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Managing the Multinational Financial System. Chapter 16. 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. TAX ARBITRAGE.

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managing the multinational financial system1
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
tax arbitrage
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
tax arbitrage1
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.
financial market arbitrage
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
regulatory arbitrage
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
intercompany fund flow mechanisms
INTERCOMPANY FUND-FLOWMECHANISMS
  • II. INTERCOMPANY FUND-FLOW MECHANISMS:
  • the name given to the methods used to move funds from one subsidiary to another.
intercompany fund flow mechanisms1
INTERCOMPANY FUND-FLOWMECHANISMS
  • COMMONLY USED MECHANISMS:

A. Unbundling

B. Transfer Pricing

C. Reinvoicing Centers

D. Royalties

E. Leading and Lagging

F. Mechanism: Dividends

unbundling
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.
transfer pricing
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.
transfer pricing1
TRANSFER PRICING
  • 2. Uses of Transfer Pricing
  • a.) Reduces taxes paid
  • b.) Reduces tariffs
  • c.) Avoids exchange controls
transfer pricing an example
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.
transfer pricing an example1
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.
transfer pricing an example2
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
transfer pricing an example3
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
transfer pricing an example4
TRANSFER PRICING:An Example
  • In effect:
  • Profits are shifted from a higher to a lower tax jurisdiction
reinvoicing centers
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.
reinvoicing centers1
REINVOICING CENTERS
  • d. Advantages:
  • 1.) Easier control on currency exposure
  • 2.) Invoice currency other than local
reinvoicing centers2
REINVOICING CENTERS
  • e. Disadvantages of Reinvoicing
  • 1.) Increased communications
  • costs
  • *2.) Suspicion of tax evasion by
  • local governments.
fees and royalties
FEES AND ROYALTIES
  • D. Mechanism: Royalties
  • 1. Firms have control of payment amounts.
  • 2. Host governments less suspicious.
leading and lagging
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.
dividends
DIVIDENDS!
  • F. Mechanism: Dividends
  • most important method used by MNCs to transfer funds to parent
slide23
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?