Chapter 16
Managing the Multinational Financial System
16.A Multinational Financial System (1)

Financial transactions within the MNC result from the internal
transfer of goods, services, technology, and capital.
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
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.
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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.
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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
1. Transfer pricing
2. Fee and royalty adjustments
3. Leading and lagging
4. Intercompany loans
5. Dividend adjustments
6. Investing in the form of debt versus equity
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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
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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.
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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.
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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.
Title to goods
Affiliate A
Pay for goods
Reinvoicing
Center
t = 10%
Sale/delivery
of goods
Affiliate B
t = 50%
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Pay for goods
7
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.
Title to goods
Affiliate A
Sale/delivery
of goods
Payment = $90
Reinvoicing
Center
t = 10%
Creates $25 tax
payment for which
FTCs can be used
Affiliate B
t = 50%
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Payment = $100
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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.
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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.
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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.
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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
1. Direct loans
2. Back-to-back loans
3. Parallel loans
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16.B.4 Intercompany Fund-Flow Mechanisms:
Intercompany Loans (2)

Most important types of intercompany loans, continued
1. Direct loans – straight extensions of credit from the parent to an affiliate
or from one affiliate to another.
2. 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
Intercompany loan
Affiliate in
Country B
Deposit
Bank in
Country A
Back-to-back loan
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16.B.4 Intercompany Fund-Flow Mechanisms:
Intercompany Loans (3)

Most important types of intercompany loans, continued
2. 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.
Cost =
Interest cost
to parent
-
Interest income
to parent
+
Interest cost
to affiliate
-
Tax gain on
exchange loss
– 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) - 0.08(0.66) + 0.09(0.6) – 0.40(0.11) = 2.32%
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16.B.4 Intercompany Fund-Flow Mechanisms:
Intercompany Loans (4)

Most important types of intercompany loans, continued
3. 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
Direct loan in dollars
Spanish Firm’s
U.S. Affiliate
Spanish Parent
Direct loan in euros
U.S. Firm’s
Spanish Affiliate
Draw downs, interest payments, and principal repayments made simultaneously
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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
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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)
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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).
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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.
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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)
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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
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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.
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