Managing the Multinational Financial System

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

8. INTERCOMPANY FUND-FLOWMECHANISMS • 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 1,500 2,200 2,200 • CGS <1,000> <1,500> <1,000> • Gross Profits 500 700 1,200 • Expenses<100> <100> <200> • Income b/t 400 600 1,000 • Taxes (30/50)<120> <300> <420> • Net Income 280 300 580

15. TRANSFER PRICING:An Example • HIGH MARK-UP POLICY (unit price = $18) • A B A+B • Revenue 1,800 2,200 2,200 • CGS <1,000> <1,800> <1,000> • Gross Profits 800 400 1,200 • Expenses<100> <100> <200> • Income b/t 700 300 1,000 • Taxes (30/50)<210> <150> <360> • Net Income 490 150 640

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?