1. Chapter 21
Repositioning Funds

2. Repositioning Funds
An MNE is constantly striving to create shareholder value by maximizing the after-tax profitability of the firm.
One dimension of this task is to reposition the profits of the firm, as legally and practically as possible, in low-tax environments.
Repositioning allows an MNE to increase after-tax profits by lowering its tax liabilities with the same amount of sales.
Repositioning is also useful when a MNE wishes to redeploy cash flows or funds to more value-creating activities or to minimize exposure to a potential currency collapse, or political or economic crises.
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3. Cascade Pharmaceutical, Inc. (Cascade)
Cascade is a US-based MNE specializing in the manufacture and distribution of generic drugs worldwide.
Cascade’s three foreign subsidiaries each present a unique set of concerns for management:
Cascade Europe – High-tax environment, mature business (few growth opportunities), stable currency
Cascade Mexico – Medium-tax environment, solid growth opportunities, volatile currency
Cascade China – 50%-owned joint-venture, low-tax environment, capital restrictions, significant long-term growth potential
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4. Cascade Pharmaceutical, Inc.
Exhibit Cascade Pharamceutical’s Subsidiaries & Their Growth Potentials
Cascade Pharmaceutical, Inc.
(Boston, USA)
Currency: the dollar (US$)
Tax rate: 35%
Capital restrictions: None
US Manufacturing Facility
Subsidiary status:
Business: mature
Cascade China
(Shanghai, China)
Cascade Mexico
(Monterrey, Mexico)
Cascade Europe
(Frankfurt, Germany)
Greenfield
Investment
Acquisition
Investment
Joint Venture
Investment
Currency: the euro (€)
Tax rate: 45%
Capital restrictions: None
Country:
Currency: the peso (Ps)
Tax rate: 34%
Capital restrictions: None
Country:
Currency: the renminbi (Rmb)
Tax rate: 30%
Capital restrictions: Many
Country:
Subsidiary status:
Business: mature
Subsidiary status:
Business: immediate growth
potential
Subsidiary status:
Business: long-term growth
potential

5. Cascade Pharmaceutical, Inc. (Cascade)
In practice Cascade’s senior management in the parent company (corporate) will first determine its strategic objectives for each subsidiary and then design for each a financial management plan for repositioning of profits, cash flows and capital.
The following are repositioning objectives by subsidiary:
Cascade Europe – Reposition profits from Germany to the US
Cascade Mexico – Reposition (or manage) foreign exchange risks while maintaining capital for growth
Cascade China – Reposition funds enough to protect against blocked funds (transfer risk), while balancing the needs of the JV partner
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6. Cascade Pharmaceutical, Inc. (Cascade)
Funds flows between units of a domestic business are generally unimpeded, but that is not the case in a multinational business.
A firm operating globally faces a variety of political, tax, foreign exchange, and liquidity considerations that limit its ability to move funds easily and without cost from one country or currency to another.
These constraints are the reason multinational financial managers must plan ahead for repositioning funds within the MNE.
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7. Cascade Pharmaceutical, Inc. (Cascade)
Political constraints:
Political constraints can block the transfer of funds either overtly or covertly
Overt blockage occurs when a currency becomes incontrovertible or is subject to government exchange controls that prevent its transfer at reasonable exchange rates
Covert blockage occurs when dividends or other forms of fund remittances are severely limited, heavily taxed, or excessively delayed by the need for bureaucratic approval
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8. Cascade Pharmaceutical, Inc. (Cascade)
Tax constraints:
Tax constraints arise because of the complex and possibly contradictory tax structures of various national governments through whose jurisdictions funds may pass
A firm does not want funds eroded by a sequence of nibbling tax collectors in every jurisdiction through which funds might flow
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9. Cascade Pharmaceutical, Inc. (Cascade)
Transaction costs:
Foreign currency transaction costs are incurred when one currency is exchanged for another
These costs, in the form of fees and/or the difference between bid and ask quotations, are revenue for the banks and Fx dealers that operate the Fx markets
Large or frequent transfers can have significant transaction costs (requiring that firms avoid unnecessary back-and-forth transfers)
Liquidity needs:
Needs in each individual location must be satisfied and good local banking relationships maintained
Clearly, local needs constrain a pure-optimization approach to worldwide cash positioning
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10. Conduits for Moving Funds
Multinational firms often unbundle their transfer of funds into separate flows for specific purposes.
Unbundling allows a multinational firm to recover funds from subsidiaries without piquing host country sensitivities over large dividend drains.
The following exhibit illustrates conduits separated into before-tax ad after-tax groups in the host country.
Tax goals frequently are a critical determinant for many foreign subsidiary tax structures (making the before-tax, after-tax conduit distinction of importance).
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11. Foreign Subsidiary’s Income Statement Payment to Parent Company
Exhibit Potential Conduits for Moving Funds From Subsidiary to Parent
Foreign Subsidiary’s Income Statement
Payment to Parent Company
Sales
Cost of goods sold
Gross profit
General & administrative expenses
License fees
Royalties
Management fees
Operating profit (EBITDA)
Depreciation & amortization
Earnings before interest & taxes (EBIT)
Foreign exchange gains (losses)
Interest expenses
Earnings before tax (EBT)
Corporate income tax
Net income (NI)
Dividends
Retained earnings
Payments to parent
for goods or services
Payments for technology,
trademarks, copyrights,
management or other
shared services
Before-Tax
in the
Host Country
Payments of interest
to parent for intra-
firm debt
After-Tax
in the
Host Country
Distribution of
dividends to parent

12. Transfer Pricing
The pricing of goods, services, and technology transferred to a foreign subsidiary from a related company, transfer pricing, is the first and foremost method of transferring funds out of a foreign subsidiary.
There are significant effects of transfer pricing policies:
Fund positioning effect – Transferring funds out of a particular country can be accomplished through transfer pricing (charging higher prices on goods sold to a subsidiary in that country)
Income tax effect – MNEs can influence their worldwide corporate profits by setting transfer prices to minimize taxable income in a country with a high income tax rate (and vice versa)
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13. Transfer Pricing
IRS regulations provide three methods to establish arm’s length prices (the “correct” transfer price):
Comparable uncontrolled price method – Although ideal, this is difficult to apply in practice because of variations in quality, quantity, timing of sale and proprietary trademarks
Resale price method – starts with the final selling price to an independent purchaser and subtracts an appropriate markup for the distribution subsidiary
Cost-plus method – Sets the allowable transfer price by adding an appropriate profit markup to the seller’s full cost, where full cost is the accounting definition of direct costs plus overhead allocation
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14. Transfer Pricing
When a firm is organized with decentralized profit centers, transfer pricing between centers can disrupt evaluation of managerial performance.
In the case of Cascade, transferring profit from high-tax Cascade Europe to low-tax Cascade USA changes the following for one or both companies:
Import tariffs paid
Measurements of Fx exposure
Liquidity tests
Operating efficiency
Income tax payments
Profitability
Dividend payout ratio
Internal growth rate
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15. Transfer Pricing
Although all governments have an interest in monitoring transfer pricing by MNEs, not all governments use these powers to regulate transfer prices to the detriment of MNEs.
Most foreign governments realize the need of foreign investors to repatriate a reasonable profit by their own standards, even if it seems unreasonable locally.
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16. License Fees, Royalty Fees, and Shared Services
License fees are remuneration paid to the owners of technology, patents, trade names, and copyrighted material.
License fees are usually paid on a percentage of the value of the product or on the volume of production.
As such they are calculated independently of the volume of sales.
Royalty fees are similar compensation for the use of intellectual property.
Royalty fees are, however, usually a stated percentage of sales revenue (compensation to the owner for sales volume).
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17. License Fees, Royalty Fees, and Shared Services
These types of fees can also function as a means to reposition funds between subsidiaries and parent.
These intracompany licensing and royalty fees can be further differentiated into management fees for general expertise and advice, technical assistance fees, and license fees for use of patented products or processes.
Shared services charges (often referred to as distributed charges or distributed overhead) compensate the parent for costs incurred in the general management of international operations and for other corporate services provided to foreign subsidiaries by the parent.
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18. License Fees, Royalty Fees, and Shared Services
An MNE must be careful to preserve its rights to receive funds from subsidiaries as royalties, fees, or shared services.
The contracts or agreements that establish the terms and amount of payment must be structured carefully and clearly and should address:
Sales price definitions
Coverage
Time and currency of payment
Reports
Monitoring costs
Non-financial issues (exclusiveness and limitations)
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19. International Dividend Remittances
Payment of dividends is the classical method by which firms transfer profit back to owners, be they individual shareholders or parent corporations.
Clearly, host country tax laws influence the dividend decision.
Dividends remain the most tax-inefficient method for repatriating funds because they are distributed on an after-tax basis (generating excess foreign tax credits on the dividend for the MNE).
Royalty fees or license fees, on the contrary, are pre-tax and are usually only subject to a smaller (relative) withholding tax.
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20. International Dividend Remittances
However, political risk may motivate parent firms to require foreign subsidiaries to remit all locally generated funds (not required to finance growth in sales or to support working capital needs).
Clearly, foreign exchange risks (or anticipated losses for example) would lead the MNE to speed up the transfer of funds out of the country via dividends.
Speeding up or slowing down payments is referred to as leads and lags.
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21. Leads and Lags: Retiming the Transfer of Funds
Firms can reduce both operating and transaction exposure by accelerating or decelerating the timing of payments that must be made or received in foreign currencies.
To lead is to pay early.
To lag is to pay late.
Leading and lagging is more feasible between related firms, because they presumably embrace a common set of goals for the consolidated group.
This device is readily more applicable if the MNE operates on an integrated worldwide basis.
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22. Leads and Lags: Retiming the Transfer of Funds
Because the use of leads and lags is an obvious technique for minimizing foreign exchange exposure and for shifting the burden of financing, many governments impose limits on the allowed range.
Leading or lagging between independent firms requires the time preference of one firm to be imposed to the detriment of the other firm.
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23. Re-Invoicing Centers
A re-invoicing center is a separate corporate subsidiary that serves as a type of middle-man between the parent or related unit in one location and all foreign subsidiaries in a geographic region.
As depicted in the following exhibit, the US manufacturing unit of Cascade USA invoices the firm’s re-invoicing center – in US dollars.
The re-invoicing center in turn resells to Cascade Mexico in Mexican pesos.
Consequently, all operating units deal only in their own currency, and all transaction exposure lies with the re-invoicing center.
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24. Exhibit 21.4 Use of a Reinvoicing Center
Cascade USA
(Manufactures
unfinished switches)
Cascade Mexico
(Finishes for local
sales)
Physical goods
Goods are re-sold by
reinvoicing center to
Mexican sales affiliate
in Mexican pesos (Ps)
Goods are sold by
Cascade USA to
reinvoicing center
in U.S. dollars
Reinvoicing
Center
1. Cascade USA ships goods directly to the Mexican subsidiary.
2. The invoice by Cascade USA, which is denominated in U.S. dollars, is passed to the
reinvoicing center.
3. The reinvoicing center takes legal title to the goods.
4. The reinvoicing center invoices Cascade Mexico in Mexican pesos, repositioning
the currency exposure from both operating units to the reinvoicing center.
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25. Re-Invoicing Centers The three main benefits of such a strategy are:
Managing foreign exchange exposure in one place
Guaranteeing the exchange rate for future orders
Managing intra-subsidiary cash flows
The main disadvantage is that the benefits may not justify the agency cost (an additional corporate unit with its own set of books).
The establishment of such a center is also likely to bring increased scrutiny by tax authorities.
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