Managing the Multinational Financial System

Shapiro: Chapter 16

Shapiro: Chapter 16

Problem 16.1

Multinational Financial System

“... ability to shift funds and accounting profits among its various units ...

through internal financial transfer mechanisms.”

Multinational Financial System

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

Two-way International Trade

Parent to/from a foreign Parent to/from a foreign subsidiarysubsidiary::–U. S. & Japan: 80%U. S. & Japan: 80%

–U. S. & Europe: 40%U. S. & Europe: 40%

–EC & Japan: 55%EC & Japan: 55%

Multinational Arbitrage Opportunities

Tax arbitrageTax arbitrage Financial market arbitrageFinancial market arbitrage Regulatory system arbitrageRegulatory system arbitrage

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

Multinational Financial System[Advantages]

Regulatory system arbitrage:

–disguise true profitability

–negotiating advantage Offset credit restraint or controls

–draw on external sources of funds

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

MNC Financial Channels

Transfer pricing Reinvoicing Centers Fees and royalties Leading and lagging Intercompany loans Dividends Equity vs. debt

Transfer Pricing

Reduce taxes Unit A sells to Unit B:

–if tA > tB, low transfer price

–if tA < tB, high transfer price

Transfer Pricing[A sells to B]

TaxA TaxB Transfer Price

ProfitA ProfitB

Transfer Pricing[A sells to B]

TaxA TaxB Transfer Price

ProfitA ProfitB

High Low

Transfer Pricing[A sells to B]

TaxA TaxB Transfer Price

ProfitA ProfitB

High Low Low Low High

Transfer Pricing[A sells to B]

TaxA TaxB Transfer Price

ProfitA ProfitB

High Low Low Low High

Low High

Transfer Pricing[A sells to B]

TaxA TaxB Transfer Price

ProfitA ProfitB

High Low Low Low High

Low High High High Low

Transfer Pricing Strategy

Reduce taxes Reduce tariffs Avoid exchange controls Increase profits from joint ventures Disguise affiliate’s profitability

Fees and Royalties[International Transfers]

Intangible factors of production

– headquarters services

– allocated overhead

– patents and trademarks IRC Section 482:

– “commensurate with the income” generated

Fees and Royalties [International Transfers]

Allocate total fees according to sales or assets

Leading & Lagging Payments

Accelerating or delaying payments Modifying credit terms Opportunity cost of funds:

– paying unit

– receiving unit

– interest rate differentials

Leading & Lagging Payments

Advantages over direct loans:Advantages over direct loans:–no formal note of indebtednessno formal note of indebtedness

–less government interferenceless government interference

–interest free for 6 months (Sec. interest free for 6 months (Sec. 482)482)

Leading & Lagging Payments

Borrowing Rate

Lending Rate

United States 3.8% 2.9%

Germany 3.6% 2.7%

Leading & Lagging Payments Borrowing

Rate Lending

Rate

United States 3.8% 2.9%

Germany 3.6% 2.7%

Germany

(+) (-)

(+)

United States (-)

Leading & Lagging Payments Borrowing

Rate Lending

Rate

United States 3.8% 2.9%

Germany 3.6% 2.7%

Germany

(+) (-)

(+) 2.9% - 2.7% [+0.2%]

United States (-)

Leading & Lagging Payments Borrowing

Rate Lending

Rate

United States 3.8% 2.9%

Germany 3.6% 2.7%

Germany

(+) (-)

(+) 2.9% - 2.7% [+0.2%]

2.9% - 3.6% [-0.7%]

United States (-) 3.8% - 2.7% [+1.1%]

3.8% - 3.6% [+0.2%]

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

Intercompany Loans (2)

Direct Loans Back-to-Back Financing Parallel Loans

Direct Loans

Straight extension of credit From parent to affiliate From one affiliate to another No intermediary involved

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

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

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

Parent firmParent firmin Country Ain Country A

Subsidiary inSubsidiary inCountry BCountry B

Structure of a Back-to-Back LoanStructure of a Back-to-Back Loan

Parent firmParent firmin Country Ain Country A

Subsidiary inSubsidiary inCountry BCountry BDirect Loan

Structure of a Back-to-Back LoanStructure of a Back-to-Back Loan

Parent firmParent firmin Country Ain Country A

Bank in Bank in Country ACountry A

Subsidiary inSubsidiary inCountry BCountry BDirect Loan

Deposit

Structure of a Back-to-Back LoanStructure of a Back-to-Back Loan

Parent firmin Country A

Bank in Country A

Subsidiary inCountry BDirect Loan

Back-to-Back Loan

Deposit

Structure of a Back-to-Back LoanStructure of a Back-to-Back Loan

Parallel Loans

Two related but separate borrowings Usually involves four parties Two separate countries Bank fees: 0.25%-0.50% of principal

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

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

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

Shapiro: Problem 16-1

a. 1,500 (27,000 - P) (.45 - .50)

P = $30,000 maximizes tax savings

b. 1,500 (27,000 - P)[.45+.15-.50(1.15)]

= 1,500 (27,000 - P) (.025)

P = $25,000 maximizes tax savings

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