international finance fin456 ♦ fall 2012 michael dimond

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International Finance FIN456 Fall 2012 Michael Dimond

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Page 1: International Finance FIN456 ♦ Fall 2012 Michael Dimond

International FinanceFIN456 ♦ Fall 2012Michael Dimond

Page 2: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool of Business Administration

International Trade Finance

Page 3: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool of Business Administration

The Trade Relationship

• Trade financing shares a number of common characteristics with traditional value chain activities conducted by all firms– All companies must search out suppliers for goods and services– Must determine if supplier can provide products at required

specifications and quality– All must be at an acceptable price and delivered in a timely manner

Page 4: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool of Business Administration

The Trade Relationship

• Understanding the nature of the relationship between the exporter and the importer is critical to understanding the methods for import-export financing utilized in industry

• Three categories of relationships:– Unaffiliated unknown party– Unaffiliated known party– Affiliated partu

Page 5: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool of Business Administration

Financing Trade: The Flow of Goods and Funds

Page 6: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool of Business Administration

Alternative International Trade Relationships

Page 7: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool of Business Administration

The Trade Dilemma

• International trade must work around a fundamental dilemma:– Imagine an importer and an exporter who would like to do business

with one another– Because of the distance between the two, it is not possible to

simultaneously hand over goods and receive payments in person– How do participants in international trade mitigate the risks associated

with conducting business with a stranger?

Page 8: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool of Business Administration

Key Documents

• As we will see in the following exhibits, letters of credit, order bills of lading and sight drafts are critical in conducting international trade– An example of a letter of credit occurs when an importer obtains a

bank’s promise to pay on its behalf, knowing the exporter will trust the bank

– When the exporter ships the merchandise to the importer’s country, title to the merchandise is given to the bank on a document called an order bill of lading

– The exporter asks the bank to pay for the goods using a sight draft

– The bank, having paid for the goods, now passes title to the importer who eventually reimburses the bank

Page 9: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool of Business Administration

The Mechanics of Import and Export

Page 10: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool of Business Administration

The Bank as the Import/Export Intermediary

Page 11: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool of Business Administration

The Trade Transaction Time-Line and Structure

Page 12: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool of Business Administration

Letter of Credit (L/C)

• Letter of Credit (L/C) is a bank’s conditional promise to pay issued by a bank at the request of an importer in which the bank promises to pay an exporter upon presentation of documents specified in the L/C

• The essence of an L/C is the promise of the issuing bank to pay against specified documents, which means that certain elements must be present for the bank– Issuing bank must receive a fee for issuing L/C– Bank’s L/C must contain specified maturity date– Bank’s commitment must have stated maximum amount– Bank’s obligation must arise only on presentation of specific

documents and bank cannot be called on for disputed items– Bank’s customer must have unqualified obligation to reimburse

bank on same condition of bank’s payment

Page 13: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool of Business Administration

Letter of Credit (L/C)

• Commercial L/C’s are classified as follows– Irrevocable Vs. Revocable – irrevocable letters of credit are non-

cancelable while its opposite can be cancelled at any time– Confirmed Vs. Unconfirmed – An L/C issued by one bank can be

confirmed by another bank

• Advantages of L/Cs are that it reduces risk of default and a confirmed L/C helps secure financing

• Disadvantages of L/Cs are the fees charged and that the L/C reduces the available credit of the importer

Page 14: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool of Business Administration

Parties to a Letter of Credit (L/C)

Page 15: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool of Business Administration

Essence of a Letter of Credit (L/C)

Page 16: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool of Business Administration

Draft

• A draft, sometimes called a bill of exchange (B/E), is the instrument normally used in international commerce to effect payment– It is a written order by an exporter instructing an importer or its agent

to pay a specified amount at a specified time– The party initiating the draft is the maker, drawer, or originator while

the counterpart is the drawee– In a commercial transaction where the buyer is the drawee it is a

trade draft, or the buyer’s bank when it is called a bank draft

Page 17: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool of Business Administration

Draft

• If properly drawn, drafts can become negotiable instruments– As such they provide a convenient instrument for financing the

international movement of merchandise– To become a negotiable instrument, there are four requirements

• Must be written and signed by buyer

• Must contain unconditional promise to pay

• Must be payable on demand or at a fixed date

• Must be payable to bearer

Page 18: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool of Business Administration

Draft

• Types of drafts include– Sight drafts which is payable on presentation to the drawee– Time drafts, also called usance draft, allows a delay in payment. It is

presented to the drawee who accepts it with a promise to pay at some later date

• When a time draft is drawn on a bank, it becomes a banker’s acceptance

• When drawn on a business firm it becomes a trade acceptance

Page 19: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool of Business Administration

• Banker’s Acceptance– When a draft is accepted by a bank, it becomes a banker’s

acceptance– Example: Acceptance of $100,000 for exporter

– Exporter may discount the acceptance note in order to receive the funds up-front

Face amount of acceptance $100,000Less 1.5% p.a. commission for 6 months - 750Amount received by exporter in 6 months $ 99,250Less 7% p.a. discount rate for 6 months - 3,500Amount received by exporter at once $95,750

Banker’s Acceptances

Page 20: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool of Business Administration

Bill of Lading

• Bill of Lading (B/L) is issued to the exporter by a common carrier transporting the merchandise– It serves the purpose of being a receipt, a contract and a document of

title• As a receipt the B/L indicates that the carrier has received the

merchandise

• As a contract the B/L indicates the obligation of the carrier to provide certain transportation

• As a document of title, the B/L is used to obtain payment or written promise of payment before the merchandise is released to the importer

Page 21: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool of Business Administration

Bill of Lading

• Characteristics of the Bill of Lading– A straight B/L provides that the carrier deliver the merchandise to the

designated consignee only– An order B/L directs the carrier to deliver the goods to the order of a

designated party, usually the shipper– A B/L is usually made payable to the order of the exporter

Page 22: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool of Business Administration

Documentation in Typical Trade Transaction• Example: Assume Trident receives order from Canadian

buyer; Trident will export financed under L/C requiring a bill of lading with exporter collecting a time draft accepted by Canadian buyer’s bank– The Canadian buyer places order with Trident– Trident agrees to ship under L/C– Canadian buyer applies to bank (Northland Bank) for L/C to be issued

in favor of Trident for merchandise– Northland Bank issues L/C in favor of Trident and sends it to

Southland Bank (Trident’s bank)

Page 23: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool of Business Administration

Documentation in Typical Trade Transaction

– Trident ships the goods to the Canadian buyer– Trident prepares a time draft and presents it to Southland Bank. The

draft is drawn on Northland Bank with required documents including bill of lading

– Trident endorses the order bill of lading in blank so that title to goods goes with holder of documents – Southland Bank

– Southland Bank presents draft and documents to Northland Bank for acceptance, Northland accepts and promises to pay draft at maturity – 60 days

Page 24: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool of Business Administration

Documentation in Typical Trade Transaction

– Northland Bank returns accepted draft to Southland Bank; Southland Bank could ask for discounted draft receiving funds today

– Southland Bank, now having a banker’s acceptance, may sell the acceptance in the open market or it may hold the acceptance in its own portfolio

– If Southland Bank had kept the acceptance, it would transfer the proceeds less commission to Trident

Page 25: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool of Business Administration

Documentation in Typical Trade Transaction

– Northland Bank notifies Canadian buyer of arrival of documents; Canadian buyer signs note to pay Northern Bank for the merchandise in 60 days

– After 60 days, Northland Bank receives payment from Canadian buyer– On same day, holder of matured acceptance presents it for payment

and receives it face value; it may be presented at Northland Bank or returned to Southland Bank for collection through normal bank channels

Page 26: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool of Business Administration

Steps in a Typical Trade Transaction

Page 27: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool of Business Administration

Government Programs to Help Finance Exports• Governments of most export-oriented industrialized countries

have special financial institutions that provide some form of subsidized credit to their own national exporters

• These export finance institutions offer terms that are better than those generally available from the competitive private sector

• Thus, domestic taxpayers are subsidizing lower financial costs for foreign buyers in order to create employment and maintain a technological edge

Page 28: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool of Business Administration

Government Programs to Help Finance Exports• Export Credit Insurance

– Provides assurance to the exporter or the exporter’s bank that an insurer will pay should the foreign customer default

– In the US the Foreign Credit Insurance Association (FCIA) provides this type of insurance

• Export-Import Bank– Known as the Eximbank, it facilitates the financing of US exports

through various loan guarantee and insurance programs

Page 29: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool of Business Administration

Trade Financing Alternatives

• In order to finance international trade receivables, firms use the same financing instruments as they use for domestic trade receivables including;– Banker’s Acceptances– Trade Acceptances– Factoring– Securitization– Bank Credit Lines Covered by Export Credit Insurance– Commercial Paper

Page 30: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool of Business Administration

Instruments for Financing Short-Term Domestic & International Trade Receivables

Page 31: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool of Business Administration

Forfaiting: Medium and Long Term Financing• Forfaiting is a specialized technique to eliminate the risk of

nonpayment by importers in instances where the importing firm and/or its government is perceived by the exporter to be too risky for open account credit

• The essence of forfaiting is the non-recourse sale by an exporter of bank-guaranteed promissory notes, bills of exchange, or similar documents received from an importer in another country

• The following exhibit outlines a typical forfaiting transaction

Page 32: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool of Business Administration

Typical Forfaiting Transaction

Page 33: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool of Business Administration

Multinational Working Capital Management

Page 34: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool of Business Administration

Working Capital Management

• The operating cycle of a business generates funding needs, cash inflows and outflows – the cash conversion cycle – and foreign exchange rate and credit risks

• The funding needs generated by operations of the firm constitute working capital

• The cash conversion cycle is the period of time extending between cash outflows for purchased inputs and cash inflow from cash settlement

Page 35: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool of Business Administration

Goals and constraints on repositioning MNC funds

Page 36: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool of Business Administration

Repositioning Decisions

• While fund flows between units of a domestic business are generally unimpeded, a firm operating globally faces a variety of considerations which limit its ability to move funds easily and without cost from one country or currency to another;– Political constraints– Tax constraints– Transaction costs– Liquidity needs

Page 37: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool of Business Administration

Repositioning Decisions• Multinational firms often unbundle their transfers of funds into

separate flows for specific purposes• The conduits, or means of moving funds, are separable into those

which are before-tax and after-tax in the host country• These are various conduits available for repositioning funds:

Page 38: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool of Business Administration

• As foreign operations expand, a MNC will increase its inventories and accounts payable as well as accounts receivables

• These components make up net working capital

• Note that short-term debt is not a part of net working capital although it is a part of gross working capital

(A/P) - Inventory) (A/R C)capital(NW gNet workin

Working Capital Funding

Page 39: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool of Business Administration

Working Capital Funding

• The previous slide depicts a key managerial decision for any subsidiary – should A/P be paid off early?

• The alternative financing for NWC is short-term debt– Example: Paraña Electronics is one of Trident’s suppliers; their credit

terms to Trident on a R$180,000 shipment is 5/10 net 60– 5/10 net 60 means that the entire amount is due in 60 days but if

Trident pays within 10 days they will receive a 5% discount– R$180,000 x (1-.05) = R$171,000

Page 40: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool of Business Administration

30.7days 50

days 365

Working Capital Funding

– Managers must decide which is the lower cost method for financing the NWC

– Short-term debt in Brazil costs 24% p.a. so we must compare this cost to the cost of financing offered by Paraña’s credit terms

– Trident is effectively paid 5% for giving up 50 days of financing– Assuming a 365 day count for interest;

Page 41: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool of Business Administration

p.a. 42.%or ,428.1)05.01( 30.7

Working Capital Financing

– To calculate the effective annual interest cost of the supplier financing, the 5% discount for 50 days 7.30 times, yields a cost of carry of

– Paraña is effectively charging Trident 42.8% p.a. for financing as opposed to short-term financing offered at 24% p.a.

Page 42: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool of Business Administration

Working Capital Financing

• Days working capital is a common method used to calculate the NWC of a firm– This method is based on using a “days sales” basis– If the value of A/R, inventories and A/P are divided by the annual daily

sales– The firm’s NWC can be summarized in the number of days sales of

NWC– These results vary among industries and countries so the averages

and levels will vary

Page 43: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool of Business Administration

Days Working Capital for Selected U.S. and European Technology Hardware and Equipment Firms, 2001

Page 44: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool of Business Administration

Working Capital Financing• Intra-Firm working capital

– Within an MNC, the various subsidiaries’ operations create differing levels of payables, inventories and receivables at inter and intra-firm levels

– This can create severe mismatches

Page 45: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool of Business Administration

Working Capital Financing

• Managing Receivables– A firm’s operating cash inflow is derived primarily from the collection

of receivables– There are several factors that go into the management of receivables

• Independent customers – requires decisions about currency of denomination and payments terms

• Payment terms

• Self-liquidating bills – secured by physical inventory that has been sold and the funds are lent based on the securitization

• Other terms

Page 46: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool of Business Administration

18-46

Working Capital Financing

• Inventory Management– Anticipating devaluation – management must decide whether to build

inventory of items that carry foreign exchange exposure– Anticipating price freezes– Free trade zones and free industrial zones – free trade zones

combines the idea of duty-free ports with legislation that reduces customs duties to retailers or manufacturers who structure their operations to benefit from the technique

Page 47: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool of Business Administration

International Cash Management

• International cash management is the set of activities determining the levels of cash balances held throughout the MNC, cash management, and the facilitation of its movement cross border, settlements and processing

• Cash levels are determined independently of working capital management decisions– Cash balances, including marketable securities, are held partly for

day-to-day transactions and to protect against unanticipated variations from budgeted cash flows

– These two motives are called the transaction motive and the precautionary motive

Page 48: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool of Business Administration

International Cash Management

• Cash disbursed for operations is replenished from two sources– Internal working capital turnover– External sourcing, traditionally short-term borrowing

• All firms engage in some sort form of the following steps– Planning – a financial manager anticipates cash flows over future days,

weeks, or months– Collection – controlled through time lags between the the shipment

date and the payment date

– Disbursement – steps included are avoiding unnecessary early payment, maximizing float and selecting a disbursement bank

– Covering cash shortages – anticipated cash shortages can be managed by borrowing locally

– Investing surplus cash – if a subsidiary of an MNC generates surplus cash, the MNC must decide whether to handle its own short-term liquidity or whether surplus funds should be controlled centrally

Page 49: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool of Business Administration

International Cash Settlements & Processing• Four techniques for simplifying and lowering the cost of

settling cash flows between related and unrelated firms– Wire transfers– Cash pooling– Payment netting– Electronic fund transfers

Page 50: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool of Business Administration

International Cash Settlements & Processing• Wire Transfers

– Variety of methods but two most popular for cash settlements are CHIPS and SWIFT

• CHIPS is the Clearing House Interbank Payment System owned and operated by its member banks

• SWIFT is the Society for Worldwide Interbank Financial Telecommunications which also facilitates the wire transfer settlement process

• Whereas CHIPS actually clears transactions, SWIFT is purely a communications system

Page 51: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool of Business Administration

International Cash Settlements & Processing• Cash Pooling and Centralized Depositories

– Businesses with widely dispersed operating subsidiaries can gain operational benefits by centralizing cash management

– Subsidiaries hold minimum cash for their own transactions and no cash for precautionary purposes

– All excess funds are remitted to a central cash depository– Information advantage is attained by central depository on currency

movements and interest rate risk– Precautionary balance advantages as MNC can reduce pool without

any loss in level of protection

Page 52: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool of Business Administration

Decentralized vs Centralized Cash Depositories

Page 53: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool of Business Administration

International Cash Settlements & Processing

• Multilateral Netting– Defined as the process that cancels via offset all, or part, of the

debt owed by one entity to another related entity– Netting of payments is useful primarily when a large number of

separate foreign exchange transactions occur between subsidiaries

– Example: Quad Belge owes Deutscheland Quad $5,000,000 and Deutscheland Quad simultaneously owes Quad Belge $3,000,000

– Bilateral settlement calls for $2,000,000 payment from Belgium to Germany and cancellation of remainder

– Multilateral system is expanded version• Assume that payments are due between Quad’s European

operations each month.

• Without netting Quad Belge would make 3 separate transactions each way

Page 54: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool of Business Administration

Multilateral Matrix Before Netting (US$ 000s)

Page 55: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool of Business Administration

Multilateral Matrix Before Netting (US$ 000s)

Page 56: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool of Business Administration

Financing Working Capital

• All firms need to finance working capital and most of the short-term financing needs is done through the use of bank credit lines

• Banking sources available to MNCs are– In-house Banks– Commercial Banking Offices

Page 57: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool of Business Administration

Financing Working Capital

• In-house Bank is not a separate corporation. Rather it is a set of functions performed by the existing treasury department– The purpose of the In-house Bank is to provide banking services to

the various units of the firm– It can provide lower credit spreads because it does not have to meet

any capital requirements imposed on commercial banks– The In-house Bank can also better handle currency related risks

Page 58: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool of Business Administration

Financing Working Capital

• Commercial Banking can support MNC’s needs through various offices– Correspondent Banks with local banks in important cities across the

world– Representative Offices are established in a foreign country to help

parent bank clients– Branch Banks are foreign branches that are a legal and operational

part of the parent bank– Affiliates are locally incorporated banks owned in part by a foreign

parent– Edge Act Corporations are subsidiaries of US banks to engage in

international banking and financing operations

Page 59: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool of Business Administration

Multinational Tax Management

Page 60: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool 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

Page 61: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool 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

Page 62: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool 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

Page 63: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool of Business Administration

Corporate Tax Rates Compared

Page 64: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool 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

Page 65: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool 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

Page 66: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool 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

Page 67: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool 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

Page 68: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool 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

Page 69: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool 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

Page 70: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool of Business Administration

Corporate Tax Rates for Selected Countries

Page 71: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool of Business Administration

Example: Value-Added Tax

Page 72: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool 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

Page 73: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool of Business Administration

Foreign Tax Credits

Page 74: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool of Business Administration

FTC Example

United States Taxation: Grossup 2011

Gross dividend remitted 4,509$ Less withholding taxes - b. Net dividend remitted 4,509$

Add back proportion of corp income tax 891$ Add back withholding taxes paid - Grossed-up dividend for US tax purposes 5,400$ Theoretical US tax liability (1,890) Foreign tax credits (FTCs) (891) Additional US taxes due? (999) Excess foreign tax credits? -

c. Net dividend, after-tax 3,510$

Total taxes paid on this income 1,890 Income before tax 5,400

NI x Dividend Payout RateRate given as 0.0%

HK Corp Income Taxes x Dividend Payout RateFrom above (Rate given as 0.0%)

$5,400 x US Corp. Tax RateCorp Inc Tax + Withholding Tax PaidTheoretical US Tax Liability – FTCFTC - Theoretical US Tax Liability

FTC + Additional US Tax Due

Depends on which is larger, FTC orTheoretical US Tax Liability.Lower limit = 0.

Page 75: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool 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

Page 76: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool 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

Page 77: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool 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

Page 78: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool 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

Page 79: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool of Business Administration

Effect of Transfer Price on Net Income (US$ 000s)

Page 80: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool of Business Administration

Tax Management of Foreign-Source Income

Page 81: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool of Business Administration

International Offshore Financial Centers

Page 82: International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael DimondSchool of Business Administration

Tax Management at Trident

• The MNC has operations in Brazil and Germany and must manage its taxes when remitting income from these subsidiaries– The corporate tax rate in Germany is 40%, higher than the US rate of

35%• Because this rate is higher, the US parent will realize excess FTCs

– The corporate tax rate in Brazil is 25%, thus the parent will not realize FTCs

– Management would like to manage the dividend remittances to match the credits with the deficits