Managing the Multinational Financial System

1. Managing the Multinational Financial System Shapiro: Chapter 16

2. Shapiro: Chapter 16 • Problem 16.1

3. Multinational Financial System • “... ability to shift funds and accounting profits among its various units ... • through internal financial transfer mechanisms.”

4. Multinational Financial System • “ … over 38% of U. S. imports and exports are transactions between U. S. firms and their foreign affiliates or parents.”

5. Two-way International Trade • Parent to/from a foreign subsidiary: • U. S. & Japan: 80% • U. S. & Europe: 40% • EC & Japan: 55%

6. Multinational Arbitrage Opportunities • Tax arbitrage • Financial market arbitrage • Regulatory system arbitrage

7. Multinational Financial System[Advantages] • Tax arbitrage: • high-tax to low-tax nations • taxpaying to tax-loss units • Financial market arbitrage: • circumvent exchange controls • earn higher risk-adjusted returns • reduce borrowing costs

8. Multinational Financial System[Advantages] • Regulatory system arbitrage: • disguise true profitability • negotiating advantage • Offset credit restraint or controls • draw on external sources of funds

9. Tax Factors(Intercompany Transfers) • Types of taxes (host country) • corporate income taxes • taxes on dividends, interest, and fee remittances • taxes on retained earnings • Foreign tax credit • offsets U. S. taxes

10. MNC Financial Channels • Transfer pricing • Reinvoicing Centers • Fees and royalties • Leading and lagging • Intercompany loans • Dividends • Equity vs. debt

11. Transfer Pricing • Reduce taxes • Unit A sells to Unit B: • if tA > tB, low transfer price • if tA < tB, high transfer price

12. Transfer Pricing[A sells to B]

13. Transfer Pricing[A sells to B]

14. Transfer Pricing[A sells to B]

15. Transfer Pricing[A sells to B]

16. Transfer Pricing[A sells to B]

17. Transfer Pricing Strategy • Reduce taxes • Reduce tariffs • Avoid exchange controls • Increase profits from joint ventures • Disguise affiliate’s profitability

18. Fees and Royalties[International Transfers] • Intangible factors of production • headquarters services • allocated overhead • patents and trademarks • IRC Section 482: • “commensurate with the income generated”

19. Fees and Royalties [International Transfers] • Allocate total fees according to sales or assets

20. Leading & Lagging Payments • Accelerating or delaying payments • Modifying credit terms • Opportunity cost of funds: • paying unit • receiving unit • interest rate differentials

21. Leading & Lagging Payments • Advantages over direct loans: • no formal note of indebtedness • less government interference • interest free for 6 months (Sec. 482)

22. Leading & Lagging Payments

23. Leading & Lagging Payments

24. Leading & Lagging Payments

25. Leading & Lagging Payments

26. Intercompany Loans (1) • Transfer of funds through making and repaying of intercompany loans • More valuable than arm’s-length transactions if the following exist: • credit rationing • currency controls • differential tax rates

27. Intercompany Loans (2) • Direct Loans • Back-to-Back Financing • Parallel Loans

28. Direct Loans • Straight extension of credit • From parent to affiliate • From one affiliate to another • No intermediary involved

29. Back-to-Back Loans (1)[Fronting loans; link financing] • Used in countries with: • high interest rates • restricted capital markets • currency controls • different tax rates for loans from a financial institution

30. Back-to-Back Loans (2) • Parent deposits funds with a bank in Country A • Bank lends funds to subsidiary in Country B • Effectively, an intercompany loan channeled through a bank

31. Back-to-Back Loans (3) • Risk free for the bank - deposit collateralizes the loan • Bank serves as intermediary • Bank’s compensation is the difference between borrowing and lending rates

32. Structure of a Back-to-Back Loan Parent firm in Country A Subsidiary in Country B

33. Structure of a Back-to-Back Loan Parent firm in Country A Subsidiary in Country B Direct Loan

34. Structure of a Back-to-Back Loan Parent firm in Country A Subsidiary in Country B Direct Loan Deposit Bank in Country A

35. Structure of a Back-to-Back Loan Parent firm in Country A Subsidiary in Country B Direct Loan Deposit Back-to-Back Loan Bank in Country A

36. Parallel Loans • Two related but separate borrowings • Usually involves four parties • Two separate countries • Bank fees: 0.25%-0.50% of principal

38. Dividends • Most important transfer mechanism • Over 50% of remittances to USA • Parent’s dividend payout ratio (D/E) • Other factors: • tax effects • financing requirements • exchange controls

39. Equity vs. Debt? • MNCs generally prefer loans to equity • Easier to repatriate interest and principal than dividends and equity • Tax benefits of debt: • interest deductible in host country • loan repayments not taxable to parent

40. Designing a Global Policy • How much money to remit? • When to remit? • Where to transmit funds? • Which transfer method to use? • Satisfactory vs. optimal decisions

41. Shapiro: Problem 16-1 • Navistar’s Canadian subsidiary sells 1,500 trucks per month to a French subsidiary at $27,000 per unit. • Canadian tax rate = 45% • French tax rate = 50% • Price between $25,000 and $30,000

42. Shapiro: Problem 16-1.a • a. 1,500 (27,000 - P) (.45 - .50) P = $30,000 maximizes tax savings

43. Shapiro: Problem 16-1.b • a. French government imposes an “ad valorem” tariff of 15% on imported tractors • b. 1,500 (27,000 - P)[.45+.15-.50(1.15)] = 1,500 (27,000 - P) (.025) P = $25,000 maximizes tax savings

44. Shapiro: Problem 16-1 • c. $27,000 X 1.05 = $28,350 1,500 (27,000 - 28,350) (.45 - .50) = $101,250 (decline in tax) 1,500 (28,350-27,000)[.45+.15-.5(1.15)] = $50,625