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CHAPTER 20 MANAGING THE MULTINATIONAL FINANCIAL SYSTEM Chapter 20 describes the nature of the multinational financial system and why the ability to shift profits and funds internally is potentially of far greater value to the MNC than to the purely domestic firm. It points out that the value of the multinational financial system arises out of the firm's ability to use it to take advantage through arbitrage of market imperfections and tax differences. The three principal forms of arbitrage opportunities discussed include: 1.



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.



2.



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.



3.



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.



The chapter then analyzes at length the most important conduits used by MNCs to transfer funds and profits internally: transfer pricing, fees and royalties, dividends, loans, leads and lags, and parent investment as debt or equity. It also illustrates the close relationship between a firm's marketing, production, and logistics decisions (i.e., its real decisions) and its financial decisions. The greater the internal transfer of goods, technology, capital, and materials worldwide, the greater the scope for financial activities to enhance the value of the MNC globally. When teaching this material, I always emphasize the potential conflicts with home and host country governments inherent in taking advantage of the various arbitrage opportunities presented. An article that illustrates this point is M. Edgar Barrett, "Case of the Tangled Transfer Price," Harvard Business Review, May-June 1977, pp. 20-36.



SUGGESTED ANSWERS TO CHAPTER 20 QUESTIONS 1.a. What is the internal financial transfer system of the multinational firm? ANSWER. The internal financial transfer system of the multinational firm is the collection of internal transfer mechanisms that enables the MNC to move money and profits among its various affiliates. These mechanisms for fund flows within the MNC stem from the internal transfer of goods, services, technology, and capital. b.



What are its distinguishing characteristics?



ANSWER. Although the financial transfer mechanisms available to the MNC exist among independent firms, the MNC has greater control over the mode and timing of these financial transfers. The MNC has considerable freedom in selecting the financial channels through which funds and allocated profits are moved. In addition, most MNCs have some flexibility regarding the timing of fund flows. They can speed up or slow down dividend payments, loan repayments, and payments for fees, royalties, and interaffiliate sales of goods and services. c.



What are the different modes of internal fund transfers available to the MNC?



ANSWER. The mechanisms for transferring funds internally include transfer prices on goods and services traded internally, intracorporate loans and equity investments, dividend payments, leading (speeding up) and lagging (slowing down) intercompany payments, and fee and royalty charges.



2 2.



How does the internal financial transfer system add value to the multinational firm?



ANSWER. The MNC's ability to transfer funds and profits internally may enable it to reduce its tax payments globally, circumvent currency controls and other regulations, and tap previously inaccessible investment and financing opportunities. 3.



California, like several other states, applies the unitary method of taxation to firms doing business within the state. Under the unitary method a state determines the tax on a company's worldwide profit through a formula based on the share of the company's sales, assets, and payroll falling within the state. In California's case, the share of worldwide profit taxed is calculated as the average of these three factors.



a.



What are the predictable corporate responses to the unitary tax?



ANSWER. Aside from lobbying against such a tax, firms can be expected to modify their business activities in such a way as to reduce the incidence of the unitary tax. In California, for example, this would mean moving assets and employees out of the state and using transfer prices to lower the value of reported in-state sales. b.



What economic motives might help explain why Oregon, Florida, and several other states have eliminated their unitary tax schemes?



ANSWER. These states were losing a lot of new investment, because any firm that increased its in-state assets was assessed a higher unitary tax. By eliminating unitary taxes, these states were able to better compete for new investments with states that do not impose a unitary tax. 4.



In comparisons of a multinational firm's reported foreign profits with domestic profits, caution must be exercised. This same caution must also be applied when analyzing the reported profits of the firm's various subsidiaries. Only coincidentally will these reported profits correspond to actual profits.



a.



Describe five different means that MNCs use to manipulate reported profitability among their various units.



ANSWER. MNCs can manipulate reported profit by adjusting transfer prices of goods, fees and royalties linked to patents, trademarks, and management assistance, allocated overhead, and interest rates on interaffiliate debt. The parent can also adjust the amount of equity it invests and, hence, the amount of debt and interest payments the unit must bear. b.



What adjustments to its reported figures would be required to compute the true profitability of a firm's foreign operations so as to account for these distortions?



ANSWER. "True profitability" is an amorphous concept, but basically it involves determining the marginal revenue and marginal costs associated with the unit. In effect, it is necessary to determine worldwide cash flows with the unit less worldwide cash flows without the unit. This involves adding back allocated corporate overhead in excess of the amount attributable to managing the unit, adjusting transfer prices to reflect marginal costs, and adding back fees and royalties on patents and trademarks that would otherwise go unused. Chapter 17 discussed other adjustments. c.



Describe at least three reasons that might explain some of these manipulations.



ANSWER. Firms manipulate transfer prices on goods and services in order to reduce total tax and tariff payments, to get around currency controls, and to access lower cost sources of funds.



5.



In 1987, U.S.-controlled companies earned an average 2.09 percent return on assets, nearly four times their foreign-controlled counterparts. A number of American politicians have used these figures to argue that there is widespread tax cheating by foreign-owned multinationals.



a.



What are some economically plausible reasons (other than tax evasion) that would explain the low rates of return earned by foreign-owned companies in the United States? Consider the consequences of the debt-financed U.S.-investment binge that foreign companies went on during the 1980s and the dramatic depreciation of the U.S. dollar beginning in 1985.



ANSWER. The 1980s buying binge in the U.S. meant big interest payments on acquisition debt and huge depreciation write-offs for newly acquired plant and equipment. Both depressed the bottom line, lowering tax liability. Many foreign companies have also spent millions building factories in the U.S., and that generates even more write-offs and lowers the reported return on assets. In addition, new investment usually involves high start-up costs, lowering initial returns as well. Moreover, historical-cost accounting means that the book value of older (mostly American) assets is often far below market value. So returns on these assets appear higher than those on newer, foreign investment. The devaluation of the dollar also raised the dollar cost of components imported into the United States. b.



What are some of the mechanisms that foreign-owned companies can use to reduce their tax burden in the U.S.?



ANSWER. They can raise transfer prices on goods and services supplied to their U.S. affiliates and lower them on goods and services exported to their non-U.S. units. They can also force their U.S. affiliates to have more debt in their capital structures to gain the interest tax shield. c.



The corporate tax rate in Japan is 60 percent, whereas it is 34 percent in the United States. Are these figures consistent with the argument that big Japanese companies are overcharging their U.S. subsidiaries in order to avoid taxes? Explain.



ANSWER. Since the Japanese corporate tax rate at 60% is almost double the 34% U.S. corporate tax rate, the taxminimizing strategy for Japanese firms would be to shift profit from Japan to the United States. Thus, these figures are inconsistent with the tax avoidance story. However, some observers claim that Japanese companies that shift profits to Japan, and thereby boost Japanese tax revenue at the expense of the United States, are "taken care of" by their government in other ways. Another explanation for shifting profit to Japan is that Japanese culture is such that everything goes to make the head office look more profitable.



ADDITIONAL CHAPTER 20 QUESTIONS AND ANSWERS 1.



In what aspect of an MNC's multinational financial system does its value reside?



ANSWER. The multinational financial system enables the MNC to engage in tax arbitrage, financial market arbitrage, and regulatory system arbitrage. 2.



Under what circumstances is leading and lagging likely to be of most value?



ANSWER. Leading and lagging has minimal impact on taxes and is of little value in currency risk management since companies can hedge their exchange risk in other ways. Expropriation risk can be managed, if need be, by shifting assets out of the country. The major value of leading and lagging is to enable firms to elude exchange and capital controls. 3.



What are the principal advantages of investing in foreign affiliates in the form of debt instead of equity?



ANSWER. By investing in the form of debt rather than equity, companies may be able to reduce their taxes (because principal repayments are treated as a return of capital and are not taxed) and to avoid currency controls (because governments are more reluctant to block loan repayments, even to a parent, than dividend payments).



SUGGESTED SOLUTIONS TO CHAPTER 20 PROBLEMS 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 percent and 50 percent, respectively.



a.



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? Explain.



ANSWER. Switching from a transfer price of $27,000 to a new transfer price P will lead to a monthly tax savings of 1,500(27,000 - P)(.45 - .50). Tax savings are maximized when P is set equal to $30,000. In effect, the firm will be shifting profits from France, where they are taxed at 50%, to Canada, where they are taxed at 45%. b.



Suppose the French government imposes an ad valorem tariff of 15 percent on imported tractors. How would this affect the optimal transfer pricing strategy?



ANSWER. If the ad valorem tariff is paid by the French affiliate and is tax deductible, a change in the transfer price from $27,000 to P will lead to monthly tax savings of 1,500(27,000 - P)[.45 + .15 - .50(1.15)] = 1,500(27,000 - P) (.025). In order to maximize the tax savings, P should now be set at its minimum level of $25,000. c.



If the transfer price of $27,000 is set in euros and the euro revalues by 5 percent, what will happen to the firm's overall tax bill? Consider the tax consequences both with and without the 15 percent tariff.



ANSWER. A 5% euro revaluation will increase the dollar value of the transfer price to $28,350. In the absence of a tariff, total taxes paid monthly will decline by 1,500(27,000 - 28,350)(.45 - .50) = $101,250. With a 15% tariff, monthly taxes will increase by 1,500(28,350 - 27,000)[.45 + .15 - .50(1.15)] = $50,625. d.



Suppose the transfer price is increased from $27,000 to $30,000 and credit terms are extended from 90 days to 180 days. What are the fund-flow implications of these adjustments?



ANSWER. Ignoring taxes, the month-by-month cash flows from the French affiliate to the Canadian affiliate before and after the changes in the transfer price and credit terms are: Cash Flow/Month ($ million)



1



2



3



4



5



6



7+



New Original



0 40.5



0 40.5



0 40.5



40.5 40.5



40.5 40.5



40.5 40.5



45.0 40.5



Net change Cumulative change



-40.5 -40.5



-40.5 -81.0



-40.5 -121.5



0 -121.5



0 -121.5



0 -121.5



4.5 -117.0



These calculations assume that the new credit terms will be applied retroactively to previous credit sales. 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. 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



b.



Assume the 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 is the impact on after-tax cash flows for the first 90 days?



ANSWER. This problem is more complex because the tax effects occur prior to settling interaffiliate accounts with cash. The Swiss unit's taxes are now $325,000/month (.25 x $1,300,000) as compared with $250,000 previously, while the German unit's monthly tax write-off has risen to $650,000 (.5 x $1,300,000) as compared to $500,000 before.



Cash Flows for Swiss Affiliate Month New Terms Collection of receivables Tax payments



1 $100,000 -325,000



2 0 -325,000



3 $1,300,000 -325,000



Net cash inflow



$675,000



-$325,000



$975,000



Old terms Collection of receivables Tax payments



1,000,000 -250,000



1,000,000 -250,000



1,000,000 -250,000



Net cash inflow



$750,000



$750,000



$750,000



Change in net cash inflow Cumulative change



-$75,000 -$75,000



-$1,075,000 -$1,150,000



$225,000 -$925,000



1 $1,000,000 -650,000



2 0 -650,000



3 $1,300,000 -650,000



$350,000



-$650,000



$650,000



$1,000,000 -500,000



$1,000,000 -500,000



$1,000,000 -500,000



$500,000



$500,000



$500,000



-$150,000 -$150,000



-$1,150,000 -$1,300,000



$150,000 -$1,150,000



Cash Flows for German Affiliate Month New Terms Payment of payables Value of tax write-offs Net cash outflow Old terms Payment of payables Value of tax write-offs Net cash outflow Change in net cash outflow Cumulative change



The net result of the simultaneous change in credit terms and transfer price is that for the first 90 days the Swiss unit's after-tax cash inflow drops by $925,000 and the German unit's after-tax cash outflow falls by $1,150,000. The $225,000 gain in net cash flow is attributable to the change in transfer price which leads to a shift of $300,000 in reported monthly income from Germany to Switzerland, or a shift of $900,000 over the first 90 days. Because income in Switzerland is taxed at a rate of 25%, while German income is taxed at 50%, the net effect of this income shift for the first three months is to save an amount of taxes equal to $900,000 x (.50 - .25) = $225,000. 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?



ANSWER. 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. 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.



ADDITIONAL CHAPTER 20 PROBLEMS AND SOLUTIONS 1.



Suppose that covered after-tax lending and borrowing rates for three units of Eastman Kodak--located in the United States, France, and Germany--are:



United States France Germany



Lending (%)



Borrowing (%)



3.1 3.0 3.2



3.9 4.2 4.4



Currently, the French and German units owe $2 million and $3 million, respectively, to their U.S. parent. The German unit also has $1 million in payables outstanding to its French affiliate. The timing of these payments can be changed by up to 90 days in either direction. Assume that Kodak U.S. is borrowing funds while both the French and German subsidiaries have excess cash available. a.



What is Kodak's optimal leading and lagging strategy?



The following matrix of effective after-tax dollar interest rate differentials, which is based on the covered rates presented in the problem, can be used to determine the value of leading and lagging for Kodak. The countries on the top of the matrix are those which receive payment from the countries listed on the left. Each subsidiary column is subdivided into "L" and "B." The "L" column is applicable if the unit has excess funds which it can invest in the local money market. The "B" column is applicable if the subsidiary is currently borrowing on the local money market or would have to borrow in order to pay an intercompany account. ANSWER.



Receiving Units U.S. Paying Units U.S. France Germany



L L B L B L B



0.1 -1.1 -0.1 -1.2



France B



0.9 -0.3 0.7 -0.5



Germany



L



B



L



B



-0.1 -0.9



1.1 0.3



-0.2 -1.4



1.0 -0.2



0.1 -0.7 0.2 -1.0



1.3 0.5 1.4 0.2



The entries refer to the dollar interest differentials that exist between each pair of affiliates given their current liquidity status. If this interest differential is positive, Kodak as a whole, by leading payments between the respective units, will either pay less on its borrowings or earn more interest on its investments. Lagging will be worthwhile if the interest differential is negative. According to the prevailing interest differentials, both subs should speed up their payments to the parent while the German unit should lag its payments to the French firm. b.



What is the net profit impact of these adjustments?



ANSWER. The net effect of these adjustments is that Kodak U.S. reduces its borrowings by $5,000,000, the German unit has $2,000,000 less in cash, and the French affiliate winds up with a decrease in its cash balances of $3,000,000, all for 90 days. U.S. interest expense is pared by $48,750 ($5,000,000 x .039 x 90/360) while German and French interest income are reduced by $16,000 ($2,000,000 x .032 x 90/360) and $22,500 ($3,000,000 x .03 x 90/360), respectively, for a net savings of $10,250. This savings can be computed more directly by taking the interest differentials from the appropriate cells of the matrix. These differentials (in %) are: -.9 (France "L" - U.S. "B"); -.7 (Germany "L" - U.S. "B"); and -.2 (Germany "L" - France "L"). Net interest saved equals .25[.009($2,000,000) + .007($3,000,000) + .002($1,000,000)] = $10,250. Moreover, for each additional 90 days that this new payment schedule exists, net interest savings worldwide will be $10,250. c.



How would Kodak's optimal strategy and associated benefits change if the U.S. parent has excess cash available?



ANSWER. If Kodak U.S. has excess cash, then the prevailing interest differentials indicate that the French affiliate should lag its payments to both the U.S. and French units. The higher interest earnings associated with this strategy can be calculated directly using the interest differentials taken from the matrix in part a). These differentials are: .1(U.S. "L" - France "L"); .1(Germany "L" - U.S. "L"); and .2(Germany "L" - France "L"). Net additional interest earnings then are 1/4[.001($2,000,000) + .001($3,000,000) + .002($1,000,000)] = $1,750. 2.



Suppose that in the section titled Dividends, International Products has $500,000 in excess foreign tax credits available. How will this situation affect its dividend remittance decision?



ANSWER. Even if IP has $500,000 in excess foreign tax credits available, the company should still pay dividends out of its German affiliate. Since the French tax rate exceeds 46%, IP does not pay U.S. tax on dividends from France. Hence, paying dividends out of France does not save any U.S. taxes. If the dividend is paid by the Irish affiliate, IP saves $460,000 in tax, cutting worldwide taxes to $2,020,000. But this still exceeds worldwide taxes of $1,910,000 if the dividend is paid by the German affiliate.



3.



Suppose affiliate A sells 10,000 chips monthly to affiliate B at a unit price of $15. Affiliate A's tax rate is 45%, and affiliate B's tax rate is 55%. In addition, affiliate B must pay an ad valorem tariff of 12% on its imports. If the transfer price on chips can be set anywhere between $11 and $18, how much can the total monthly cash flow of A and B be increased by switching to the optimal transfer price?



ANSWER. For each $1 increase in income shifted from B to A, A's taxes rise by $.45. At the same time, B owes an extra $.12 in tariffs. The before-tax increase of $1.12 in B's cost gives it a tax write-off worth $1.12 x .55 = $.616. By shifting $1 in income from B to A, the effect is to lower B's tax payments by $.616 and raise its tariffs by $.12, a net decrease in tax plus tariff payments of $.496. The net effect of switching $1 in income from B to A is to lower tax plus tariff payments to the world by $.496 - .45 = $.046. Thus, the transfer price should be set as high as possible in order to shift as much income to A from B as possible. The new transfer price should, therefore, be set at $18, a $3 increase over the old transfer price. The resulting increase in monthly cash flow is $.046 x 3 x 10,000 = $1,380. 4.



Suppose GM France sells goods worth $2 million monthly to GM Denmark on 60-day credit terms. A switch in credit terms to 90 days will involve a one-time shift of how much money between the two affiliates?



ANSWER. Under the old 60-day terms, GM France is carrying two month's worth of sales as receivables or $4 million. By switching credit terms to 90 days, GM France will now carry receivables equal to three month's worth of sales or $6 million. The net result is a transfer of $2 million from GM France to GM Denmark. 5.



Merck Mexicana SA, the wholly owned affiliate of the U.S. pharmaceutical firm, is considering alternative financing packages for its increased working capital needs resulting from growing market penetration. Ps 250 million are needed over the next six months and can be financed as follows: --From the Mexican banking system at the semiannual rate of 50%. --From the U.S. parent company at the semiannual rate of 6%. The parent company loan would be denominated in dollars and would have to be repaid through the floating-exchange-rate tier of the Mexican exchange market. The exchange loss would, thus, be fully incurred by the Mexican subsidiary. The exchange rate as of March 1, 1984, was Ps 250 = $1 and widely expected to depreciate further.



a.



If interest payments can be made through the stabilized tier of the Mexican exchange market where the dollar is worth Ps 125, what is the break-even exchange rate on the floating tier that would make Merck Mexicana indifferent between dollar and peso financing?



ANSWER. If it borrows pesos from the Mexican bank at a 180-day interest rate of 50%, Merck Mexicana will owe before-tax dollar principal plus interest payments in 180 days equal to 250,000,000(1 + .50) x e180 = 375,000,000e180 where e180 is the (unknown) spot rate in 180 days. Alternatively, if Merck Mexicana uses dollar financing, it would need to borrow $1 million (the dollar equivalent of Ps 250 million at the current exchange rate of Ps 250 = $1). At a semesterly rate of 6%, the total dollar interest plus principal payments owed in 180 days would be $1,000,000 + 125,000,000 x .e180 = $1,000,000 + 7,500,000e180 The latter term reflects the fact that interest payments can be made at an exchange rate of Ps 125 to the dollar or a total of Ps 125,000,000 x .06 in peso interest payments on a loan of $1 million at 6% interest.



The breakeven exchange rate--the rate at which the dollar cost of peso financing just equals the dollar cost of dollar financing--can be found by setting the two costs equal: 375,000,000e180 = 1,000,000 + 7,500,000e180 The solution is Ps 1 = $.00272 or Ps 367.50 = $1. b.



Merck Mexicana imports from its U.S. parent $500,000 worth of chemical compounds monthly, payable on a 90-day basis. Suppose that the parent adjusts its transfer prices so that Merck Mexicana must now pay $700,000 monthly for its chemical supplies. All payments for imports of chemicals involved in the manufacture of pharmaceuticals are transacted through the stabilized tier of the exchange market. At the current exchange rate of Ps 250 = $1, what is the net before-tax annual benefit to Merck of this transfer price increase?



ANSWER. Because the importation of chemical compounds is carried out through the subsidized tier (i.e., at Ps 125 per dollar) Merck could lend in pesos rather than dollars but charge its subsidiary for the principal loss by setting a higher dollar transfer price. The parent would break even and the subsidiary would effectively pay for the principal loss through the subsidized exchange rate. In effect, Merck Mexicana would be paying back part of the principal at an exchange rate of Ps125 per dollar instead of the market rate, which will be at least Ps 250 = $1. If the dollar appreciates to Ps 300 = $1 from Ps 250 = $1, the dollar principal loss on a $1 million peso-denominated parent loan is $1,000,000 - 250,000,000/300 = $166,667 The term 250,000,000/300 is the peso equivalent of $1 million at an exchange rate of Ps 250 = $1 converted at an end-of-period exchange rate of Ps 300 = $1. To make up the loss on principal repayment, the subsidiary would have to pay $166,667 extra to the parent. At an exchange rate of Ps 125 = $1, this translates into added payments to the parent of Ps 20,833,334 through higher transfer prices. If the loss is to be made up over a period of six months, this means that transfer prices would have to be raised such that monthly imports go up by one-sixth of this amount or Ps 20,830,000/6 = Ps 3,472,223. With current monthly imports of Ps 100 million, this requires a transfer price increase of about 3.47%. 6.



A well-known U.S. firm has a reinvoicing center (RC) located in Geneva. The reinvoicing center handles an annual sales volume of $1.2 billion--$700 million in interaffiliate sales and the rest in third-party sales. The RC buys goods manufactured by the parent company or other subsidiaries and reinvoices the product to other affiliates or third parties. Many of these trades are with "low-volume, highly complex countries." When buying the goods, the RC takes title to them, but it does not take actual possession of the goods. The RC pays the selling company in its own currency and receives payment from the purchasing company in its own currency. What benefits can such a center provide?



ANSWER. The reinvoicing center can provide several benefits to its parent company. It can: a)



Shift liquidity from surplus to deficit affiliates.



b) Centralize management of transaction exposure. c)



Reduce taxes by transfer price adjustments.



d) Assure consistent pricing to customers placing orders with more than one unit. e)



Net intercompany transfers.



f)



Take advantage of economies of scale in financing and investing.



g) Concentrate trading expertise. h) Reduce FX trading costs by dealing in larger volumes i)



Centralize control over finance functions.



NOTES ON INTERAFFILIATE TRANSACTIONS 1.



Overview a) Mode of transfer b) Timing flexibility



2.



Transfer pricing a) Tax effects A sells 100,000 circuit boards annually to B at a unit price of $10. Changing the transfer price to $10.50 will simultaneously increase A's income by $50,000 and decrease B's income by $50,000. If corporate tax rates for A and B are 35% and 50%, respectively, the net effect will be to increase A's taxes by $17,500 and reduce B's taxes by $50,000. Net tax savings are $7,500 annually. b) Section 482 i. what it is ii. its consequences for setting transfer prices c)



3.



Shifting funds The above transfer price change will increase A's after-tax cash flow by $32,500 and reduce B's after-tax cash flow by $25,000.



Invoicing currency a) Importer's currency i. no exposure or tax effects for importer ii. exporter bears the currency exposure and tax effects b) Exporter's currency i. no exposure or tax effects for exporter ii. importer bears the currency exposure and tax effects



4.



Leads and lags a) Shifting liquidity b) Costs and benefits i. take advantage of interest differentials Borrowing rate United States Germany



8.7% 8.1%



7.6% 7.2%



U.S. interest rate - German interest rate for surplus (+) and deficit (-) positions.



+ United States -



Germany + .4% - .5% 1.5%



ii. avoid currency controls iii. exposure management



.6%



c)Information requirements i. intercompany payables and receivables ii. exchange control regulations iii. relevant tax laws iv. affiliate liquidity positions and fund requirements v. sources and availability of funds to each party vi. expected currency changes vii. forward exchange rates viii. currency exposures 5. Dividend planning a)Tax considerations b)Cash requirements c)Currency controls d)Corporate practice 6. Global tax planning a)U.S. taxation of foreign source income i. branches versus subsidiaries ii.foreign tax credits iii. Subpart F income iv. FSCs b)Information requirements i. tax rates by affiliate ii.cross-border tax rates iii. liquidity by affiliate iv. tax credits c)Information requirements i. intercompany payables and receivables ii.exchange control regulations iii. relevant tax laws iv. affiliate liquidity positions and fund requirements v. sources and availability of funds to each party vi. expected currency changes vii. forward exchange rates viii. currency exposures