What's the function?

by Pennsylvania CPA Journal (Apr 17, 02:03 AM)

The global marketplace is more competitive than ever before, as
numerous companies today are doing business with foreign entities and
establishing subsidiaries in foreign countries. The opportunities
offered to U.S. businesses in foreign markets is substantial. With
this opportunity for significant growth comes the responsibility of
the treasurer, cash manager, and tax manager to be cognizant of the
rules and regulations that govern business practices and banking
systems around the globe. This feature details some of the challenges
that treasurers of international businesses face.

International cash management focuses on the efficient use of a
company's global cash resources in a manner that is consistent with
the company's goals. International cash management holds many of the
same challenges that domestic cash management does, but it can be more
complex due to the following three risk factors: cash flow complexity,
foreign exchange exposure, and political risk issues. Cash flow
complexity includes the currency variation issues, tax law variations,
and differences in banking regulations that confront a treasurer
because of his or her multinational company's dealing with
subsidiaries, suppliers, and customers in several different countries.
Foreign exchange exposure arises when multinational companies are
forced to account for sometimes difficult-to-predict fluctuations in a
country's currency, thus requiring the use of hedging techniques to
manage the risk. The political risks arise when dealing with foreign
governments that have approaches very unlike those of the U.S.
government.

Therefore, knowledge of the laws, regulations, and customs governing
business activities in these foreign countries is essential.

The international cash management of multinational companies can be a
centralized, decentralized, or combined organization. The structure of
the company and its foreign entities will determine the most efficient
organization for the multinational company. For example, a
multinational company with sales offices in foreign countries, staffed
by a few people, will warrant the use of the centralized form of cash
management, which enables the company to lower operating costs and
benefit from economies of scale.

International Banking and Payment Systems

The international banking landscape changes rapidly as foreign
countries constantly attempt to increase trade and introduce
competition into their countries. The rules and regulations governing
banks operating in the U.S. are different from those governing foreign
banks. For example, foreign banks may own a minor or controlling
equity interest in corporations with which they do business; in the
U.S., this ownership is forbidden. In the U.S., there are thousands of
independent financial institutions; overseas, a few banks operating on
a national basis characterize the banking systems. Offering
zero-balance and sweep accounts is not required in foreign countries
as foreign banks have the ability to pay interest on corporate demand
deposits-a practice that is restricted in the U.S.

Paper-based and electronic payment systems offer widely different
methods and timing of payments, and the choice of each largely depends
on the countries performing the clearing and payment function. The
check-- clearing process varies from country to country, and is often
a slow and complicated process. This disparity in the clearing
processes between countries offers the treasurer a set of challenges
in managing cash flow and float. The electronic form of payment is
more common outside of the U.S., and can be managed using various
tools, including the use of credit-based transactions (ACH or Fedwire
credits), through correspondent balances, and through the use of the
Society for Worldwide Interbank Financial Telecommunications (SWIFT)
network. Most company-to- company electronic payments are credit
transactions; while the majority of electronic payment systems outside
of the U.S. are cleared through correspondent balances of the banks
involved in the transfers. The SWIFT network is an interbank
telecommunications network that enables member banks to send
authenticated messages electronically in standard formats. These
messages do not transfer value, but are electronic messages containing
payment-related information. The value is transferred via the use of
correspondent bank balances.

Cash Management and International Financing

Several methods are employed to efficiently manage cash
internationally. These methods include pooling and netting funds
through multinational subsidiaries. Pooling involves gathering excess
funds within a company to offset negative balances of other accounts
of the parent company or subsidiaries. This pooling can be performed
where a variety of currencies exist, however, it requires a company to
use the same bank for its accounts, and to work with a credit facility
to cover any deficit balances existing in the pool of funds. Positive
and negative balances are theoretically aggregated each day so the
bank can calculate interest income or expense on the pooled accounts.

Netting is used by multinational companies as a way to minimize
cross-border payments among its units. The individual fund flows,
denominated in foreign currencies, between subsidiaries and the parent
are consolidated or eliminated to reduce costs and create efficiency
in the cash management. Bilateral and multilateral netting are two
forms of netting used. Bilateral netting refers to the netting of
multiple transactions between subsidiaries, whereby the net balance,
calculated on a periodic basis, is transferred. Multilateral netting
uses the same technique, but there are more than two subsidiaries
involved. By reducing the number and frequency of cross-border
payments, the multinational company can better manage its foreign
currency risk resulting from the consolidation of funds. The firm can
also improve cash flow forecasting for both the subsidiary and parent
as a result of better preplanning for its cross-border payments. By
adopting a netting system, the multinational company can employ the
use of leading and lagging. Leading and lagging assist the treasurer
in managing foreign currency risk by enabling the payment of
cross-border payments either ahead of schedule-leading-or behind
schedule-lagging. When foreign currency is expected to depreciate
relative to the parent's home currency, leading can be beneficial; if
the currency is expected to appreciate, lagging can be beneficial.

Other methods of international cash management use tactics such as
reinvoicing, internal factoring, and multicurrency accounts.
Reinvoicing is a method of managing foreign currency risk through
which a company sets up a subsidiary that buys goods from an exporting
subsidiary and resells them to the firm's importing subsidiary. Title
to the goods passes through 10the reinvoicing center. The reinvoicing
center then manages the payment of funds to and from the exporting and
importing units. This tactic enables the center to more effectively
manage foreign currency exposure and improve short-term cash liquidity
through the use of leading and lagging payments. Also, economies of
scale can be achieved by initiating larger trade sizes of foreign
funds, thereby improving foreign exchange rates.

Paper-based

and electronic

payment systems

offer widely

different methods

and timing of

payments, and

the choice of each

largely depends

on the countries

performing the

clearing and

payment function.

Internal factoring is similar to reinvoicing, but instead of taking
title to the goods, the internal factoring unit buys the accounts
receivable of the exporting unit, thus enjoying the same benefits as
the reinvoicing center.

Multicurrency accounts are special arrangements with a bank where a
corporate customer is permitted to make international payments in a
range of currencies from a single account. At the inception of this
agreement, the base currency, the portfolio of accepted currencies,
and the margin over spot rate of the foreign currencies are all
specified.

Other considerations of a multinational corporation that need a
treasurer's planning and management include export financing, credit
insurance, offshore financing alternatives, and tax considerations.
For U.S. companies, the primary sources of financing are commercial
banks and the Export-Import Bank of the U.S. (Eximbank).

The Eximbank is an independent agency of the U.S. government with the
charter to finance and guarantee payment for U.S. exports. Export
credit insurance may be purchased to insure against both political and
commercial credit risks. The Eximbank and several private insurers
sell credit insurance, which is insurance purchased through Eximbank
that is backed by the U.S. government.

Offshore financing sources provide multinational companies with
several benefits, including:

* The diversification of credit relationships among various sources.

* Management of foreign currency risk through the ability to hedge
such risk. A credit facility providing a liability in one currency can
hedge a similar term asset in that same currency.

* Lower borrowing rates for the parent company. A U.S. parent company
may be able to borrow in a foreign currency at lower borrowing rates
than the U.S. borrowing rate, even after hedging costs are considered.

* Lower borrowing rates for foreign subsidiaries. A foreign subsidiary
maybe able to borrow at lower rates from its local banks than its
parent company.

* Potential tax savings. It also may be possible to shift income and
expenses between high-tax and low-tax jurisdictions, creating tax
savings from tax rate "arbitrage."

International Tax Considerations

Offshore financing structures may offer potential tax savings, but
U.S. and foreign jurisdiction tax rules combine to present a trap for
unwary U.S. parent companies.

The U.S. tax system is a combination of a residencebased system and a
source-based system. U.S. residents and corporations are subject to
U.S. tax on worldwide income, regardless of the geographic source of
that income. All other parties are subject to U.S. tax only on U.S.
source income.

This difference provides U.S. taxpayers with an incentive to structure
their operations in a manner that defers a foreign operation's income
from current U.S. income tax until that income is repatriated or
deemed to be repatriated to the U.S.

Although a U.S. parent company may be able to defer U.S. taxation on
earnings generated by foreign entities, those earnings are likely to
be subject to taxes in the country of origin. A U.S. parent, however,
may be able to maximize the tax efficiency of an offshore financing
structure through the choice of the legal form of the entity and the
location of the foreign operation.

The choice of a flow-through entity-such as a partnership or
branch-instead of a corporate form may impact the amount of local
country tax to which foreign earnings are subject. The structure might
also impact the U.S. parent's ability to defer income from current
U.S. income tax. Fortunately, U.S. "check-the-box" regulations permit
U.S. taxpayers to elect how certain foreign legal entities will be
treated for U.S. tax purposes, regardless of the treatment of the
entity under local country law. The "check-the- box" election provides
an opportunity for an entity to select the most efficient form for
both local country tax purposes, as well as U.S. tax purposes.

In addition to the choice of legal form, the location of foreign
entities also impacts the tax efficiency of a multinational structure.
Among the location factors to consider are the statutory tax rate,
tax-favorable regime for foreign-owned entities, treaty provisions
between the foreign country and other countries- including the
U.S.-and withholding tax rates on certain types of payments made to
parties outside the country, such as interest, dividends, and
royalties.

The U.S. Anti-Deferral Regime

The U.S. has a series of rules that address potential abuses of the
general deferral rule. An important set of provisions, collectively
referred to as Subpart F-in reference to their place in the Internal
Revenue Code (IRC)-subject U.S. shareholders of a controlled foreign
corporation (CFC) to U.S. income tax on certain types of income earned
by the CFC.' In the absence of Subpart F, the earnings of a CFC
accumulate on a U.S. tax-deferred basis and are recognized by the
CFC's U.S. shareholders for U.S. tax purposes only on repatriation,
deemed repatriation, or a sale of stock in the CFC.

The impact of Subpart F is to currently tax U.S. shareholders of CFCs
on certain types of income earned by the CFC.2 There are a variety of
different patterns that may give rise to Subpart F income with respect
to financing operations. The most common types include:

* Foreign Personal Holding Company Income, such as passive income
earned by CFC from:

- Gain from commodities transactions

- Foreign currency gain

Multi-currency

accounts repre

sent a special

arrangment

where a bank

allows its corpo

rate customer to

make interna

tional payments

in a range of

currencies from a

single account

- Income equivalent to interest3

* Investment of foreign earnings in U.S. property from

-Tangible property located in the U.S.

-Stock of a U.S. corporation

-An obligation of a U.S. citizen

- Any right to the use of intagible property in the U.S.4

The Subpart F rules are complex and do present potential issues, but
there are a number of exceptionsand exceptions to the exceptions- that
may allow continued deferral of the above types of income.

Treasury professionals must be aware that an investment in U.S.
property is easy to create, which can cause unintentional negative
U.S. tax consequences. For example, while cash pooling may offer
benefits from a treasury perspective, if U.S. parties are net
borrowers to the pool then participating CFCs may be deemed to have an
investment in U.S. property. Another unintentional way to invest in
U.S. property is the U.S. parent company's pledge of more than 66 2/3
percent of a CFC's stock as security for U.S. obligations: the CFC's
assets are deemed to be indirectly invested in U.S. property.' Both
examples trigger an immediate U.S. tax on earnings that were otherwise
intended to benefit from the general deferral provisions.

Foreiqn Tax Credit System

When earnings from foreign operations become subject to U.S. income
tax through repatriation or the deemed repatriation of Subpart F
income, the potential exists for taxpayers to be subject to double
taxation-by the local country and the U.S.

In an effort to avoid penalizing such taxpayers, U.S. tax rules offer
a credit for foreign taxes paid. This credit is for certain foreign
taxes paid directly by the U.S. taxpayer-such as withholding taxes-and
indirectly on distribution to a U.S. corporation by a 10 percent, or
greater, owned foreign corporation.6 The foreign tax credit is granted
for "any income, war profit, and excess profit taxes paid or accrued
during the taxable year to any foreign country or to any possession of
the United States."7

The amount of foreign taxes that a U.S. taxpayer may credit against
its current U.S. income tax is limited to the ratio of foreign source
income to worldwide income, within certain "baskets of income."8 A
U.S. taxpayer determines its foreign source income after allocating
and apportioning both direct and indirect expenses against income from
sources outside the U.S. Excess credit can be carried back two tax
years and forward for up to five taxable years. The expiration or the
U.S. taxpayer's inability to use its foreign tax credits, however,
represents an increased cost of doing business overseas.

Conclusion

Embarking on business outside the U.S. offers great opportunities, but
it comes with risks as well-particularly in the area of cash flow and
taxation. Proper planning before entering a particular market is
important from both a treasury and a tax perspective.*

Peter Kaye, CPA

Jeffrey

Mensch, JD

Dmitri Shiry, CPA

' IRC $957(a) defines a CFC as a foreign corporation in which 10
percent United States shareholders own more than 50 percent of the
total combined voting power and total value of the stock in the
foreign corporation. Unless otherwise noted, all section references
are to the Internal Revenue Code of 1986, as amended, or to the
treasury regulations promulgated.

2 See generally IRC (sec)951(a).

3 See IRC (sec)954(c)(1).

4 See IRC (sec)956(c)(1).

5 Under Treas. Reg. (sec)1.956-2(c), if the "assets of a CFC serve at
any time, even though indirectly, as security for the performance of
an obligation of a U.S. person," then the CFC shall be treated as
having made an investment in U.S. property in an amount equal to the
unpaid principal amount of the obligation for which the CFC's assets
serve as a sercurity. See also Treas. Reg. (sec) 1.956-1(e)(2).

6 See generally IRC (secs)901 and 902.

7 IRC 901(b)(1).

8 IRC (sec) 904(a).

Peter Kaye, CPA, is CFO and controller, U.S. operations, at XRT Inc.,
a French-owned treasury and risk management software company. He can
be reached at pkaye@us.xrt. com.

Jeffrey Mensch, JD, is a manager in the Pittsburgh office of Deloitte
& Touche LLP He can be reached at jmensch@deloitte. com.

Dmitri Shiry is a tax partner in the Pittsburgh office of Deloitte er
Touche LLP and is an adjunct professor at Duquesne University. He can
be reached at dshiry@deloitte. com.

Both Kaye and Shiry are members of the Pennsylvania CPA Journal
Editorial Board.

Copyright Pennsylvania Institute of Certified Public Accountants Spring 2003