Do not be too clever by half: a guide to managing finance in a subsidiary overseas

Establishing a company in a new territory

As countries develop and become wealthier,they tend to question whether foreign companies should be in control of resources that are vital to their economies.

Their governments start asking whether what is good for the companies concerned is what's best for the nation.

With this in mind, I would recommend the following measures to a subsidiary establishing itself in a new country:

  • Employ a skilled local public relations professional who has good connections with the authorities of the host nation.
  • Become recognised by the public as an asset to their country by sponsoring a popular activity such as a sporting event, say, or offering scholarships for bright students from poor backgrounds.
  • Work hard to be seen as a good citizen by the government. If you work in an ­extractive industry, for example, you should be aware that United Nations general assembly resolution 1803 states that international organizations “shall strictly and conscientiously respect the sovereignty of peoples and nations over their natural wealth and resources”.

Large multinationals usually own their subsidiaries outright, but there is much to be said for having a local partner with a minority interest. It should know the market well, possess useful contacts and have some influence with the authorities should problems arise.

Your business is also less likely to be a nationalization target if it is partly owned by local interests. But a local partner can become a liability if it has its own agenda.

Also, if it has several other commercial interests, it may be reluctant to challenge the government on your behalf for fear of jeopardizing these.

Jurisdiction prudence

Transfer pricing can be a real source of contention. As an accountant, you have learnt the principle of keeping costs in the higher-tax country and revenues in the lower-tax country.

A minnow may get away with this, but a big fish should be particularly careful if its impact on the local economy is great. If you transfer commodities or finished products between group companies that are used all around the world, there is limited scope for manipulation because these have a global price.

If you transfer finished goods for which price compar­isons cannot be made so readily, some scope remains. But most large companies understand the long-term benefits of being good citizens and are therefore careful with their transfer pricing.

In one case I know of, oil companies sold oil to their affiliates at a discount on world prices, claiming that this allowed the affiliates a margin when they sold it on.

The host government rejected their argument and imposed "fiscal export prices", which gen­erally exceeded world prices. Being too clever here turned out to be a costly mistake.

In another case, the CFO of a large firm that was important to the host country's economy devised ways of minimizing its tax burden. After some years the government got fed up with this and expropriated the company. Its negotiated compensation payment was considerably lower than the business’s market value.

A company's tax payments should be commensurate with its size, turnover and importance to the host nation's economy. But you'll have inherited the corporate structure and you probably have little say in how profits are channeled through the group.

High sales and low tax payments are a phenomenon of the developed world. Developing nations rarely accept measures contrived to reduce tax payments. This means that payments to other group companies will be scrutinized by them. If a firm continues paying too little tax, it may be expropriated.

When a foreign firm starts up in a new country, the host government will often insist that it brings in "new money". This makes sense, since funds may be in short supply locally and the government wants them to be used to finance local business.

But not all countries have this rule and you may be able to obtain loans from the local banks or arrange back-to-back deals with a foreign bank.

Another possibility is to finance local operations with loans from a group company rather than bringing in capital. Some developed countries apply "thin capitalization" rules and disallow some or even all of the interest.

Germany, for instance, deems the interest to be a dividend payment. Be aware that some developing countries adopt a similar stance and disallow the interest as tax deductible. If they do allow the interest, you may have to substantiate that the interest charged is at the going rate.

Currency affairs

Developing countries are prone to devaluations. If you believe that one is coming, collect debts quickly but delay paying creditors.

But departing from your normal credit practices can sour relationships with the authorities, so do this judiciously.

You may also take out a bank loan locally in anticipation of a devaluation, but do consider how the finance ministry might react. Consult your management team before proceeding.

Look at ways of increasing payments to your parent company. If you are using technology patented by group companies, there may be scope for raising royalty payments, but do ensure that these can be substantiated, or they may be disallowed.

Head office may incur costs in providing technical help, conducting R&D, procuring equipment and seeking new markets etc, which it then apportions to all group companies.

Consider whether the block payment for these services could be increased. The host country will usually accept a service charge, providing that the amount is reasonable.

In brief, the best policy for the long term is to be sensible with transfer pricing and other payments to group companies, while paying a reasonable amount of tax and sticking to the rules. Be inventive with ideas for increasing profits by all means, but beware of being too clever by half – it can easily backfire.

No one makes an investment expecting that it will be expropriated – and being a good citizen certainly reduces this likelihood. But it may still occur, often for political reasons, so an astute accountant will be prepared.

You can reduce your exposure from the start by owning few physical assets. It is important that the parent company, or another up the chain, is constituted in a country that has a bilateral investment treaty (BIT) with the host nation.

This ensures that arbitration arrangements, usually with the International Centre for the ­Settlement of Investment Disputes (ICSID), are in place if things go wrong.

A typical BIT will make the following statement:"Neither party shall take any measures to expropriate or nationalise investments, unless the following conditions are complied with: the measures are taken in the public interest and under due process of law; the measures are not discriminatory or contrary to any undertaking that the contracting party taking such measures may have given; the measures are taken against just compensation. Such compensation shall represent the market value of the investments affected immediately before the measures were taken or the impending measures became public knowledge, whichever is earlier."

If "just compensation" is not forthcoming – usually because the company and the government differ greatly with their valuations of the business – the treaty allows for arbitration at the ICSID.

But this is a last resort, as cases take years to resolve. It's possible that the local ambassador or the CEO of your holding company may intervene in the negotiations.

This may help, but I believe it is better for the holding company to give guidance on acceptable terms, but leave the talking to executives, including the CFO, in the local company.

They may well have already met the government officials personally in a social setting, which makes for a better rapport.

In practice, the market value is seldom obtained, since the host, country has the upper hand, but all is not lost. The approach I would recommend is to see what your group has that the government needs but doesn't have, and to exploit that to the full.

For example, the group may have crucial patents, the technical specialists needed to operate and maintain plant, essential research capabilities and training facilities.

You can offer to continue providing these resources – at a premium – for a decade, say, renewable for a further 10 years. Since the only out-of-pocket cost is the provision of specialized staff, the ongoing revenue can be substantial.

If you have a strong market position, you may also negotiate a long-term contract to purchase the output at an attractive price.

You may think that your investment is safe, but a change of government in the host country can alter things quickly, so be prepared. If you are considering a new investment, check the number of cases your target country has under international arbitration.

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