International Finance FIN456 ♦ Fall 2012 Michael Dimond.
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Transcript of International Finance FIN456 ♦ Fall 2012 Michael Dimond.
International FinanceFIN456 ♦ Fall 2012Michael Dimond
Michael DimondSchool of Business Administration
International Trade Finance
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
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
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Financing Trade: The Flow of Goods and Funds
Michael DimondSchool of Business Administration
Alternative International Trade Relationships
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?
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
Michael DimondSchool of Business Administration
The Mechanics of Import and Export
Michael DimondSchool of Business Administration
The Bank as the Import/Export Intermediary
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The Trade Transaction Time-Line and Structure
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
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
Michael DimondSchool of Business Administration
Parties to a Letter of Credit (L/C)
Michael DimondSchool of Business Administration
Essence of a Letter of Credit (L/C)
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
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
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
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
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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
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
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)
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
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
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
Michael DimondSchool of Business Administration
Steps in a Typical Trade Transaction
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
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
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
Michael DimondSchool of Business Administration
Instruments for Financing Short-Term Domestic & International Trade Receivables
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
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Typical Forfaiting Transaction
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Multinational Working Capital Management
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
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Goals and constraints on repositioning MNC funds
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
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:
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• 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
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
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;
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.
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
Michael DimondSchool of Business Administration
Days Working Capital for Selected U.S. and European Technology Hardware and Equipment Firms, 2001
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
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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
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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
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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
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
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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
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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
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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
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Decentralized vs Centralized Cash Depositories
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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 $2,000,000 payment from Belgium to Germany and cancellation of remainder
– Multilateral system is expanded version• Assume that payments are due between Quad’s European
operations each month.
• Without netting Quad Belge would make 3 separate transactions each way
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Multilateral Matrix Before Netting (US$ 000s)
Michael DimondSchool of Business Administration
Multilateral Matrix Before Netting (US$ 000s)
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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
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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
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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
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Multinational Tax Management
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
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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
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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
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Corporate Tax Rates Compared
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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 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
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
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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
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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 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
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Corporate Tax Rates for Selected Countries
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Example: Value-Added Tax
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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 DimondSchool of Business Administration
Foreign Tax Credits
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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.
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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 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
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
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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
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Effect of Transfer Price on Net Income (US$ 000s)
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Tax Management of Foreign-Source Income
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International Offshore Financial Centers
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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