International Finance

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International Finance

• FIN456Michael Dimond

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Strategic Multinational Financial Management

• The ability to shift profits and funds internally
  adds value to the MNC (compared to a purely
  domestic firm). This value of the multinational
  financial system arises out of the MNC's ability
  to take advantage of market imperfections and tax
  differences.
• Tax arbitrage--By shifting profits from units
  located in high-tax nations to those in lower-tax
  nations or from those in a taxpaying position to
  those with tax losses, MNCs can reduce their tax
  burden. 
• Financial market arbitrage--By transferring funds
  among units, MNCs may be able to circumvent
  exchange controls, earn higher risk-adjusted
  yields on excess funds, reduce their
  risk-adjusted cost of borrowed funds, and tap
  previously unavailable capital sources.
• Regulatory system arbitrage--Where subsidiary
  profits are a function of government regulations
  (e.g., where a government agency sets allowable
  prices on the firm's goods) or union pressure,
  rather than the marketplace, the ability to
  disguise true profitability by reallocating
  profits among units may provide the multinational
  firm with a negotiating advantage.

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International Offshore Financial Centers
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Multinational Tax Management

• The primary objective of multinational tax
  planning is the minimization of the firms
  worldwide tax burden
• Tax planning for MNC operations is extremely
  complex but a vital aspect of international
  business
• To plan effectively, MNCs must understand not
  only the intricacies of their own operations
  worldwide, but also the different structures and
  interpretations of tax liabilities across
  countries

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Tax Principles

• Tax morality the MNC must decide whether to
  follow a practice of full disclosure to tax
  authorities or to adopt the principle of when in
  Rome, do as the Romans
• Tax neutrality when governments levy taxes,
  they must consider not only the potential revenue
  from the tax but also the effect the proposed tax
  can have on private economic behavior
• The ideal tax should not only raise revenue
  efficiently but also have as few negative effects
  on economic behavior as possible

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Tax Principles

• Domestic neutrality the burden of taxation on
  each currency unit of profit earned in the home
  country should equal the burden of taxation on
  the currency equivalent profit earned by the same
  firm in its foreign operations
• Foreign neutrality the tax burden on each
  foreign subsidiary should equal the tax burden on
  its competitors in the same country
• Tax equity an equitable tax that imposes the
  same total burden on all taxpayers who are
  similarly situated and located in the same tax
  jurisdiction

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Corporate Tax Rates Compared
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National Tax Environments

• Nations typically structure their tax systems
  along one of two basic approaches
• Worldwide approach
• Territorial approach
• Both approaches are attempts to determine which
  firms, foreign or domestic by incorporation, or
  which incomes, foreign or domestic in origin, are
  subject to the taxation of host country tax
  authorities

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National Tax Environments

• Worldwide approach is also referred to as the
  residential or national approach
• It levies taxes on the income earned by firms
  that are incorporated in the host country
  regardless of where the income was earned
• Territorial approach is also termed the source
  approach
• It focuses on the income earned by firms within
  the legal jurisdiction of the host country, not
  the country of incorporation

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National Tax Environments

• Tax deferral foreign subsidiaries of MNCs pay
  host country income taxes but many parent
  companies defer claiming additional income taxes
  on that foreign source income until it is
  remitted to the parent firm
• If the worldwide approach was followed to the
  letter of the law, then the tax deferral
  privilege would end
• Tax treaties provide a means of reducing double
  taxation
• They typically define whether taxes are to be
  imposed on income earned in one country by the
  nationals of another country and if so, how much

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National Tax Environments

• Tax treaties
• Tax treaties are bilateral, with the two
  signatories specifying what rates are applicable
  to which types of income
• Tax treaties also typically result in reduced
  withholding tax rates
• This is important to MNCs operating foreign
  subsidiaries earning active income and individual
  investors earning passive income

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Tax Types

• Income Tax many governments rely on this tax as
  their primary source of revenue
• Withholding Tax passive income (dividends,
  royalties, interest) earned by a resident of one
  country within the jurisdiction of a second
  country are normally subject to a withholding tax
  in the second country
• Government wishes a minimum payment for earning
  income within their tax jurisdiction knowing that
  party wont file a tax return in the host country

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Tax Types

• Value-Added Tax type of national sales tax
  collected at each stage of production or sale of
  goods in proportion to the value added during
  that stage
• Other National Taxes there are several other
  taxes levied which vary in importance from
  country to country
• Turnover Tax tax on purchase/sale of securities
  in stock market
• Property and Inheritance Tax
• Tax on Undistributed Profits

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Corporate Tax Rates for Selected Countries
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Example Value-Added Tax
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Value-added Tax Problem

• 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 marginal tax rates on corporate income
  are assumed to equal 45 and 50, respectively.
  Suppose 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?
• Now suppose the French government imposes an ad
  valorem tariff of 15 percent on imported
  tractors. How would this affect the optimal
  transfer pricing strategy? (assume the VAT is
  paid by the French affiliate and is tax
  deductible)

The firm should be shifting profits from the
high-tax region (France) to the low-tax region
(Canada), so the transfer price should be set to
30,000.
Now the deductible VAT offsets part of the French
tax, so the transfer price should be 25,000
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Value-added Tax Problem

• 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 marginal tax rates on corporate income
  are assumed to equal 45 and 50, respectively.
  Suppose 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?
• Tax Savings 1,500(27,000 - P)(.45 - .50)
• 1,500(27,000 -
  P)(-.05)
• Now suppose the French government imposes an ad
  valorem tariff of 15 percent on imported
  tractors. How would this affect the optimal
  transfer pricing strategy? (assume the VAT is
  paid by the French affiliate and is tax
  deductible)
• Tax Savings 1,500(27,000 - P)(.45 .15 -
  .50(1.15)) 1,500(27,000 -
  P)(.025)

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Foreign Tax Credits

• To prevent double taxation, many countries grant
  a foreign tax credit (FTC) for income taxes paid
  to the host country
• FTCs vary widely by country and are also
  available for withholding taxes
• Value-added taxes are typically deducted as an
  expense from pre-tax income so FTCs dont apply
• A tax credit is a direct reduction of taxes that
  would otherwise be due and payable
• It is not a deductible expense because it does
  not reduce the taxable income

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Foreign Tax Credits
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FTC Example
NI x Dividend Payout Rate
Rate given as 0.0
HK Corp Income Taxes x Dividend Payout Rate
From above (Rate given as 0.0)
5,400 x US Corp. Tax Rate
Corp Inc Tax Withholding Tax Paid
Theoretical US Tax Liability FTC
FTC - Theoretical US Tax Liability
Depends on which is larger, FTC orTheoretical US
Tax Liability.Lower limit 0.
FTC Additional US Tax Due
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FTC Problem

• Suppose a firm earns 1 million before tax 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,
  how much U.S. tax will the parent owe on this
  dividend?

Under current U.S. tax law, the firm's U.S. tax
owed on the dividend is calculated as
follows   Dividend 480,000 Spanish tax
paid 520,000 Included in U.S. taxable
income 1,000,000 U.S. tax _at_ 35
350,000 Less U.S. indirect tax credit
520,000 Net U.S. tax owed (170,000)   As a
result of paying Spanish tax at a rate that
exceeds the U.S. tax rate of 35, the company
receives a 170,000 FTC that can be used to
offset U.S. taxes owed on other foreign source
income.
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Transfer Pricing

• The pricing of goods, services, and technology
  transferred to a foreign subsidiary from an
  affiliated company, transfer pricing, is the
  first and foremost method of transferring funds
  out of a foreign subsidiary
• These costs enter directly into the cost of goods
  sold component of the subsidiarys income
  statement
• This is a particularly sensitive problem for the
  MNC
• Both funds positioning and income tax effects
  must be taken into consideration

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MNCs can transfer funds and profits internally

• Purely Financial Transfers
• Transfer pricing
• Fees and royalties
• Dividends
• Loans
• Leads and lags
• Parent investment as debt or equity
• A close relationship between a firm's marketing,
  production, and logistics decisions (real
  decisions) and its financial decisions creates
  greater scope for financial activities to enhance
  the value of the MNC from worldwide internal
  transfers
• Goods
• Technology
• Materials

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Transfer Pricing

• Fund positioning
• A parent wishing to transfer funds out of a
  particular country can charge higher prices on
  goods sold to its subsidiary in that country to
  the degree that government regulations allow
• A foreign subsidiary can be financed by the
  reverse technique, a lowering of transfer prices
• Payments by a subsidiary for imports transfers
  funds out of the subsidiary
• A high transfer price allows funds to be
  accumulated in the selling country

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Transfer Pricing

• Income tax effect
• A major consideration in setting a transfer price
  is the income tax effect
• Worldwide corporate profits may be influenced by
  setting a transfer prices to minimize taxable
  income in a country with a high income tax rate
• This can also be done to maximize income in a
  country with a low income tax rate

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Transfer Pricing

• IRS regulations provide three methods to
  establish arms length prices
• Comparable uncontrolled prices
• Regarded as the best evidence of arms length
  pricing
• Transfer price is the same as bond fide sales of
  the same items between unrelated firms
• Resale prices
• Begins with the final selling price to an
  independent purchaser less an appropriate markup
• Cost-plus calculations
• Begins with full cost to the seller plus a profit
  margin

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Effect of Transfer Price on Net Income (US 000s)
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Tax Management of Foreign-Source Income