Dr. A. DeMaskey Managing the Multinational Financial System International Finance

Learning Objectives What are the principal transfer mechanisms that MNCs use to move funds among their various affiliates? What are the three arbitrage opportunities available to MNCs that stem from their ability to shift liquidity internally? What are the costs, benefits, and constraints associated with each transfer mechanism? How can the MNC benefit from its internal financial transfer system?

The Multinational Corporate Financial System The MNC can control the mode and timing of internal financial transfers and thereby maximize global profits. Mode of Transfer Transfer pricing Timing Flexibility Leading and lagging

The Value of the Multinational Financial System The ability to transfer funds and to reallocate profits internally presents MNCs with three different types of arbitrage opportunities: Tax arbitrage Financial market arbitrage Regulatory system arbitrage

Constraints on Positioning of Funds Political constraint Differential tax rates Transaction costs Liquidity requirements

Intercompany Fund-Flow Mechanisms Unbundling Tax planning Transfer pricing Leading and lagging

Unbundling of Fund Transfers Breaking up total intracorporate transfer of funds into separate flows which correspond to the nature of payment. Financial Payments Dividend remittance Interest and principal repayment Operational Payments License and royalty fees Management and technical assistance fees Overhead charges Transfer prices

Intercompany Loans Intercompany loans are valuable to MNCs if credit rationing, exchange controls, or differences in national tax rates exist. Direct Loans Back-to-Back Loans Parallel Loans

Equity versus Debt MNCs can realize several advantages from investing funds overseas in the form of loans rather than equity. Repatriation of Funds Tax Benefits Equity Investment

Tax Factor Total tax payments on internal funds transfers depend on the tax regulations of both the host and the recipient nations. Types of taxes Corporate income tax Dividend withholding tax If T d > T f, parent companies must pay an incremental tax cost on remitted dividends and other payments. Foreign tax credit

Tax Planning (1) Suppose an affiliate earns $1 million before taxes 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, the U.S. tax owed on the dividend is calculated as:

Tax Planning (2) Suppose the Spanish government imposes a dividend withholding tax of 10%. What is the effective tax rate on the Spanish affiliate’s before-tax profits from the standpoint of its U.S. parent? Under current U.S. tax law, the parent firm’s U.S. tax owed on the dividend is calculated as:

Transfer Pricing The most important uses of transfer pricing include: Reducing taxes Reducing tariffs Avoiding exchange controls Increasing profits from a joint venture Disguising profitability

Tax Effects MNCs can minimize taxes by using transfer prices to shift profits from the high-tax to the low-tax nation. Set the transfer price as low as possible if Set the transfer price as high as possible if

Transfer Pricing: Tax Effect 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 tax rates on corporate income equal 45% and 50%, respectively. 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?

Tariffs Ad-valorem import duty Levied on the invoice price of the imported goods. Raising the transfer price will thus increase the import duty. In general, the higher the ad-valorem tariff relative to the income tax differential, the more desirable it is to set a low transfer price.

Transfer Pricing: Tariff Effect Suppose the French government imposes an ad-valorem tariff of 15% on imported trucks. How would this affect the optimal transfer pricing strategy, assuming that the ad-valorem tariff is paid by the French affiliate and is tax deductible?

Constraints on Transfer Pricing The transfer pricing mechanism is constrained by: Tax regulations in the parent and host countries Working relationships with authorities in host countries Interest and goals of local joint venture partner

Tax Provisions Section 482 of the U.S. IRS code Arm’s length transaction Methods of determining transfer prices: Comparable uncontrolled price Resale price Cost-plus price Others

Reinvoicing Center Reinvoicing centers, located in tax havens, take title to goods and services used in intracorporate transactions. The physical flow of goods from purchasing units to receiving units is not changed. Basic purpose: Disguising profitability Avoiding government regulations Coordinating transfer pricing policy

Leading and Lagging Leading and lagging of interaffiliate payments is a common method of shifting liquidity from one unit to another. The value of leading and lagging is determined by the opportunity cost of funds to both the paying and receiving units. There is no formal debt obligation and no interest is charged up six months. Government regulations on intercompany credit terms are tight and can change quickly.

Leading and Lagging: Illustration A U.S. parent owes its British affiliate $5 million. The timing of this payment can be changed by up to 90 days in either direction. The U.S. lending and borrowing rates are 3.2% and 4.0%, respectively. The U.K. lending and borrowing rates are 3.0% and 3.6%, respectively. If the U.S. parent is borrowing funds and the British affiliate has excess funds, should the parent speed up or slow down its payment to the U.K.? What is the net effect of the optimal payment activities in terms of changing the units’ borrowing costs and/or interest income?