Voyevodins' Library _ "International Business: Competing in the Global Marketplace" / Charles W.L. Hill ... Chapter 20 ... subsidy, swaps, systematic risk, tariff, tax credit, tax haven, tax treaty, technical analysis, temporal method, theocratic totalitarianism, time draft, time-based competition, timing of entry, total quality management, totalitarianism, trade creation, trade deficit, trade diversion, trade surplus, trademark, transaction costs, transaction exposure, transfer fee, transfer price, translation exposure, transnational corporation, transnational financial reporting, transnational strategy, Treaty of Rome, tribal totalitarianism, turnkey project, unbundling, uncertainty avoidance, universal needs, value creation, values, vehicle currency, vertical differentiation, vertical foreign direct investment, vertical integration, voluntary export restraint (VER), wholly owned subsidiary, World Bank, World Trade Organization (WTO), worldwide area structure, worldwide product division structure, zero-sum game Voevodin's Library: subsidy, swaps, systematic risk, tariff, tax credit, tax haven, tax treaty, technical analysis, temporal method, theocratic totalitarianism, time draft, time-based competition, timing of entry, total quality management, totalitarianism, trade creation, trade deficit, trade diversion, trade surplus, trademark, transaction costs, transaction exposure, transfer fee, transfer price, translation exposure, transnational corporation, transnational financial reporting, transnational strategy, Treaty of Rome, tribal totalitarianism, turnkey project, unbundling, uncertainty avoidance, universal needs, value creation, values, vehicle currency, vertical differentiation, vertical foreign direct investment, vertical integration, voluntary export restraint (VER), wholly owned subsidiary, World Bank, World Trade Organization (WTO), worldwide area structure, worldwide product division structure, zero-sum game



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Chapter 20 Outline

Moving Money Across Borders:
Attaining Efficiencies and Reducing Taxes

Pursuing the objectives of utilizing the firm's cash resources most efficiently and minimizing the firm's global tax liability requires the firm to be able to transfer funds from one location to another around the globe. International businesses use a number of techniques to transfer liquid funds across borders. These include dividend remittances, royalty payments and fees, transfer prices, and fronting loans. Some firms rely on more than one of these techniques to transfer funds across borders--a practice known as unbundling. By using a mix of techniques to transfer liquid funds from a foreign subsidiary to the parent company, unbundling allows an international business to recover funds from its foreign subsidiaries without piquing host-country sensitivities with large "dividend drains."

A firm's ability to select a particular policy is severely limited when a foreign subsidiary is part-owned either by a local joint venture partner or by local stockholders. Serving the legitimate demands of the local co-owners of a foreign subsidiary may limit the firm's ability to impose the kind of dividend policy, royalty payment schedule, or transfer pricing policy that would be optimal for the parent company.

Dividend Remittances

Payment of dividends is probably the most common method by which firms transfer funds from foreign subsidiaries to the parent company. The dividend policy typically varies with each subsidiary depending on such factors as tax regulations, foreign exchange risk, the age of the subsidiary, and the extent of local equity participation. For example, the higher the rate of tax levied on dividends by the host-country government, the less attractive this option becomes relative to other options for transferring liquid funds. With regard to foreign exchange risk, firms sometimes require foreign subsidiaries based in "high-risk" countries to speed up the transfer of funds to the parent through accelerated dividend payments. This moves corporate funds out of a country whose currency is expected to depreciate significantly. The age of a foreign subsidiary influences dividend policy in that older subsidiaries tend to remit a higher proportion of their earnings in dividends to the parent, presumably because a subsidiary has fewer capital investment needs as it matures. Local equity participation is a factor because local co-owners' demands for dividends must be recognized.

Royalty Payments and Fees

Royalties represent the remuneration paid to the owners of technology, patents, or trade names for the use of that technology or the right to manufacture and/or sell products under those patents or trade names. It is common for a parent company to charge its foreign subsidiaries royalties for the technology, patents, or trade names it has transferred to them. Royalties may be levied as a fixed monetary amount per unit of the product the subsidiary sells or as a percentage of a subsidiary's gross revenues.

A fee is compensation for professional services or expertise supplied to a foreign subsidiary by the parent company or another subsidiary. Fees are sometimes differentiated into "management fees" for general expertise and advice and "technical assistance fees" for guidance in technical matters. Fees are usually levied as fixed charges for the particular services provided.

Royalties and fees have certain tax advantages over dividends, particularly when the corporate tax rate is higher in the host country than in the parent's home country. Royalties and fees are often tax deductible locally (because they are viewed as an expense), so arranging for payment in royalties and fees will reduce the foreign subsidiary's tax liability. If the foreign subsidiary compensates the parent company by dividend payments, local income taxes must be paid before the dividend distribution, and withholding taxes must be paid on the dividend itself. Although the parent can often take a tax credit for the local withholding and income taxes it has paid, part of the benefit can be lost if the subsidiary's combined tax rate is higher than the parent's.

Transfer Prices

In any international business, there are normally a large number of transfers of goods and services between the parent company and foreign subsidiaries and between foreign subsidiaries. This is particularly likely in firms pursuing global and transnational strategies because these firms are likely to have dispersed their value creation activities to various "optimal" locations around the globe (see Chapter 12). As noted in Chapter 19, the price at which goods and services are transferred between entities within the firm is referred to as the transfer price.12

Transfer prices can be used to position funds within an international business. For example, funds can be moved out of a particular country by setting high transfer prices for goods and services supplied to a subsidiary in that country and by setting low transfer prices for the goods and services sourced from that subsidiary. Conversely, funds can be positioned in a country by the opposite policy: setting low transfer prices for goods and services supplied to a subsidiary in that country and setting high transfer prices for the goods and services sourced from that subsidiary. This movement of funds can be between the firm's subsidiaries or between the parent company and a subsidiary.

Benefits of Manipulating Transfer Prices

At least four gains can be derived by manipulating transfer prices.

  1. The firm can reduce its tax liabilities by using transfer prices to shift earnings from a high-tax country to a low-tax one.

  2. The firm can use transfer prices to move funds out of a country where a significant currency devaluation is expected, thereby reducing its exposure to foreign exchange risk.

  3. The firm can use transfer prices to move funds from a subsidiary to the parent company (or a tax haven) when financial transfers in the form of dividends are restricted or blocked by host-country government policies.
  1. The firm can use transfer prices to reduce the import duties it must pay when an ad valorem tariff is in force--a tariff assessed as a percentage of value. In this case, low transfer prices on goods or services being imported into the country are required. Since this lowers the value of the good or services, it lowers the tariff.

Problems with Transfer Pricing

Significant problems are associated with pursuing a transfer pricing policy. Few governments like it.13 When transfer prices are used to reduce a firm's tax liabilities or import duties, most governments feel they are being cheated of their legitimate income. Similarly, when transfer prices are manipulated to circumvent government restrictions on capital flows (e.g., dividend remittances), governments perceive this as breaking the spirit--if not the letter--of the law. A number of governments limit international businesses' ability to manipulate transfer prices in the manner described. The United States has strict regulations governing transfer pricing practices. According to Section 482 of the Internal Revenue Code, the Internal Revenue Service (IRS) can reallocate gross income, deductions, credits, or allowances between related corporations to prevent tax evasion or to reflect more clearly a proper allocation of income. Under the IRS guidelines and subsequent judicial interpretation, the burden of proof is on the taxpayer to show that the IRS has been arbitrary or unreasonable in reallocating income. The correct transfer price, according to the IRS guidelines, is an arm's-length price--the price that would prevail between unrelated firms in a market setting. Such a strict interpretation of what is a correct transfer price theoretically limits a firm's ability to manipulate transfer prices to achieve the benefits we have discussed. In reality, however, transfer pricing is still widely practiced, as indicated in the accompanying Management Focus which looks at transfer pricing in the United States and Japan.

Another problem associated with transfer pricing is related to management incentives and performance evaluation.14 Transfer pricing is inconsistent with a policy of treating each subsidiary in the firm as a profit center. When transfer prices are manipulated by the firm and deviate significantly from the arm's-length price, the subsidiary's performance may depend as much on transfer prices as it does on other pertinent factors, such as management effort. A subsidiary told to charge a high transfer price for a good supplied to another subsidiary will appear to be doing better than it actually is, while the subsidiary purchasing the good will appear to be doing worse. Unless this is recognized when performance is being evaluated, serious distortions in management incentive systems can occur. For example, managers in the selling subsidiary may be able to use high transfer prices to mask inefficiencies, while managers in the purchasing subsidiary may become disheartened by the effect of high transfer prices on their subsidiary's profitability.

Despite these problems, research suggests that many international businesses do not use arm's-length pricing but instead use some costbased system for pricing transfers among their subunits (typically cost plus some standard markup). A survey of 164 US multinational firms found that 35 percent of the firms used marketbased prices, 15 percent used negotiated prices, and 65 percent used a costbased pricing method. (The figures add up to more than 100 percent because some companies use more than one method.)15 Only market and negotiated prices could reasonably be interpreted as arm's-length prices. The opportunity for price manipulation is much greater with costbased transfer pricing.

Although a firm may be able to manipulate transfer prices to avoid tax liabilities or circumvent government restrictions on capital flows across borders, this does not mean the firm should do so. Since the practice often violates at least the spirit of the law in many countries, the ethics of engaging in transfer pricing are dubious at best.

Fronting Loans

A fronting loan is a loan between a parent and its subsidiary channeled through a financial intermediary, usually a large international bank. In a direct intrafirm loan, the parent company lends cash directly to the foreign subsidiary, and the subsidiary repays it later. In a fronting loan, the parent company deposits funds in an international bank, and the bank then lends the same amount to the foreign subsidiary. Thus, a US firm might deposit $100,000 in a London bank. The London bank might then lend that $100,000 to an Indian subsidiary of the firm. From the bank's point of view, the loan is risk free because it has 100 percent collateral in the form of the parent's deposit. The bank "fronts" for the parent, hence the name. The bank makes a profit by paying the parent company a slightly lower interest rate on its deposit than it charges the foreign subsidiary on the borrowed funds.

Firms use fronting loans for two reasons. First, fronting loans can circumvent host-country restrictions on the remittance of funds from a foreign subsidiary to the parent company. A host government might restrict a foreign subsidiary from repaying a loan to its parent in order to preserve the country's foreign exchange reserves, but it is less

20.01

Figure 20.1

An Example of the Tax Aspects of a Fronting Loan

likely to restrict a subsidiary's ability to repay a loan to a large international bank. To stop payment to an international bank would hurt the country's credit image, whereas halting payment to the parent company would probably have a minimal impact in its image. Consequently, international businesses sometimes use fronting loans when they want to lend funds to a subsidiary based in a country with a fairly high probability of political turmoil that might lead to restrictions on capital flows (i.e., where the level of political risk is high).

A fronting loan can also provide tax advantages. For example, a tax haven (Bermuda) subsidiary that is 100 percent owned by the parent company deposits $1 million in a London-based international bank at 8 percent interest. The bank lends the $1 million to a foreign operating subsidiary at 9 percent interest. The country where the foreign operating subsidiary is based taxes corporate income at 50 percent (see Figure 20.1).

Under this arrangement, interest payments net of income tax will be as follows:

  1. The foreign operating subsidiary pays $90,000 interest to the London bank. Deducting these interest payments from its taxable income results in a net after-tax cost of $45,000 to the foreign operating subsidiary.

  2. The London bank receives the $90,000. It retains $10,000 for its services and pays $80,000 interest on the deposit to the Bermuda subsidiary.

  3. The Bermuda subsidiary receives $80,000 interest on its deposit tax free.

The net result is that $80,000 in cash has been moved from the foreign operating subsidiary to the tax haven subsidiary. Because the foreign operating subsidiary's after-tax cost of borrowing is only $45,000, the parent company has moved an additional $35,000 out of the country by using this arrangement. If the tax haven subsidiary had made a direct loan to the foreign operating subsidiary, the host government may have disallowed the interest charge as a tax-deductible expense by ruling that it was a dividend to the parent disguised as an interest payment.

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