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Managing the Multinational Financial System. International Finance. Dr. A. DeMaskey. Learning Objectives. What are the principal transfer mechanisms that MNCs use to move funds among their various affiliates?

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Managing the multinational financial system l.jpg

Managing the Multinational Financial System

International Finance

Dr. A. DeMaskey

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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?

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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

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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

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Constraints on Positioning of Funds

  • Political constraint

  • Differential tax rates

  • Transaction costs

  • Liquidity requirements

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Intercompany Fund-Flow Mechanisms

  • Unbundling

  • Tax planning

  • Transfer pricing

  • Leading and lagging

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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

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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

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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

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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

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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:

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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:

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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

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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

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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?

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  • 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.

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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?

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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

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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

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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

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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.

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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?