1. Managing the Multinational Financial System
Chapter 16

2. 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

3. 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

4. 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.

5. 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

6. 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

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

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

9. 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.

10. 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.

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

12. 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.

13. 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.

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

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

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

17. 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.

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

19. REINVOICING CENTERS e. Disadvantages of Reinvoicing
1.) Increased communications
costs
*2.) Suspicion of tax evasion by
local governments.

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

21. 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.

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

23. 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?