1 - 1 International Cost Accounting

1 - 2 TAX ES AND TRANSFER PRICING n Some MNCs use a reinvoicing center to avoid taxes. n A French Subsidiary of a U.S.Parent produces a component at a cost of $100. The French subsidiary transfers title to a reinvoicing center in Puerto Rico at a transfer price of $100. Puerto Rico has no income tax. This center then transfers title to the U.S. subsidiary of the parent corporation at a transfer price of $200.

1 - 3 TAX ES AND TRANSFER PRICING The U.S. subsidiary sells the component for $200. The component is not subject to U. S. tax because it is ostensibly sold at cost. Without the reinvoicing center, if the French subsidiary had set the transfer price at $200 it would have been subject to the French tax (40%). If the transfer price had been set at $100, no French tax would have been paid, but the U.S. sub (selling for $200) would have

1 - 4 TAX ES AND TRANSFER PRICING realized a profit of $100 that would have been subject to the U.S. tax of 35%. The reinvoicing center took title to but never possession of the product. It is clearly set up to evade corporate income taxes. This is the type of abuse IRS Code Section 482 was set up to prevent. Section 482 allows, in effect, three transfer pricing methods that approximate an arms- length

1 - 5 TAX ES AND TRANSFER PRICING transaction and a special pricing arrangement. These are: (1) Comparable uncontrolled price method; (2) Resale price method and (3) Cost Plus method. Examples: 1. The U.S. sub purchases a component from the French sub that has a market price of $38. Freight and insurance costs are $5. Commissions and marketing costs are $3.80. The transfer price may be set at:

1 - 6 TAX ES AND TRANSFER PRICING $38 + $5 - $3.80 = $ Resale Price Method The component made in France has no outside market. U.S. sub sells the component for $50 and normally receives a mark-up of 40% on the cost of goods sold. The transfer price would be $50/1.40 = $ Cost plus

1 - 7 TAX ES AND TRANSFER PRICING n Assume the French subs manufacturing costs are $20. Landing costs are $5.

1 - 8 TAX ES AND TRANSFER PRICING n The transfer price is set at $25. n 4. Advanced Pricing Agreement (APA) n This is an advance agreement between the company and the IRS for a specified period of time. It is not made public. It may be done so that the IRS and the company can agree about valuing certain assets such as intangibles.

1 - 9 TAX ES AND TRANSFER PRICING n For example, a U.S. firm may develop a product and license its Puerto Rican subsidiary to produce it. The product would then be purchased by the parent for sale in the U.S., and a royalty would be charged to the subsidiary. The royalty rate would be taxable income to the parent, but at a low rate.

TAX ES AND TRANSFER PRICING Because the transaction was similar to other third party transactions the IRS could not challenge it. The IRS added a super royalty provision to Section 482 linking the transfer price of the intangible to the income attributable to the intangible. Because this “ income” is difficult to measure the TP is often negotiated using an APA.

TAX ES AND TRANSFER PRICING n The example in the textbook illustrates how taxes can distort incentives. Recall that the market method for transfer pricing satisfies all the criteria for an acceptable transfer price. Assuming the market is perfectly competitive for the intermediate product the tax saving resulting from use of the cost plus method would encourage use of that method.

International Trade International Trade – Imports – When multinational corporations (MNCs) import materials for use in production, a tariff – (tax, duty) is levied by the federal government. – This tax becomes part of the cost of materials. Companies look for ways to reduce these taxes. One way is to alter the materials by adding more U.S. content and gain more

International Trade. – favorable tariff status. Another way is to utilize a foreign trade zone. – Foreign Trade Zone (FTZ) – FTZs are areas that are physically on U.S. soil but are considered to be outside U.S. commerce. Companies in FTZs can manufacture or warehouse. They also do not have to pay duty on imports subject to their

International Trade... – being reported to the U.S. Customs and remaining within designated FTZs. If the items leave the FTZ bound for non-U.S. destinations, there is no tariff (duty). If they leave the FTZ for U.S. destinations, then a tariff is due. FTZs must be located near a U.S. customs port of entry. Goods imported into an FTZ are tariff free until they leave the zone.

International Trade... – This has important implications for companies that import raw materials. Since duty is not due until the imported materials leave the zone, the company postpones payment and any associated loss of working capital. Further, the company in the FTZ does not pay duty on defective material not – included in the finished product. This results

International Trade in savings from not having to pay for defective material and not having to pay the carrying cost of the duty. See example on page 400 of handout. Other advantages of FTZs Imports that do not comply with U.S. standards can be imported into an FTZ and

International Trade n modified to comply without being subject to a fine. n In an FTZ a company can assemble high tariff component parts into a lower tariff finished product. Adding domestic labor content during assembly makes the high tariff foreign parts eligible for more favorable tariff treatment.

International Trade n Owners of FTZs are usually city or county authorities. They have the authority to reallocate FTZ areas to other foreign trade sub zones if it can be justified. See example page 401 handout. Remember there are a number of foreign auto plants that are FTZs. The U.S. has at times considered curtailing these FTZs in effect using them as a trade weapon against the home country.

International Trade n Exports The sale of a company’s products to n foreign countries. Products can be sold directly to customers in a foreign country. Or the company may work with a distributor in a foreign country. It could also buy an established business (create a wholly owned subsidiary or branch).

International Trade n Wholly Owned Subsidiary n The parent company buys a foreign company. n It is relatively simple because the foreign company usually has an outlet for the product

International Trade n See Whirlpool example on page 402 of handout. Some companies move a business function to another country. Outsourcing is the payment by a company for a business function that was formerly done in house. When a company out sources to buy technical expertise this is known as advantageous outsourcing. Outsourcing also allows

International Trade companies to work around the clock. See TI example on page 402. companies to work around the clock. See TI example on page 402. Joint Ventures A type of partnership in which investors co-own the enterprise. A JV is necessary when the type of expertise needed by the MNC is not for sale. For example, China, India and Thailand do not allow MNCs to purchase companies or set up subsidiaries so JVs are required. See page 403 for examples of JVs.

Foreign Currency Exchange n Currency Risk Management n Transaction risk-future cash transactions will be affected by changing exchange rates. n Economic risk-the present value of future cash flows will be affected by exchange rate fluctuations. n Translation risk-the degree to which financial

Foreign Currency Exchange statements are exposed to exchange rate changes. Terminology Spot rate: the exchange rate of one currency for another today. Eg. $1U.S. = $1.56 Canadian Appreciation: One currency can buy more of another currency. Ex. $1U.S. = $1.56 Canadian today. Next week $1 U.S. = $1.80 Canadian. Depreciation: One currency can buy less of a

– another currency. Ex. $1U.S. = $1.56 Canadian today. Next week $1 U.S. = $1.40 Canadian. – Transaction Risk – Exchange rate gains and losses for receivables and payables. See examples on page 405 and 406 of the handout. – Hedging: The use of forward exchange contracts to ensure against foreign currency

Foreign Currency Exchange gains and losses. See examples on page 407. The premium expense needs to be netted against the difference between what would have been paid or received without the hedge to determine if the hedge was profitable. Even if the result is negative it still may be considered successful because it reduced risk (anxiety and worry).

Foreign Currency Exchange n If you are owed a receivable in foreign currency do you want the dollar to appreciate or depreciate relative to the foreign currency? n What if you owe a payable?

Foreign Currency Exchange.. – Economic Risk – This occurs when exchange rates change the cost of competing products in different countries. Eg. The exchange rate changes the price for heavy equipment in Japan from $80,000 to $74,286 while the price in the U.S. remains at $80,000. This was caused by the dollar appreciating relative to the yen. In this

Foreign Currency Exchange.. – case a strong dollar makes the U.S. less competitive internationally. A strong dollar often contributes to a large trade deficit. – Economic risk can be managed by hedging. See example of page 406. It should also be managed by awareness in budgeting and financial planning. E.g. by giving consideration to exchange rate fluctuations.

Foreign Currency Exchange.. – Translation Risk – This occurs when financial statements are translated in the parent currency and there has been significant depreciation or appreciation between the parent currency and the home country currency. See example on page 409. This can be managed by a common sense approach. Look at the financial statements

Foreign Currency Exchange.. – before translation and after translation to determine the economic impact in the home country. The objective of denominating internal reports in the parent currency is to – measure all figures on the same basis. However, when making comparisons over time local currency statements should be placed alongside parent denominated reports.

Foreign Currency Exchange.. – In sum transaction and economic risk can be managed by hedging. Translation risk is managed by common sense on a case by case basis.

Measuring Performance in an MNC n The evaluation of the manager of an MNC sub unit (division) should be separated from the evaluation of the division. The manager’s evaluation should not include factors over which he/she exercises no control. These factors include currency fluctuations and taxes. n Managers should be evaluated on the basis of revenues and costs incurred.

Measuring Performance in an MNC n Once the manager is evaluated the sub financial statements can be restated to the home currency and uncontrollable costs can be allocated. n Examples of Factors that differ: n Legal- Potted plants cannot enter the U.S. but florists have a high demand for poinsettias at Christmas time. See page 411

Measuring Performance in an MNC n Cultural: The most common form of credit in Brazil is postdated checks. This required adjustments by Wal-Mart. n Infrastructure: Clothing manufacturers in developing countries had to put in roads and communication equipment in the area where the manufacturing plant was located. They also had to provide training.

Measuring Performance in an MNC – Comparison of Divisional Performance: – In order to measure divisional performance in different countries adjustments must often be made. Eg. The example on page 412 illustrates how this type of measurement should be done on a case by case basis. In this case the Canadian firm used historical cost and the Brazilian firm adjusted for inflation. Therefore, the return on investment

Measuring Performance in an MNC measurements were not comparable. It is necessary to get behind the numbers and make appropriate adjustments so that comparability is established before performance can be effectively measured. Exhibit 11-2 on page 413 details the environmental factors affecting performance evaluation in MNCs.

Measuring Performance in an MNC n One example of different environmental factors is differences in GAPP. E.g. Canadian GAAP allows a company to net cash against an existing line of credit on the B.S. As a result Canadian balance sheets may show no cash.

Measuring Performance in an MNC n Other Factors: n Look at the last paragraph at the top of page 414 to see how variance analysis used to be handled in the Soviet Union. Is this going on in Russia today? What about other former eastern block countries or anywhere for that matter?

Ethics n This is often a subjective area. Ethics vary from country to country. E.g. a service fee in one country is a bribe in another. n Prerequisites for an ethical business environment: n societal stability, legitimacy and accountability of government, confidence in the system.

Ethics n Enforcing contracts requires some type of strong underlying system such as a legal system or cultural system. In the U.S. deviations from a contract are enforced by a strong legal system. In Japan deviations are enforced by a strong cultural system.

Ethics Other examples of differences are: Russian tax laws may change frequently with little or no notice to the MNC and they are usually retroactive. See example. Child labor laws differ between and among countries. Insider trading is illegal in the U.S. but legal in Europe.

Ethics Sometimes making the “ethically” correct decision can have an adverse impact on the individuals in the home country. See the Walmart example on page 419. Guideline questions: Is the action right legally? And then, is the action right morally?

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