CHAPTER 20

Managing the Multinational Financial

System

MANAGING THE MULTINATIONAL FINANCIAL SYSTEM

I. THE VALUE OF THE MULTINATIONAL FINANCIAL SYSTEM

A. Its ability to arbitrage in the following areas:

1. Tax systems2. Financial markets3. Regulatory systems

TAX ARBITRAGE

Tax Arbitrage is possible because we know:1. Wide variations exist in global

tax systems

examples:

2. Firms want to reduce taxes paid

especially the “triple-taxed” MNC

move funds to low-tax jurisdiction

TAX ARBITRAGE

3. Tax Factors (triple taxation):a. Taxes may be levied on

1.) corporate income2.) personal income

(includes dividends)3.) subsidiary income

b. U.S. Tax System ProvisionsOffset:Foreign tax credit given on

tax already paid abroad.

FINANCIAL MARKET ARBITRAGE

Financial Market Arbitrage is possible if we

1. assume imperfect markets exist because

a. Formal barriers to trade existb. Informal also existc. Imperfections in domestic

capital markets exist.2. agree parity conditions not in effect

a. interest rate parityb. International Fisher Effect

REGULATORY ARBITRAGE

Regulatory Arbitrage1. Arises when subsidiary profits vary

due to local regulations.

2. Examples of local regulations:a. Government price controls

b. Union wage pressuresFirms may disguise true profits

in order to gain better negotiations advantages

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-FLOWMECHANISMS

COMMONLY USED MECHANISMS:

A. Unbundling

B. Transfer Pricing

C. Reinvoicing Centers

D. Royalties

E. Leading and Lagging

F. Mechanism: Dividends

UNBUNDLING

A. Unbundling Mechanismbreaks 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

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 PRICING

2. Uses of Transfer Pricing

a.) Reduces taxes paid

b.) Reduces tariffs

c.) Avoids exchange controls

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 for A to B.

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 Example

Without markup policyA 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 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 Example

In effect:

Profits are shifted from a higher to a lower tax jurisdiction

REINVOICING CENTERS

C. Mechanism: Reinvoicing Centers

1. Set up in low-tax nations.

2. Center takes title to all gods.

3. Center pays seller/paid by buyer

all within the MNC.

REINVOICING CENTERS

d. Advantages:1.) Easier control on currency

exposure2.) Invoice currency other than

local

REINVOICING CENTERS

e. Disadvantages of Reinvoicing1.) Increased communications

costs

2.) Suspicion of tax evasion by

local governments.

FEES AND ROYALTIES

D. Mechanism: Royalties1. Firms have control of payment

amounts.2. Host governments less suspicious.

LEADING AND LAGGING

E. Leading and Lagging1. Highly favored by MNCs

2. Often used instead of formal debt - may be prohibited by local government

3. Less chance of local governmentsuspicion.

DIVIDENDS!

F. Mechanism: Dividendsmost important method used by MNCs to transfer funds to parent