In emergency situations, the host country may block funds that the subsidiary attempts to repatriate to the parent company. For example, the host government may make its compulsory that profits generated by the subsidiary be reinvested locally for a specific time period before they can be remitted, these funds are known as blocked funds. For using the blocked funds, the parent company may instruct the subsidiary company to obtain financing from a local bank rather than from the parent. In this context, the parent company should investigate the potential of future funds blockage. Unexpected funds blockage after an investment has been made is, however, a political risk with which the multinational company (MNC) must contend.
The various methods for moving the blocked funds are transfer pricing strategies, parallel and back to back loan, leading and lagging, direct negotiates, etc.
Leading and lagging strategy
Leading means shortening of credit terms in number of days, while lagging means extending or enlarging of the days of credit. Shortening of the period of credit causes greater flow of cash from the purchaser (importer) to the seller (exporter). MNCs can accelerate (lead) or delay (lag) the timing of foreign currency payments by modifying the credit terms extended by one unit to another. Companies generally accelerate the payments of hard currency payables and delay the payments of soft currency payables so as to reduce foreign exchange exposure. Thus, companies use the lead/lag strategy to reduce transaction exposure by paying or collecting foreign finance obligations early (lead) or late (lag) depending on whether the currency is hard or soft.
Using netting to reduce overall transaction costs
Netting is a technique of optimising cash flow movements with the joint efforts of subsidiaries. Netting is, in fact, the elimination of counter payments. This means that only net amount is paid. For example, if the parent company is to receive US $ 6.0 million from its subsidiary and if the same subsidiary is to get US $ 2.0 million from the parent company, these two transactions can be netted to one transaction where the subsidiary will transfer US $ 4.00 million to the parent company. If the amount of these two payments is equal, there will be no movements of funds, and transaction cost will reduce to zero. The process involves the reduction of administration and transaction costs that result from currency conversion. Netting is of two types: (1) Bilateral netting system; and (2) Multinational netting system.
Bilateral netting system
A bilateral netting system involves transactions between the parent and a subsidiary or between two subsidiaries. For example, US parent and the German affiliate have to receive net $ 40,000 and $ 30,000 from one another. Thus, under a bilateral netting system, only one payment will be made the German affiliate pays the US parent an amount equal to $ 10,000 (Fig.14.1).
After bilateral netting
Pays $ 10,000
Multinational netting system
A multinational netting system involves a move complex interchange among the parent and its several affiliates but it results in a considerable saving in exchange and transfer costs. Under this system, each affiliate nets all its interaffiliate receipts against all its disbursements. It then transfers or receives the balance, depending on whether it is a net receiver or a payer. To make a multinational netting system effective, it needs the services of a centralised communication system and discipline on the part of subsidiaries involved. Consider an example of multinational netting system, subsidiary X sells $ 20 million worth of goods to subsidiary Y, subsidiary Y sells $ 20 million worth of goods to subsidiary Z and subsidiary Z sells $ 20 million worth of goods to subsidiary X. In this case, multinational netting would eliminate interaffiliate fund transfers completely (Fig. 14.2).
$ 20 M $ 20 M
$ 20 M
Minimising the tax on cash flow through international transfer pricing
In a multinational company having many subsidiaries, goods and services are frequently transferred from one subsidiary to another. The profits of the various subsidiaries are determined by the price that will be charged by the transferring affiliate to receiving affiliate. Higher the transfer price, the larger will be the gross profit of the transferring affiliate and smaller to the receiving affiliate. This strategy highlights how the high tax subsidiary is subsidising other subsidiaries. Such a strategy reduces the subsidiary’s profits but increases the overall cash flow for the MNC. However, there may be some limitations in the transfer pricing policy since host governments may attempt to prevent MNCs from implementing such a strategy.