Download MIM700 - Prof Dimond

International Finance
FIN456
Michael Dimond
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.
Michael Dimond
School of Business Administration
International Offshore Financial Centers
Michael Dimond
School of Business Administration
Multinational Tax Management
• The primary objective of multinational tax planning is
the minimization of the firm’s 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
Michael Dimond
School of Business Administration
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
Michael Dimond
School of Business Administration
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
Michael Dimond
School of Business Administration
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
Michael Dimond
School of Business Administration
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
Michael Dimond
School of Business Administration
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
Michael Dimond
School of Business Administration
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
Michael Dimond
School of Business Administration
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 won’t file a tax return in the
host country
Michael Dimond
School of Business Administration
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
Michael Dimond
School of Business Administration
Corporate Tax Rates for Selected Countries
Michael Dimond
School of Business Administration
Corporate Tax Rates Compared
Michael Dimond
School of Business Administration
Foreign Tax Credits
• To prevent double taxation, many countries grant a foreign
tax credit (FTC) for income taxes paid to the host country
– FTC’s 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 don’t 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
Michael Dimond
School of Business Administration
Foreign Tax Credits
Michael Dimond
School of Business Administration
P20-4
• 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
Spanish tax paid
Included in U.S. taxable income
U.S. tax @ 35%
Less: U.S. indirect tax credit
Net U.S. tax owed
$480,000
520,000
$1,000,000
350,000
520,000
($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.
Michael Dimond
School of Business Administration
FTC Example
United States Taxation: Grossup
Gross dividend remitted
Less withholding taxes
b. Net dividend remitted
Add back proportion of corp income tax
Add back withholding taxes paid
Grossed-up dividend for US tax purposes
Theoretical US tax liability
Foreign tax credits (FTCs)
Additional US taxes due?
Excess foreign tax credits?
c. Net dividend, after-tax
Total taxes paid on this income
Income before tax
2011
$
$
$
$
$
4,509
4,509
NI x Dividend Payout Rate
Rate given as 0.0%
891
5,400
(1,890)
(891)
(999)
-
HK Corp Income Taxes x Dividend Payout Rate
From above (Rate given as 0.0%)
3,510
1,890
5,400
$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 or
Theoretical US Tax Liability.
Lower limit = 0.
FTC + Additional US Tax Due
Michael Dimond
School of Business Administration
Tax Management of Foreign-Source Income
Michael Dimond
School of Business Administration
P20-5
5.
Suppose a French affiliate repatriates as dividends all the after-tax profits it earns. If the French income tax rate
is 50 percent and the dividend withholding tax is 10 percent, what is the effective tax rate on the French affiliate's
before-tax profits, from the standpoint of its U.S. parent?
ANSWER. Assume the French affiliate earns $1 million before tax. It then pays $500,000 in French income tax and
remits the remaining $500,000 as a dividend to its U.S. parent. Only $450,000 gets through because of the 10%
French dividend withholding tax. It appears as if the effective tax rate on this affiliate's earnings from the parent's
standpoint is 55%. However, the parent will receive a foreign tax credit of $210,000, the difference between the
$550,000 total tax payments to the French government and the $340,000 in U.S. tax owed on the $1 million in pre-tax
earnings. If the full FTC can be used, then the parent's effective tax rate declines to 34%. If the FTC is unusable, the
parent's effective tax rate on the affiliate's earnings is 55%. If part, but not all, of the tax credit is usable, the parent's
effective tax rate on its French unit's earnings will lie between 34% and 55%. The higher the fraction of the FTC that
is usable, the lower the parent's effective tax rate.
Michael Dimond
School of Business Administration
P20-1
• 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?
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.
Michael Dimond
School of Business Administration
P20-1
• 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)
Tax Savings = 1,500(27,000 - P)(-.05)
Tax Savings is -150,000 for low markup and 225,000 for high markup
Michael Dimond
School of Business Administration
P20-1
• We could set this out in a per-unit schedule to examine it better. Assume
Navistar sells the tractors to the end customer for 34,500
BEFORE ADJUSTMENT
Canadian Subsidiary
Sales
27000
COGS
25000
Gross profit
2000
No VAT
0
Pre-tax Profit
2000
tax rate
45%
Tax
900
Profit after tax
1100
French Subsidiary
34500
27000
7500
0
7500
50%
3750
3750
Parent POV
34500
25000
9500
0
9500
LOW MARKUP POLICY
Canadian Subsidiary
Sales
25000
COGS
25000
Gross profit
0
No VAT
0
Pre-tax Profit
0
tax rate
45%
Tax
0
Profit after tax
0
French Subsidiary
34500
25000
9500
0
9500
50%
4750
4750
Parent POV
34500
25000
9500
0
9500
HIGH MARKUP POLICY
Canadian Subsidiary
Sales
30000
COGS
25000
Gross profit
5000
No VAT
0
Pre-tax Profit
5000
tax rate
45%
Tax
2250
Profit after tax
275000%
French Subsidiary
34500
30000
4500
0
4500
50%
2250
225000%
Parent POV
34500
25000
9500
0
9500
4650
4850
Comparing the tax to the
“Before Adjustment” scenario
shows tax increasing 100 per
unit (150,000 total)
4750
4750
4500
5000
Comparing the tax to the
“Before Adjustment” scenario
shows tax decreasing 150 per
unit (225,000 total)
Michael Dimond
School of Business Administration
Example: Value-Added Tax
This is an example of an Output VAT. If this crossed
borders, we might see an input VAT, like a tarriff
Michael Dimond
School of Business Administration
P20-1
• 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?
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 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)
Now the deductible VAT offsets part of the French tax,
so the transfer price should be $25,000
This is an example
of an Input VAT, a
Michael Dimond
School of Business Administration
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)
Tax Savings = 1,500(27,000 - P)(-.05)
Tax Savings is -150,000 for low markup and 225,000 for high markup
• 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))
Tax Savings = 1,500(27,000 - P)(.025)
Tax Savings is 75,000 for low markup and -112,500 for high markup
Michael Dimond
School of Business Administration
P20-1
• Again, we could set this out in a per-unit schedule to examine it better.
Assume Navistar sells the tractors to the end customer for 34,500
BEFORE ADJUSTMENT
Canadian Subsidiary
Sales
27000
COGS
25000
Gross profit
2000
15% VAT
0
Pre-tax Profit
2000
tax rate
45%
Tax
900
Profit after tax
1100
French Subsidiary
34500
27000
7500
4050
3450
50%
1725
1725
Parent POV
34500
25000
9500
4050
5450
LOW MARKUP POLICY
Canadian Subsidiary
Sales
25000
COGS
25000
Gross profit
0
15% VAT
0
Pre-tax Profit
0
tax rate
45%
Tax
0
Profit after tax
0
French Subsidiary
34500
25000
9500
3750
5750
50%
2875
2875
Parent POV
34500
25000
9500
3750
5750
HIGH MARKUP POLICY
Canadian Subsidiary
Sales
30000
COGS
25000
Gross profit
5000
15% VAT
0
Pre-tax Profit
5000
tax rate
45%
Tax
2250
Profit after tax
2750
French Subsidiary
34500
30000
4500
4500
0
50%
0
0
Parent POV
34500
25000
9500
4500
5000
2625
2825
Comparing the tax + VAT to
the “Before Adjustment”
scenario shows tax
decreasing 50 per unit
(75,000 total)
2875
2875
2250
2750
Comparing the tax + VAT to
the “Before Adjustment”
scenario shows tax increasing
75 per unit (112,500 total)
Michael Dimond
School of Business Administration
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 subsidiary’s income statement
• This is a particularly sensitive problem for the MNC
• Both funds positioning and income tax effects must be taken
into consideration
Michael Dimond
School of Business Administration
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
Michael Dimond
School of Business Administration
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
Michael Dimond
School of Business Administration
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
Michael Dimond
School of Business Administration
Transfer Pricing
• IRS regulations provide three methods to establish arm’s
length prices
– Comparable uncontrolled prices
• Regarded as the best evidence of arm’s 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
Michael Dimond
School of Business Administration
P20-2
2.
Suppose a U.S. parent owes $5 million to its English affiliate. The timing of this payment can be changed by up
to 90 days in either direction. Assume the following effective annualized after-tax dollar borrowing and lending
rates in England and the United States.
United States
England
a.
Lending
(%)
Borrowing
(%)
4.0
3.6
3.2
3.0
If the U.S. parent is borrowing funds while the English affiliate has excess funds, should the parent speed up or
slow down its payment to England?
ANSWER. Under the circumstances, the parent's opportunity cost of funds is 3.2%, whereas the British unit's
opportunity cost of funds is 3.6%. Since the British unit has the higher opportunity cost of funds, the U.S. parent
should speed up its $5 million payment by 90 days.
b.
What is the net effect of the optimal payment activities in terms of changing the units' borrowing costs and/or
interest income?
ANSWER. The U.S. parent will borrow an additional $5 million for 90 days, adding $5,000,000 x .032 x .25 = $40,000
to its interest expense. At the same time, the British unit will invest an additional $5 million for 90 days, raising its
interest income by $5,000,000 x .036 x .25 = $45,000. The net effect is to raise consolidated income by $5,000.
Michael Dimond
School of Business Administration
P20-3
3.
Suppose that DMR SA, located in Switzerland, sells $1 million worth of goods monthly to its affiliate DMR
Gmbh, located in Germany. These sales are based on a unit transfer price of $100. Suppose the transfer price is
raised to $130 at the same time that credit terms are lengthened from the current 30 days to 60 days.
a.
What is the net impact on cash flow for the first 90 days? Assume that the new credit terms apply only to new
sales already booked but uncollected.
ANSWER. This problem can best be worked by examining cash flows under the new setup and then subtracting cash
flows under the old setup. Note that by changing credit terms to 60 days from 90 days, goods shipped in the first
month are not paid for until the third month. The net effect during the first 90 days of simultaneously switching credit
terms and changing the transfer price is to shift $700,000 from the Swiss affiliate to the German affiliate. This can
be seen in the following exhibit, which traces out the cash flow effects of these changes.
Cash Inflows for Swiss Unit and Cash Outflows for German Unit
Month
1
2
3
New Terms
Old Terms
$1,000,000
1,000,000
0
1,000,000
$1,300,000
1,000,000
Change
Cumulative
0
0
-$1,000,000
-$1,000,000
+$300,000
-$700,000
Michael Dimond
School of Business Administration
$1,000,000
-650,000
New Terms
Payment of payables
Value of tax write-offs
P20-3 cont’d
Net cash outflow
$350,000
b.
0
-650,000
$1,300,000
-650,000
-$650,000
$650,000
Assume the tax rate is 25 percent in Switzerland and 50 percent in Germany and that reven
costs deducted upon sale or purchase of goods, not upon collection. What is the impact on af
for the first 90 days?
b. Old
Assume
termsthe tax rate is 25 percent in Switzerland and 50 percent in Germany and that revenues are taxed and
costs deducted
upon sale or purchase of
goods, not upon
collection.
What $1,000,000
is thebecause
impact
on after-tax cash flows
Payment
of payables
$1,000,000
$1,000,000
ANSWER
. This problem is more complex
the tax effects occur prior to settling interaffili
for the
90 days?
cash. The Swiss unit's taxes are now $325,000/month (.25 x $1,300,000) as compared with $25
Value
offirst
tax write-offs
-500,000
-500,000
-500,000
while the German unit's monthly tax write-off has risen to $650,000 (.5 x $1,300,000) as comp
before.
ANSWER
. This
problem is more complex because
the tax effects
occur prior to settling
interaffiliate accounts with
Net cash
outflow
$500,000
$500,000
$500,000
Cash Flows for Swiss Affiliate
cash. The Swiss unit's taxes are now $325,000/month (.25 x $1,300,000) as compared with $250,000 previously,
Month
3
while
the German
unit's
monthly tax write-off
has risen to-$1,150,000
$650,000 (.5 x $1,300,000)
as1 compared20 to $500,000
Change
in net cash
outflow
-$150,000
$150,000
$100,000
$1,300,000
New Terms
Collection of receivables -$1,150,000
-325,000
-325,000
-325,000
before.
Cumulative change
-$150,000
-$1,300,000
Tax payments
Net cash inflow
$675,000
-$325,000
$975,000
2
0
-650,000
3
$1,300,000
-650,000
-$650,000
$650,000
$1,000,000
-500,000
$1,000,000
-500,000
$500,000
$500,000
-$1,150,000
$150,000
Flows
Swiss Affiliate
TheCash
net result
of for
the simultaneous
change in credit terms and transfer price is that for the first 90 days the Swiss unit's
Old terms
b.
Assume
the
tax
rate
is
25
percent
in
Switzerland
and 50 percent
in Germany
and that revenues
are taxed
and
after-tax
cash
inflow
drops
by $925,000
and
theis the
German
unit's
after-tax
cash outflow
falls by1,000,000
$1,150,000.
The
Collection
of receivables
1,000,000
1,000,000
costs
deducted
upon
sale
or
purchase
of
goods,
not
upon
collection.
What
impact
on
after-tax
cash
flows
Month
1
2
3
-250,000
-250,000
-250,000in
$225,000
inpayments
transfer price which leads
to a shift
of $300,000
for the first gain
90 days?in net cash flow is attributable to the changeTax
$100,000 or a Net
0
$1,300,000
New Terms income from Germany to Switzerland,
cashof
inflow
$750,000
$750,000
reported
shift
$900,000
over
the $750,000
first 90 days.
Because income
ANSWER. Thismonthly
problem is more complex because the tax effects occur prior to settling interaffiliate
accounts
with
Collection
-325,000
-325,000
cash.Switzerland
The Swiss unit'sof
taxes
are nowat
$325,000/month
(.25 x $1,300,000)
as comparedincome
with $250,000
previously,
in
is receivables
taxed
a rate of 25%,
while-325,000
German
is
taxed
50%, the
net -$75,000
effect of -$1,075,000
this income shift
for
Change
in net cashatinflow
$225,000
whileTax
the German
unit's
monthly
tax
write-off
has
risen
to
$650,000
(.5
x
$1,300,000)
as
compared
to
$500,000
Cumulative change
-$75,000
-$1,150,000
-$925,000
payments
the
first three months is to save an amount of taxes equal to $900,000 x (.50 - .25) = $225,000.
before.
Net cash inflow
$675,000
Cash Flows for Swiss Affiliate
Month
New Terms
Collection of receivables
Tax payments
1
2
0
-325,000
3
$1,300,000
-325,000
$100,000
Old terms
Collection of receivables -325,000
Tax payments
Net cash inflow
$675,000
1,000,000
-250,000
-$325,000
$975,000
Old terms
Collection of receivables
Tax payments
1,000,000
-250,000
Net cash inflow
1,000,000
-250,000
$750,000
1,000,000
-250,000
Change in net cash inflow$750,000
Cumulative
change
Change
in net cash inflow
-$75,000
$750,000
-$75,000
-$1,075,000 -$75,000
$225,000
Cumulative change
-$1,150,000
Net cash inflow
-$75,000
$750,000
-$925,000
-$325,000
$975,000
Cash Flows for German Affiliate
Month
New Terms
Payment of payables
Value of tax write-offs
1,000,000
-250,000
Net cash outflow
Old terms
Payment of payables
Value of tax write-offs
$750,000
-$1,075,000
Net cash outflow
-$1,150,000
Change in net cash outflow
1
$1,000,000
-650,000
1,000,000
-250,000
$350,000
$750,000
$1,000,000
-500,000
$225,000
$500,000
-$925,000
-$150,000
-$150,000 Dimond
-$1,300,000
-$1,150,000
Michael
ofandBusiness
Administration
The net result of the simultaneous change inSchool
credit terms
transfer price
is that for the first 90 da
Cumulative change