Managing the Multinational Financial System

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Managing the Multinational Financial System

• Chapter 16

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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

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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

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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.

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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

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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

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INTERCOMPANY FUND-FLOWMECHANISMS

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

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INTERCOMPANY FUND-FLOWMECHANISMS

• COMMONLY USED MECHANISMS

A. Unbundling
B. Transfer Pricing
C. Reinvoicing Centers
D. Royalties
E. Leading and Lagging
F. Mechanism Dividends
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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.

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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.

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TRANSFER PRICING

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

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TRANSFER PRICINGAn 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.

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TRANSFER PRICINGAn Example

• Basic rules
• If tA gt tB , set the transfer price and the
  mark-up policy as LOW as possible.
• If tA lt tB , set the transfer price and the
  mark-up policy as HIGH as possible.

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TRANSFER PRICINGAn Example

• Without markup policy
• A B AB
• Revenue 1,500 2,200 2,200
• CGS lt1,000gt lt1,500gt lt1,000gt
• Gross Profits 500 700
  1,200
• Expenses lt100gt lt100gt lt200gt
  
• Income b/t 400 600
  1,000
• Taxes (30/50) lt120gt lt300gt lt420gt
• Net Income 280 300
  580

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TRANSFER PRICINGAn Example

• HIGH MARK-UP POLICY (unit price 18)
• A B AB
• Revenue 1,800 2,200 2,200
• CGS lt1,000gt lt1,800gt lt1,000gt
• Gross Profits 800 400
  1,200
• Expenses lt100gt lt100gt lt200gt
  
• Income b/t 700 300
  1,000
• Taxes (30/50) lt210gt lt150gt lt360gt
• Net Income 490 150
  640

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TRANSFER PRICINGAn Example

• In effect
• Profits are shifted from a higher to a lower tax
  jurisdiction

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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.

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REINVOICING CENTERS

• d. Advantages
• 1.) Easier control on currency exposure
• 2.) Invoice currency other than local

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REINVOICING CENTERS

• e. Disadvantages of Reinvoicing
• 1.) Increased communications
• costs
• 2.) Suspicion of tax evasion by
• local governments.

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FEES AND ROYALTIES

• D. Mechanism Royalties
• 1. Firms have control of payment amounts.
• 2. Host governments less suspicious.

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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.

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DIVIDENDS!

• F. Mechanism Dividends
• most important method used by MNCs to transfer
  funds to parent

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• Suppose Navistars 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?