Managing the Multinational Financial System

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

2. 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?

3. 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

4. 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

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

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

7. 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

8. 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

9. 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

10. 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 Td > Tf, parent companies must pay an incremental tax cost on remitted dividends and other payments. • Foreign tax credit

11. 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:

12. 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:

13. 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

14. 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

15. 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?

16. 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.

17. 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?

18. 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

19. 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

20. 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

21. 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.

22. 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?