0. Managing the Multinational Financial System
Chapter 16
Managing the Multinational Financial System

1. 16.A Multinational Financial System (1)
Financial transactions within the MNC result from the internal transfer of goods, services, technology, and capital.
Mode of transfer
Intermediate to finished goods – transfer pricing facilitates movement of profits and cash from one unit to another.
Intangibles such as management skills, trademarks, and patents – transfer facilitated by selling outright to affiliate or through fees and royalties
Timing flexibility
Leading and lagging – some internally generated financial claims require a fixed payment schedule while others can be accelerated or delayed.
Timing of fee and royalty payments can be modified when all parties are related.
Shipping schedules can be altered so one unit carries additional inventory for a sister affiliate.
Chapter 16: Managing the Multinational Financial System

2. 16.A Multinational Financial System (2)
The value of the MNC’s financial network stems from the wide variations in national tax systems and costs and barriers associated with internal financial transfers.
The ability to transfer funds and reallocate profits internally creates arbitrage opportunities for MNCs.
Tax arbitrage – MNCs can reduce their global tax burden by shifting profits from units located in high-tax countries to those in lower-tax countries, or from units in a taxpaying position to those with tax losses.
Financial market arbitrage – internal funds transfers may enable MNCs to circumvent exchange controls, earn higher risk-adjusted yields on excess funds, reduce risk-adjusted cost of borrowed funds, and access previously unavailable capital sources.
Regulatory system arbitrage – when affiliate profits are a function of government regulations or union pressure, the ability to disguise profitability by reallocating profits among units may give MNCs a negotiating advantage.
Chapter 16: Managing the Multinational Financial System

3. 16.B Intercompany Fund-Flow Mechanisms
Tax factors
Total tax payments on intercompany fund transfers depend on tax regulations in both the host and recipient countries.
Two types of taxes levied by the host country
Corporate income taxes
Withholding taxes on dividend, interest, and fee remittances
Foreign tax credits (FTCs) – credits provided by the recipient country in consideration of foreign taxes paid on repatriated earnings.
Channels available to the MNC for moving money and profits internationally
Transfer pricing
Fee and royalty adjustments
Leading and lagging
Intercompany loans
Dividend adjustments
Investing in the form of debt versus equity
Chapter 16: Managing the Multinational Financial System

4. 16.B.1 Intercompany Fund-Flow Mechanisms: Transfer Pricing (1)
Home and host governments have policing mechanisms to review the transfer pricing policies of MNCs.
The most important uses of transfer pricing include
Reducing taxes – general rule
If tA > tB, set transfer prices as low as possible
If tA < tB, set transfer prices as high as possible
If price is too high, tax authorities in Affiliate B’s host country will see revenues forgone.
If price is too low, Affiliate A’s government may infer tax evasion through transfer pricing.
Reducing tariffs
If Affiliate B is subject to ad valoerm tariffs (import duties set as a percentage of the value of the imported goods), increasing the transfer price will increase the duties Affiliate B must pay.
In general, the higher the ad valorem tariff relative to the income tax differential, the more likely a low transfer price is desirable.
Avoiding exchange controls
Chapter 16: Managing the Multinational Financial System

5. 16.B.1 Intercompany Fund-Flow Mechanisms: Transfer Pricing (4)
U.S. Revenue Code Section 482 provides for four alternative methods to establish intercompany arm’s length pricing.
Comparable uncontrolled price method – transfer prices are set by direct reference to market prices charged by the MNC or comparable companies to unrelated parties.
Resale price method – transfer prices are determined by reducing the price at which a good is resold to an independent purchaser by an appropriate markup.
Cost-plus method – adds an appropriate profit markup to the seller’s cost to determine arm’s length transfer prices.
Another appropriate method – in some cases, the use of combinations of the above methods or other methods are appropriate.
Advance pricing agreements – the MNC, IRS, and foreign tax authority agree in advance on a method to compute transfer prices.
Chapter 16: Managing the Multinational Financial System

6. 16.B.1 Intercompany Fund-Flow Mechanisms: Transfer Pricing (5)
Exchange controls
Given a U.S. corporate tax rate of 35%, in the absence of offsetting FTCs, a U.S. MNC will net after-tax earnings of $0.65Q0 for each dollar increase in the price at which it sells Q0 units to an affiliate with blocked funds.
A transfer price increase from P0 to P1 results in an increase of 0.65(P1–P0)Q0 dollars to the parent.
The affiliate will show a corresponding decrease in its cash balances and taxes due to higher COGS.
Joint ventures
Conflicts over transfer pricing may result when an affiliate is owned jointly by one or more other partners.
Outside partners may be suspicious that transfer pricing is being used to shift shared profits from the joint venture to a wholly owned subsidiary.
Chapter 16: Managing the Multinational Financial System

7. 16.B.1 Intercompany Fund-Flow Mechanisms: Transfer Pricing (6)
Reinvoicing centers
MNCs may use reinvoicing in low-tax countries to disguise profitability.
The reinvoicing center takes title to all goods sold by one corporate unit to another, while the goods move directly from the factory or warehouse to the purchaser.
The center pays the seller and is in turn paid by the purchasing unit.
Affiliate A
Affiliate B
t = 50%
Reinvoicing
Center
t = 10%
Sale/delivery of goods
Title to goods
Pay for goods
Chapter 16: Managing the Multinational Financial System

8. 16.B.1 Intercompany Fund-Flow Mechanisms: Transfer Pricing (7)
Reinvoicing centers, continued
U.S. Revenue Act of 1962 – declared reinvoicing to be Subpart F income.
Subpart F income – a category of foreign-source income subject to U.S. taxation immediately, whether or not remitted to the U.S.
A 1977 IRS ruling allocated to an MNC’s foreign affiliates certain parent expenses that previously could be written off in the U.S.
Additional FTCs are generated that can be utilized only against U.S. taxes owed on foreign-sourced income.
Subpart F income generated by reinvoicing centers offsets excess FTCs.
Affiliate A
Affiliate B
t = 50%
Reinvoicing
Center
t = 10%
Sale/delivery of goods
Title to goods
Payment = $90
Payment = $100
Creates $25 tax payment for which FTCs can be used
Chapter 16: Managing the Multinational Financial System

9. 16.B.2 Intercompany Fund-Flow Mechanisms: Fees and Royalties
Management services such as headquarters advice, allocated overhead, patents, and trademarks are often unique and thus have no reference market price.
By varying the fees and royalties charged for their use, intangible resources become additional routes for funneling remittances from foreign affiliates.
By setting low transfer prices on intangibles to manufacturing affiliates in low-tax locations, MNCs can receive profits essentially tax free.
To counter such an occurrence, Section 482 provides that the transfer price of an intangible asset must be “commensurate with the income” the intangible generates.
A related-party transfer price for an intangible is not arm’s length unless it produces a split in profits between transferor and transferee that falls within the range of profits that unrelated parties realize on similar intangibles in similar circumstances.
Chapter 16: Managing the Multinational Financial System

10. 16.B.3 Intercompany Fund-Flow Mechanisms: Leading and Lagging (2)
The value of leading and lagging depends on the opportunity cost of funds to both the Affiliate A and Affiliate B.
When an affiliate in a surplus position receives payment, it can invest the additional funds at the prevailing local lending rate or use it to reduce its borrowings at the borrowing rate.
If the paying unit has excess funds, it loses cash it would have invested at the lending rate, and if in a deficit position, it has to borrow at the borrowing rate.
Chapter 16: Managing the Multinational Financial System

11. 16.B.3 Intercompany Fund-Flow Mechanisms: Leading and Lagging (6)
Advantages of leading and lagging strategy
No formal note is required.
The amount of credit can be adjusted up or down by adjusting the terms on the accounts.
Governments are less likely to interfere with payments on intercompany accounts than on direct loans.
Section 482 allows intercompany accounts up to six months to be interest free while interest must be charged on intercompany loans.
Chapter 16: Managing the Multinational Financial System

12. 16.B.4 Intercompany Fund-Flow Mechanisms: Intercompany Loans (1)
Intercompany loans are more valuable than arm’s length transactions only if at least one of the following market distortions exists:
Credit rationing (due to a ceiling on local rates);
Currency controls;
Differential tax rates among countries.
Most important types of intercompany loans
Direct loans
Back-to-back loans
Parallel loans
Chapter 16: Managing the Multinational Financial System

13. 16.B.4 Intercompany Fund-Flow Mechanisms: Intercompany Loans (2)
Most important types of intercompany loans, continued
Direct loans – straight extensions of credit from the parent to an affiliate or from one affiliate to another.
Back-to-back (also called fronting or link) loans
The parent deposits funds with a bank in country A that in turn lends the money to a subsidiary in country B.
Typically used to finance affiliates in countries with high interest rates or restricted capital markets.
Parent in
Country A
Bank in
Affiliate in
Country B
Deposit
Back-to-back loan
Intercompany loan
Chapter 16: Managing the Multinational Financial System

14. 16.B.4 Intercompany Fund-Flow Mechanisms: Intercompany Loans (3)
Most important types of intercompany loans, continued
Back-to-back loans, continued
Advantages of back-to-back loans over direct loans
Certain countries apply different withholding tax rates to interest paid to a foreign parent and interest paid to a financial institution. Thus, a back-to-back loan may offer cost savings through lower taxes.
If currency controls are imposed, the government will typically permit the affiliate to honor bank loan payments while not necessarily authorizing repayment of an intercompany loan.
Costs are evaluated as follows.
Interest cost to parent
Interest income to parent
Interest cost to affiliate
Tax gain on exchange loss - +
Cost =
Example: parent’s opportunity cost of funds = 10%, parent and affiliate tax margins = 34% and 40% respectively, parent lending rate = 8%, affiliate borrowing rate = 9%.
Cost of loan = 0.10(0.66) (0.66) (0.6) – 0.40(0.11) = 2.32%
Chapter 16: Managing the Multinational Financial System

15. 16.B.4 Intercompany Fund-Flow Mechanisms: Intercompany Loans (4)
Most important types of intercompany loans, continued
Parallel loan
Consists of two related but separate (i.e., parallel) borrowings and usually involves four parties in at least two countries.
Used to repatriate blocked funds, circumvent exchange control restrictions, avoid a premium exchange rate for investments abroad, finance foreign affiliates without incurring additional exchange risk, or obtain foreign currency financing at attractive rates.
Example: a U.S. MNC wishing to invest in Spain lends dollars to the U.S. affiliate of a Spanish MNC wishing to invest in the U.S., which lends euros to the U.S. firm’s Spanish affiliate.
U.S. Parent
Spanish Firm’s
U.S. Affiliate
Spanish Parent
U.S. Firm’s
Spanish Affiliate
Direct loan in dollars
Direct loan in euros
Draw downs, interest payments, and principal repayments made simultaneously
Chapter 16: Managing the Multinational Financial System

16. 16.B.5 Intercompany Fund-Flow Mechanisms: Dividend Adjustments (1)
Dividends are the most important means of transferring funds from foreign affiliates to the parent.
Factors considered when deciding on dividend payments
Taxes
Financial statement effects
Exchange risk
Currency controls
Financing requirements
Availability and cost of funds
The parent’s dividend payout ratio
Chapter 16: Managing the Multinational Financial System

17. 16.B.5 Intercompany Fund-Flow Mechanisms: Dividend Adjustments (2)
Tax effects – by increasing payout ratios for foreign affiliates with the lowest transfer costs, the MNC can reduce its total tax burden.
Example:
U.S. MNC wants to withdraw $1 million from its affiliates through dividends.
Three affiliates – Germany, Ireland, France –each earn $2 million before tax.
Germany subject to corporate tax rate of 50% on undistributed gross earnings, 36% on dividends, and10% dividend withholding tax
Ireland grants a 15-year tax holiday on all export profits, so no taxes
France subject to 45% corporate tax rate and 10% dividend withholding tax
U.S. MNC corporate tax rate is 35%; MNC has no excess FTCs
(continued next slide)
Chapter 16: Managing the Multinational Financial System

18. 16.B.5 Intercompany Fund-Flow Mechanisms: Dividend Adjustments (4)
Dividend payments lead to liquidity shifts.
The value of moving dividends depends on the different opportunity costs of money among the affiliates.
An affiliate that must borrow funds will usually have a higher opportunity cost than a unit with excess cash.
Some subsidiaries will have access to low-cost financing sources, whereas others must borrow at a relatively high interest rate.
All else equal, a parent can increase its value by exploiting yield differences among its affiliates (i.e., setting a high dividend payout rate for affiliates with relatively low opportunity costs of funds, and vice versa).
Chapter 16: Managing the Multinational Financial System

19. 16.B.5 Intercompany Fund-Flow Mechanisms: Dividend Adjustments (5)
Effect of exchange controls on dividend decisions
Countries with balance of payments problems may restrict dividend payments to foreign companies.
An MNC may try to reduce the chance of interference by maintaining a record of consistent dividend payments.
Consistent payments imply the existence of an established program rather than an act of speculation against the host country’s currency.
Dividend payout ratios may be uniform throughout the MNC to show that all affiliates pay an equivalent percentage dividend.
Chapter 16: Managing the Multinational Financial System

20. 16.B.6 Intercompany Fund-Flow Mechanisms: Equity versus Debt (1)
MNCs generally prefer to invest through loans rather than equity.
An MNC typically has wider latitude to repatriate funds through interest and loan repayments than as dividends or reductions in equity.
Loans are more likely to create more favorable tax benefits
Interest paid on a loan is typically tax deductible in the host country, whereas dividend payments are not.
Unlike dividends, principal repayments do not normally constitute taxable income to the parent.
Example: Compare cash flows generated from parent’s $1,000,000 investment in affiliate made as debt and equity
Additional after-tax sales generated from investment = $200,000 annually
10% withholding tax on dividend and interest payments
Interest rate on principal = 10%
Interest 50% tax deductible
Use 15% discounting factor to determine present value of cash flows to parent
(see next two slides)
Chapter 16: Managing the Multinational Financial System

21. 16.C Designing a Global Remittance Policy (1)
Coordinating the use of an MNC’s financial linkages in a manner consistent with value maximization requires four interrelated decisions.
How much money (if any) to remit
When to remit
Where to transmit remittances
Which transfer method(s) to use
Chapter 16: Managing the Multinational Financial System

22. 16.C Designing a Global Remittance Policy (2)
Factors affecting the benefits of an internal financial transfer system
Number of financial linkages – the wider the range of choice, the greater a firm’s ability to achieve specific goals.
Volume of interaffiliate transactions – more affiliates specializing in different components and stages of production increase interaffiliate trade.
Foreign-affiliate ownership pattern – 100% ownership removes impediments to efficient worldwide funds allocation.
Degree of product and services standardization – the more standardization, the less latitude an MNC has to adjust transfer prices, fees, and royalties.
Government regulations – tax, credit allocation, and exchange control policies can provide incentives for or create impediments to international fund flows.
Chapter 16: Managing the Multinational Financial System