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Control and Tax Aspects of Multinational Companies

I. INTRODUCTION International business is the result of the comparative advantages of every country. That is every country is blessed with a lot of resources and with the help of the resources, the countries are able to increase their production. Once the population is fully satisfied with the produced products and the excess if any, then the country will be going for the internationals. International business activity is not new. The transfer of goods and services across national borders has been taking place for thousands of years, antedating even Josephs advise to the rulers of Egypt to establish that nation as the granary of the Middle East Since the end of the world war II, however, international business has undergone a revolution out of which has emerged what is the probably the most important economics phenomenon of the latter half of the twentieth century: he Multinational Companies (MNC)

II. THE MULTINATIONAL COMPANIES (MNCs) The Multinational Companies are the companies established with a view to produce and sell goods and services in more than one country. Mainly the parent company or the company registered initially will be situated in the home country where it was registered and they may have their branches in the other countries and thereby they function or otherwise, the parent company will purchase the majority of the shares of the other company or companies situated in other countries and convert them as its subsidiary company or companies and through

them the


company will sell their products of goods and

services. Some MNCs have upwards of 100 foreign subsidiaries scattered around the world. Based in part on the development of modern communication and transportation technologies, the raise of the Multination National Companies was unanticipated by the classical theory of International Trade as first developed by Adam Smith and David Ricardo. According to this theory, which rests on the Doctrine of comparative advantages, each nation should specialized in the production and exports of those good that it can produce with highest relative efficiency and import those good that other nation can produce relative more efficiently.
Natural resources have lost much of their previous role in national specialization as advanced, knowledge intensive societies move rapidly into the age of artificial materials and genetic engineering. Capital moves around the world in massive amounts at the speed of light; increasingly, Companies raise capital simultaneously in several major markets. Labour skills and labour wages in these countries can no longer be considered fundamentally different; many of the student enrolled in American Graduate Schools are foreign, while training has become a key dimension of many joint venture between international Companies. Technology and Know how are also closed to becoming a global pool. Trends in protection of intellectual property and exports controls clearly have less impact than the massive development of the means to communicate, duplicate, store, reproduced information.

Against this background, the ability of Companies of all sizes to use these globally available factors of production is a far bigger factor in international competitiveness than broad macroeconomics difference among countries. Contrary to the postulates of Smith and Ricardo, the very existence of the multinational enterprise is based on the international mobility of factors of production. A Swiss based pharmaceutical firm to finance the acquisition of German equipment by a subsidiary in Brazil may use capital raised in London on the Euro dollars market. It is the globally coordinated allocation of resources by a single centralized management that differentiates the multinational enterprise from other firms engaged in international business. MNCs

make decisions about market-entry strategy; ownership of foreign operations; and production, marketing, and financial activities with an eye to what is best for the Companies as a whole. The true MNCs emphasizes group performance rather than the performance of its individual parts. III. THE MULTINATIONAL FINANCIAL SYSTEM The Multi National Companies (MNCs) are entirely different from the Domestic Companies. They have vast financial resources, enlarged scope of their operations, ability to mobile their funds, sophisticated departments, strong managerial backup, internal financial transfer mechanisms etc. Generally, the domestic companies cannot compete These special characteristics collectively are the MNCs in any way.

called as the multinational financial system. III.1 The Value Of The Multinational Financial System According to Prof Allen C Shapiro, the ability to transfer funds and to reallocate profits internally presents multinationals with three different type of arbitrage opportunities. 1. Tax arbitrage: MNCs can reduce their tax burden by shifting profits from units located in high-tax nations to those in lowertax nations. Or they may shifts profits from units in a taxpaying position to those with tax losses. 2. Financial market arbitrage: By transferring funds among units, MNCs may be able to circumvent exchange controls, earn higher risk-adjusted yields on excess funds, reduce their risk adjusted cost of borrowed funds, and tap previously unavailable capital sources. 3. Regulatory system arbitrage: when subsidiary profits are a

function of government regulations. III.2 Inter-company Fund-Flow Mechanisms The MNCs can be visualized as unbundling the total flow of funds between each pair of affiliates into separate components that are associated with resources transferred in the form of products, capital services and technology. The different channels available to the multinational enterprise for moving money and profits internationally include transfer pricing, fee and royalty adjustments, leading and lagging, inter-company loans,, dividend adjustment, and investing in the form of debt versus equity. Tax factor: Total tax payments on inter-company funds transfers are dependent on the tax regulations of both the host and the recipient nations. The host country ordinarily has two types of taxes that directly affect tax costs: corporate income taxes and withholding taxes on dividend, interest, and fee remittances. In addition, several countries, such as Germany and Japan, tax retained earnings at a difficult (usually higher) rate than earnings paid out as dividends. Transfer Pricing : The pricing of goods and services traded internally is one of the most sensitive of all management subjects. Each government normally presumes that multinational use transfer pricing to its countrys detriment. The most important uses of transfer pricing include (1) reducing taxes, (2) reducing tariffs, and (3) avoiding exchange controls. Transfer prices may also be used to increase the MNCs share of profits from a joint venture and to disguise an affiliates true profitability. Exchange Controls. Another important use of transfer pricing is to currency restrictions

avoid currency controls. In fact, bypassing







whereby subsidiaries

operating in less-developed countries (LDCs) with low tax rates are sold overpriced goods by other units. Joint Ventures. Conflicts over transfer pricing often arise when one or more other partners own one of the affiliates involved jointly. The outside partners are often suspicious that transfer pricing is being used to shift profits form the joint venture, where they must be shared, to a wholly owned subsidiary. Disguising Profitability. Many LDCs erect high tariff barriers in order to develop import- substituting industries. However, because they are aware of the potential for abuse, many host governments simultaneously attempt to regulate the profit of firms operating in such a protected environment. When confronted by a situation where profits depend on government regulations, the MNC can use transfer pricing (buying goods from on affiliates at a higher price) to disguise the true profitability of its local affiliate, enabling it to justify higher local prices. Evaluation and Control: Transfer price adjustments will distort the profits of reporting units and create potential difficulties in evaluating managerial performance. In addition, managers evaluated on the basis of these reported profits may have an incentive to behave in ways that are sub-optimal for the Companies as a whole. Fees and Royalties: Management services such as headquarters advice, allocated overhead, patents, and trademarks are often unique and therefore, are without a reference market price. The consequent difficulty in pricing these corporate resources makes them suitable for use as additional routes for international funds flows by varying the fees and royalties charged for using these intangible factors of


For MNCs, these

charges have

assumed a somewhat more important role as a conduit for funneling remittances from foreign affiliates. To a certain extent, this trend reflects the fact that many of these payments are tied to overseas sales or assets that grew very rapidly during 1960s and early 1970s, as well as the growing importance of tax considerations and exchange controls.

Leading and Lagging: A highly favored means of shifting liquidity among affiliates is an acceleration (leading) or delay (lagging) in the payment of inter affiliate accounts by modifying the credit terms extended by one unit to another. Shifting Liquidity. The value of leading and lagging depends on the opportunity cost of funds to both the paying unit and the recipient. When an affiliate already in a surplus position receives payment, it can invest the additional funds at the prevailing local lending rate; if it requires working capital, the payment received can be used to reduce its borrowings at the borrowing rate; if it is in a deficit position, it has to borrow at the borrowing rate. Government Restrictions. As with all other transfer mechanisms, government controls on inter-company credit terms are often tight and given to abrupt charges. While appearing straightforward on the surface, these rules are subject to different degrees of government interpretation and sanction. Inter-company Loans: A principal means of financing foreign

operations and moving funds internationally is to engage in intercompany lending activities. The making and repaying of inter-company loans is often the only legitimate transfer mechanism available to the MNC. Inter-company loan are more valuable to the firm than arms length transactions only if at least one of the following market distortions exist: (1) credit rationing (due to a ceiling on local interest rates), (2) currency controls, or (3) differential tax rates among countries. Back-to-Back Loans. Back-to-back loans, also called fronting loans or link financing, are often employed to finance affiliates located in nations with high interest rates or restricted capital markets, especially when there is a danger of currency controls or when different rates of withholding tax are applied to loan from a financial institution.

Parallel Loans. A parallel loan is a method of effectively repatriating blocked funds (at least for the term of the arrangement), circumventing exchange control restrictions, avoiding a

premium exchange rate for investments abroad, financing foreign affiliates without incurring additional exchange risk, or obtaining currency financing at attractive rates. Dividends: Dividends are by far the most important means of transferring funds from foreign affiliates to the parent company. Among the various factors that MNCs consider when deciding on dividend payments by the affiliates are taxes, financial statement effects, exchange risk, currency controls, financing requirements, availability and cost of funds, and the parents dividend payout ratio, Firms differ, though in the relative importance they place these variables, as well as in how systematically the variables are incorporated in an overall remittance policy.

IV. CONTROL OF MULTINATIONAL COMPANIES The Currency risk affects all facets of the companys operation and therefore it should not be the concern of financial managers alone. All managers should function effectively and try to increase the productivity of their respective departments. The key to effective exposure management is to integrate currency considerations into the general management process of the MNCs. Since the finance is the life blood of the business of the MNCs and the requirements are also very heavy, the executives, managers and administrators are to be very careful in their functions of day to day routine. Moreover, the MNCs are joining and collaborating more than two countries, which require an absolute and extraordinary exercise on the controlling factors. Besides the effective planning and organising the activities at

global level, staffing, leading, communicating and controlling are to be very carefully exercised. Of all, the controlling functions are essentially coordinating functions between the different countries. Since the staff of the parent company and affiliated countrys company or branches are of the entirely different from each other. Different types of controlling techniques are to be stragised and carefully executed. Even a small lacuna will make the whole exercise as null and void besides wasting and reducing the earning per share (EPS). The Rules, Fluctuating Exchange Rates, Position Of Market both in domestic and at global level, Diminishing Marginal Productivity at all the levels of the organisation by enjoying the benefits but does not contributing anything to the organisation, unstable Political Scenario in the affiliated countries, Natural Calamities, Extraction and Depletion of the Natural Resources of the countries are the factors determining the controlling aspects of the MNCs. MNCs are to be carefully controlled by the actual meaning of the term Control. At the same time, the MNCs should not be allowed to damage the growth and developments of the domestic units of any kind. One should not cut his own neck just only because of the reason that the knife is made out of Gold and Platinum.