Abstract. Paper discussed how operating of financial management in different nations impacts investment decisions with multinational enterprise. Paper describes financial options available to the foreign subsidiary of the multiple enterprises and shows how money management in international business can be used to minimize cash balances, and taxation and introduce us to basic methods of money management. This project is focusing on financial management in the international business, discussing three sets financial decisions such as: •Investing decisions, decisions about what activities to finance. Financing decisions, decisions about how to finance those activities. •Money management decisions, decisions about how to manage firm are financial recourses most efficiently. Different currencies, tax regimes, regulation concerning cash flow through the countries, norms regarding financial activities, economical and political risks can complicate financial decisions and money management. Financial managers must keep in mind all these factors when deciding which activities to finance, what is the best way to finance them and how to protect company from future political and economical risks including foreign exchange risks.
Investment decisions are the most concern about capital budgeting. Capital budgeting is method to evaluate potential foreign projects, discussions that are made between cash flows to the project and cash flows to the parent company, costs and risks of future investment. Most of international cash out flows are negative at first, because the firms are investing heavily in production facilities. After curtain period of time, cash flows will became positive and investment cost decline and revenues grow.
Other problems that may complicate the process, for example, distinction must be made between cash flows into the project and out to the parent, political and economic risks, including foreign exchange risks can affect as well. Can flows to the project and to the parent company can be complicated because of host country regulations. For example, host country can require reinvesting certain percentage of revenues within host country and charge unfavorable tax rate. When companies use capital budgeting technique they need to consider political and economic risks that may arise in foreign location.
These risks can be incorporated into capital budgeting by using a higher discount rate or by forecasting lower cash flows for such projects. Political risks and stability of the country must be taken under consideration, for example, economical collapse in Yugoslavia, when unstable political situation lead to bloody break-up in a country what caused taxes rates and government price control increase. Magazine “Euromoney” publishes annual “country risk rating”, but all predictions are only guesses and in many cases they are wrong.
Economic risk must be taken into count as well, inflation within country may cause drop the value of country currency on foreign exchange market. There are two most common ways how firms handle risks. First way is when firms are treat all risk as a single problem by increasing the discount rates applicable to foreign projects in a countries where political and economic risks consider to be high. Second way is adjusting discount rates to reflect location riskiness. In financing international business parent company must consider two factors, such as source of the financing and financial structure.
If firm will seek for external financing it must consider borrowing funds from the lowest cost source of capital available. However some host countries must require foreign manufactories to finance its projects though local debt financing or local sales of equity. Although, initial cost of borrowing locally can be higher in some cases, sometimes it can have some wise effects in a long run because if host country has high inflation rate and currency will depreciate the initial cost will be lower. Financial structure varies from country to country and what is exceptional in one country maybe not to the another.
For example Japan relates on debt ratio them more U. S. firms. One of the explanations for different financial structures is a different tax regime. For example, if interest income were taxes at higher rate, a preference for debt financing over equity financing would be expected. However, according to the empirical research, country differences in financial structure do not seem related to any systematic to country difference in tax structure. Another explanation is that these country differences may reflect cultural norms, cultural influences not yet been explained.
Principle behind global money management is that that firms must use the firm’s cash recourses in the most efficient way and work on minimization cash balances and reducing transactional costs. Firms must hold certain cash balances that will cover payments of accounts payables and expected demand on cash. The rest of the cash assets are usually reinvested on in money markets accounts and firms earn interest on them. However, firms must have flexible accounts so it can withdraw all cash freely. Such accounts usually have low interest rates and if it doesn’t, firm can suffers from financial penalties.
That is the dilemma many firms are facing and that is why firms are minimizing cash balances, so it can earn interest in high rated market account. Another way to reduce costs of doing business internationally is to reduce transaction costs. Transaction cost is the cost of exchange, it is commission fee paid on foreign market for performing the transaction of moving cash from one country to another. According to United Nations forty percent of transactions involve exchange between national subsidiaries, one of the widely used methods to reduce transaction cost is multilateral netting discussed bellow.
Every country has different tax regimes, for example Japan and US has the highest tax regimes up to 40% and Ireland has as low as 12,5%. I found article published by about recent corporate rates. It shows results that by the end of 2009 US and Japan are the top countries with the highest corporate rates. Since the 2007 to 2009 US rates didn’t changed, as a result, the overall U. S. corporate tax rate is now 50 percent higher than the OECD average. “The OECD study also found that statutory corporate tax rates have a negative effect on firms that are in the “process of catching up with the productivity performance of the best practice firms. This suggests that “lowering statutory corporate tax rates can lead to particularly large productivity gains in firms that are dynamic and profitable, i. e. those that can make the largest contribution to GDP growth. ” This article also describes aggressive tax reductions made by Asian countries such as Korea and Taiwan and ambition of Japan to cut down its tax rate in order to stay on competitive level. Reducing corporate rates will follow by reducing double taxation rate. Other ways to reduce double taxation are tax credits, tax treaties and the deferral principle.
Tax credit is the method that allows home country to reduce taxes due on amount of taxes already paid to foreign government. Tax treaty is agreement between two countries that identified the conditions on which income will be taxed by the authorities of the country where the income was received. For example, US and Germany agreement state that US do not need to pay tax in Germany on any earnings from the German subsidiary that are remitted to the US in a form of dividends. Deferral principle states that parent companies will not tax foreign source income until they actually get dividend.
Another way to reduce taxes is to use third party banking institution. There are certain countries that called “tax heavens” such as Bahamas, Dominican Republic, Switzerland, and Cayman Islands that have low or even no income tax. International business avoid or deter income taxes by establishing a wholly owned, non-operating subsidiary in tax haven. The tax haven subsidiary owns the common stock in operating foreign subsidiary, what allow all funds from foreign operating subsidiaries to be transferred to parent subsidiaries through tax havens.
The tax levied on foreign source income by the firm’s home government, that is usually paid when foreign subsidiary declares a dividend, can be deferred under the deferral principle until the tax haven subsidiary pays the dividend to the parent. But payment can be postponed if parent operations continue to grow. That is how US firms can avoid tax liabilities in home country. Second article that I found was talking about “tax heaven” courtiers. In particular Bahamas, Bahamian prime minister agreed to give up secret information about foreign owners of banking accounts to OECD in order to follow proper taxation laws.
Prime minister of British Virgin Islands said that BVI are already following the British laws, but add that they have some rooms for improvement. Cayman Islands minister added that its country is on aboard to regulate its tax system as well. There are several techniques that can be used when cash is transferred from one country to another, for example, dividend remittances, royalty payments and fees, transfer prices, and fronting loans. A dividend remittance is the most commonly used approach to transfer funds from subsidiary to parent company.
Dividend policy typically varies from one country to another depending on such factors as taxation, foreign exchange risk and extent of local equity participation. In contract, royalty payments and fees have some tax advantages over it. Royalties represent the payment made to owners of technology, patents, or trade names for the use of the technology or the right to manufacture and/or sell products under those patents or trade names. It is very common for parent company to charge foreign subsidiary royalty fees that can be taken on sort of payment per unit of product or percentage on gross revenue.
Fee is a reimbursement for professional services or expertise the parent company to foreign subsidiary; usually it is called “management fees” or “technical assistance fees” and can be tax deductible because it considers as expense. In order to save money on taxes/tariffs and avoid foreign exchange risks firms are manipulating with prices as well. Any foreign business normally involves transfer of goods and services between foreign subsidiary and parent company.
There are several advantages parent company may gain by manipulating transfer prices: •The firm can reduce its tax liabilities by using transfer prices to shift from high tax country to low tax country. •The firm can use transfer prices to move funds from one country where currency has high fluctuation level and possibility of future currency depreciation and foreign exchange risk to another country where funds can be protected. •The firm can use transfer prices to move funds from subsidiary to parent company or tax havens when financial transfers in a forms of dividends are prohibited by policies of host country. The firm can use transfer prices to reduce the tariffs it must to pay, ad valorem tariff is used. In this case, low transfer prices on goods and services are required. Since value on goods and services are low – it lowers tariffs. There are significant problems associates with manipulation of transfer prices. Many governments are feeling cheated on their legitimate income when transferring prices are reduced. Many governments have strict regulation about transfer prices and US is among of them.
According to Section 482 of International Revenue Code, the International Revenue Services (RIS) can relocate gross income, deductions, credits, or allowances between related corporations to prevent tax evasion or to reflect more clearly in proper allocation of the income. According to RIS the correct price is arm-length’s price – the price that would prevail between unrelated firms on a market settings. Many other countries had followed the US in interpretation of fair price. As well many countries use cost based prices – it is cost price plus some mark-up.
Survey of 164 US multinational firms showed that that 35% if firms used market-based prices, 15% used negotiated prices and 65% used cost based pricing method. It gives us a little more then 100% because some companies used variety different methods. Only market and negotiated prices can be interpreted as arm length’s prices. Cost based prices are the most commonly used way by firms to reduce tax liabilities. Manipulation of transfer prices in this manner ruins counter to government regulations in many countries, it can destroy insensitive systems within the firm, and it has ethically dubious foundations.
Fronting loans is channeling money through the third party in order to have some tax advantages, usually international banks are used. Certain countries called “tax havens” are used where firms can have great tax advantages, some of the countries are tax-free. The essential points about a fronting loan are: The bank is a ‘front’ for the parent, hence the name. The bank makes a profit by charging the parent for being a front. The parent company avoids host country regulations on the repayment of the loan by the subsidiary on the assumption that the host country is less likely to stop repayment to an international bank.
Bellow is an example of the tax aspects of a fronting loan. There is two methods firms like to use on order to manage its global resources more efficiently: centralized depositaries and multilateral netting. Many firms prefer to hold its cash in centralize depositaries. It gives the way to invest its cash reserves in more efficient way. As well it can help to reduce the total size of the cash pool it needs to hold in a liquid cash accounts. Typically cash balances deposited in cash liquid accounts, such as overnight money market accounts.
Size of the interest usually depends on amount of deposited cash, by pooling cash centrally; the firm should be able to earn the highest interest rate compare to interest rate subsidiaries can get on individual levels. Most depositories located in major financial centers like New York, London, San Francisco, Tokyo, they have available information about current profitable short-term investments opportunities that typically foreign subsidiary is lacking. As well centralized depositary is able to develop skills and know-how tangible experience in investing large amount of cash that foreign subsidiaries is lacking.
By concentrating its cash reserves in one place firm reduce the total size of cash pool it must hold in highly liquid accounts, which unable the firm to invest a larger amount of cash in long-term, less liquid financial instruments that can earn higher interest. On another hand, ability to establish centralized depositary can be restricted by government-imposed restrictions on capital flows across of borders. (E. g. , controls put in place to protect a countries foreign exchange reserve). As well foreign exchange risk can play disadvantage in trying to centralize cash liquids in one place.
However, as more countries became globalized and barriers for free cash flows remove, more centralize depositaries make sense. Multilateral netting reduces the transactions costs arising when a large number of transitions accrue between a firm’s subsidiaries in the normal course of business. Multilateral netting is offsetting of receivables and payables among three or more parties to a transaction, with each making payments to an agent or clearing house for net obligations due to others or receiving net payments due from others. The process reduces credit and settlement risk.
In some cases, multilateral netting can extend to bilateral netting. Bilateral netting is the consolidations of all swap agreements between two counterparties into one master agreement. The result is that if one counterparty bankrupts, that counterparty cannot seek to collect on any swaps that are in-the-money to them while at the same time refusing to pay out on any that are out-of-the-money. Instead, the master agreement sets out that in this event all swaps between the two counterparties will be netted; only then will the bankrupt company receive money, and then only if they are net in-the-money.
References: Contrarian Musings (2009). Corporate Tax Rate by the Country. Retrieved January 24, 2010. http://alhambrainvestments. com/blog/2009/01/29/corporate-tax-rates-by-country-oecd/ Hill, C (2009). International Business Competing in the market Place. New York: McGraw-Hill/Irwin. Stabroek stuff (2010). Caribbean “Tax Haven” Towing the Line. Sunday Starboek. Retrieved on January 24, 2010. http://www. stabroeknews. com/2009/regional/03/30/caribbean-‘tax-havens’-towing-the-line/