dimond School of Business Administration Strategic Multinational Financial Management The ability to shift profits and funds internally adds value to the MNC (compared to a purely domestic firm). This value of the multinational financial system arises out of the MNC's ability to take advantage of market imperfections and tax differences. Tax arbitrage--By shifting profits from units located in high ‑ tax nations to those in lower ‑ tax nations or from those in a taxpaying position to those with tax losses, MNCs can reduce their tax burden. Financial market arbitrage ‑‑ By transferring funds among units, MNCs may be able to circumvent exchange controls, earn higher risk ‑ adjusted yields on excess funds, reduce their risk ‑ adjusted cost of borrowed funds, and tap previously unavailable capital sources. Regulatory system arbitrage ‑‑ Where subsidiary profits are a function of government regulations (e.g., where a government agency sets allowable prices on the firm's goods) or union pressure, rather than the marketplace, the ability to disguise true profitability by reallocating profits among units may provide the multinational firm with a negotiating advantage.

Michael Dimond School of Business Administration International Offshore Financial Centers

Michael Dimond School of Business Administration Multinational Tax Management The primary objective of multinational tax planning is the minimization of the firm’s worldwide tax burden Tax planning for MNC operations is extremely complex but a vital aspect of international business To plan effectively, MNCs must understand not only the intricacies of their own operations worldwide, but also the different structures and interpretations of tax liabilities across countries

Michael Dimond School of Business Administration Tax Principles Tax morality – the MNC must decide whether to follow a practice of full disclosure to tax authorities or to adopt the principle of “when in Rome, do as the Romans” Tax neutrality – when governments levy taxes, they must consider not only the potential revenue from the tax but also the effect the proposed tax can have on private economic behavior –The ideal tax should not only raise revenue efficiently but also have as few negative effects on economic behavior as possible

Michael Dimond School of Business Administration Tax Principles Domestic neutrality – the burden of taxation on each currency unit of profit earned in the home country should equal the burden of taxation on the currency equivalent profit earned by the same firm in its foreign operations Foreign neutrality – the tax burden on each foreign subsidiary should equal the tax burden on its competitors in the same country Tax equity – an equitable tax that imposes the same total burden on all taxpayers who are similarly situated and located in the same tax jurisdiction

Michael Dimond School of Business Administration National Tax Environments Nations typically structure their tax systems along one of two basic approaches –Worldwide approach –Territorial approach Both approaches are attempts to determine which firms, foreign or domestic by incorporation, or which incomes, foreign or domestic in origin, are subject to the taxation of host country tax authorities

Michael Dimond School of Business Administration National Tax Environments Worldwide approach is also referred to as the residential or national approach –It levies taxes on the income earned by firms that are incorporated in the host country regardless of where the income was earned Territorial approach is also termed the source approach –It focuses on the income earned by firms within the legal jurisdiction of the host country, not the country of incorporation

Michael Dimond School of Business Administration National Tax Environments Tax deferral – foreign subsidiaries of MNCs pay host country income taxes but many parent companies defer claiming additional income taxes on that foreign source income until it is remitted to the parent firm –If the worldwide approach was followed to the letter of the law, then the tax deferral privilege would end Tax treaties provide a means of reducing double taxation –They typically define whether taxes are to be imposed on income earned in one country by the nationals of another country and if so, how much

Michael Dimond School of Business Administration National Tax Environments Tax treaties –Tax treaties are bilateral, with the two signatories specifying what rates are applicable to which types of income –Tax treaties also typically result in reduced withholding tax rates –This is important to MNCs operating foreign subsidiaries earning active income and individual investors earning passive income

Michael Dimond School of Business Administration Tax Types Income Tax – many governments rely on this tax as their primary source of revenue Withholding Tax – passive income (dividends, royalties, interest) earned by a resident of one country within the jurisdiction of a second country are normally subject to a withholding tax in the second country –Government wishes a minimum payment for earning income within their tax jurisdiction knowing that party won’t file a tax return in the host country

Michael Dimond School of Business Administration Tax Types Value-Added Tax – type of national sales tax collected at each stage of production or sale of goods in proportion to the value added during that stage Other National Taxes – there are several other taxes levied which vary in importance from country to country –Turnover Tax – tax on purchase/sale of securities in stock market –Property and Inheritance Tax –Tax on Undistributed Profits

Michael Dimond School of Business Administration Corporate Tax Rates for Selected Countries

Michael Dimond School of Business Administration Corporate Tax Rates Compared

Michael Dimond School of Business Administration Foreign Tax Credits To prevent double taxation, many countries grant a foreign tax credit (FTC) for income taxes paid to the host country –FTC’s vary widely by country and are also available for withholding taxes –Value-added taxes are typically deducted as an expense from pre-tax income so FTCs don’t apply –A tax credit is a direct reduction of taxes that would otherwise be due and payable It is not a deductible expense because it does not reduce the taxable income

Michael Dimond School of Business Administration Foreign Tax Credits

Michael Dimond School of Business Administration P20-4 Suppose a firm earns $1 million before tax in Spain. It pays Spanish tax of $0.52 million and remits the remaining $0.48 million as a dividend to its U.S. parent. Under current U.S. tax law, how much U.S. tax will the parent owe on this dividend? Under current U.S. tax law, the firm's U.S. tax owed on the dividend is calculated as follows: Dividend $480,000 Spanish tax paid 520,000 Included in U.S. taxable income $1,000,000 U.S. 35% 350,000 Less: U.S. indirect tax credit 520,000 Net U.S. tax owed ($170,000) As a result of paying Spanish tax at a rate that exceeds the U.S. tax rate of 35%, the company receives a $170,000 FTC that can be used to offset U.S. taxes owed on other foreign source income.

Michael Dimond School of Business Administration FTC Example NI x Dividend Payout Rate Rate given as 0.0% HK Corp Income Taxes x Dividend Payout Rate From above (Rate given as 0.0%) $5,400 x US Corp. Tax Rate Corp Inc Tax + Withholding Tax Paid Theoretical US Tax Liability – FTC FTC - Theoretical US Tax Liability FTC + Additional US Tax Due Depends on which is larger, FTC or Theoretical US Tax Liability. Lower limit = 0.

Michael Dimond School of Business Administration Tax Management of Foreign-Source Income

Michael Dimond School of Business Administration P20-5

Michael Dimond School of Business Administration P20-1 Suppose Navistar's Canadian subsidiary sells 1,500 trucks monthly to the French affiliate at a transfer price of $27,000 per unit. The Canadian and French marginal tax rates on corporate income are assumed to equal 45% and 50%, respectively. 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? The firm should be shifting profits from the high-tax region (France) to the low-tax region (Canada), so the transfer price should be set to $30,000.

Michael Dimond School of Business Administration P20-1 Suppose Navistar's Canadian subsidiary sells 1,500 trucks monthly to the French affiliate at a transfer price of $27,000 per unit. The Canadian and French marginal tax rates on corporate income are assumed to equal 45% and 50%, respectively. 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? Tax Savings = 1,500(27,000 ‑ P)(.45 ‑.50) Tax Savings = 1,500(27,000 - P)(-.05) Tax Savings is -150,000 for low markup and 225,000 for high markup

Michael Dimond School of Business Administration P20-1 We could set this out in a per-unit schedule to examine it better. Assume Navistar sells the tractors to the end customer for 34,500 Comparing the tax to the “Before Adjustment” scenario shows tax increasing 100 per unit (150,000 total) Comparing the tax to the “Before Adjustment” scenario shows tax decreasing 150 per unit (225,000 total)

Michael Dimond School of Business Administration Example: Value-Added Tax This is an example of an Output VAT. If this crossed borders, we might see an input VAT, like a tarriff

Michael Dimond School of Business Administration P20-1 Suppose Navistar's Canadian subsidiary sells 1,500 trucks monthly to the French affiliate at a transfer price of $27,000 per unit. The Canadian and French marginal tax rates on corporate income are assumed to equal 45% and 50%, respectively. 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? Now suppose the French government imposes an ad valorem tariff of 15 percent on imported tractors. How would this affect the optimal transfer pricing strategy? (assume the VAT is paid by the French affiliate and is tax deductible) The firm should be shifting profits from the high-tax region (France) to the low-tax region (Canada), so the transfer price should be set to $30,000. Now the deductible VAT offsets part of the French tax, so the transfer price should be $25,000 This is an example of an Input VAT, a tariff on the cost of the imported goods, not on the final selling price

Michael Dimond School of Business Administration Value-added Tax Problem Suppose Navistar's Canadian subsidiary sells 1,500 trucks monthly to the French affiliate at a transfer price of $27,000 per unit. The Canadian and French marginal tax rates on corporate income are assumed to equal 45% and 50%, respectively. 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? Tax Savings = 1,500(27,000 ‑ P)(.45 ‑.50) Tax Savings = 1,500(27,000 - P)(-.05) Tax Savings is -150,000 for low markup and 225,000 for high markup Now suppose the French government imposes an ad valorem tariff of 15 percent on imported tractors. How would this affect the optimal transfer pricing strategy? (assume the VAT is paid by the French affiliate and is tax deductible) Tax Savings = 1,500(27,000 ‑ P)( ‑.50(1.15)) Tax Savings = 1,500(27,000 ‑ P)(.025) Tax Savings is 75,000 for low markup and -112,500 for high markup

Michael Dimond School of Business Administration P20-1 Again, we could set this out in a per-unit schedule to examine it better. Assume Navistar sells the tractors to the end customer for 34,500 Comparing the tax + VAT to the “Before Adjustment” scenario shows tax decreasing 50 per unit (75,000 total) Comparing the tax + VAT to the “Before Adjustment” scenario shows tax increasing 75 per unit (112,500 total)

Michael Dimond School of Business Administration Transfer Pricing The pricing of goods, services, and technology transferred to a foreign subsidiary from an affiliated company, transfer pricing, is the first and foremost method of transferring funds out of a foreign subsidiary These costs enter directly into the cost of goods sold component of the subsidiary’s income statement This is a particularly sensitive problem for the MNC Both funds positioning and income tax effects must be taken into consideration

Michael Dimond School of Business Administration MNCs can transfer funds and profits internally Purely Financial Transfers Transfer pricing Fees and royalties Dividends Loans Leads and lags Parent investment as debt or equity A close relationship between a firm's marketing, production, and logistics decisions (“real” decisions) and its financial decisions creates greater scope for financial activities to enhance the value of the MNC from worldwide internal transfers Goods Technology Materials

Michael Dimond School of Business Administration Transfer Pricing Fund positioning –A parent wishing to transfer funds out of a particular country can charge higher prices on goods sold to its subsidiary in that country – to the degree that government regulations allow –A foreign subsidiary can be financed by the reverse technique, a lowering of transfer prices –Payments by a subsidiary for imports transfers funds out of the subsidiary –A high transfer price allows funds to be accumulated in the selling country

Michael Dimond School of Business Administration Transfer Pricing Income tax effect –A major consideration in setting a transfer price is the income tax effect –Worldwide corporate profits may be influenced by setting a transfer prices to minimize taxable income in a country with a high income tax rate –This can also be done to maximize income in a country with a low income tax rate

Michael Dimond School of Business Administration Transfer Pricing IRS regulations provide three methods to establish arm’s length prices –Comparable uncontrolled prices Regarded as the best evidence of arm’s length pricing Transfer price is the same as bond fide sales of the same items between unrelated firms –Resale prices Begins with the final selling price to an independent purchaser less an appropriate markup –Cost-plus calculations Begins with full cost to the seller plus a profit margin

Michael Dimond School of Business Administration P20-2

Michael Dimond School of Business Administration P20-3

Michael Dimond School of Business Administration P20-3 cont’d