Question

What are the motivations for Foreign Direct Investment, what are the various methods, and what is the use of transfer pricing to minimize global tax liabilities?

Answer 1

Foreign Direct Investment is a tool for companies to enter into other nations and is considered to exist, when there is an intention of establishing a lasting interest in the country. A lasting interest is when the company has a larger than 10% stake in both voting and profits of the venture which exists because of such investments.

Over the years, with reduced government intervention on business owners there has been a growing interest in investing through this route. Companies can then have greater control on their operations and tend to have benefits of higher returns which will be illustrated in the sections that follow.

Following are some of the advantages which Foreign Direct Investments offer:-

(1) Diversification of Market

When, national markets began shrinking for companies, owing to high competition and rising costs, they turned the route of foreign expansion through Foreign Direct Investments and other similar methods. This then gave them an edge over local manufacturers and they aimed to sell their products and services across various countries and earn higher profits and have a larger customer base respectively.

(2) Lower Labor Costs

Foreign Direct Investments are the highest in countries where cost of labor is relatively lower. This happens primarily because companies have the added advantage of reduced cost of operations which increases their net and overall profits.

Countries such as China and India, which have a huge population are thus among the largest recipients of foreign direct investments.

(3) Tax Benefits

Many countries help companies with added tax advantages when they invest in selective areas in the boundaries. This helps the firm further gain as the tax benefit serves as a method of increasing overall profits for the organization.

The above benefits were specific to the company, in which they gain from such investments. Other critical benefits include higher collection of taxes for the economy, infrastructure development, enhancement of skills and technical competencies of the general population and rise of jobs in the market respectively.

The following are some of the popular modes of entry by the foreign direct investment route:-

(1) Acquisition of Shares in a Foreign Company:-

There are numerous companies which list themselves on the stock exchange and shares can be procured by any company for the same as well. This is a popular mode of entry, in which a foreign company directly or indirectly purchases stock options of the company and thus acquires direct managerial control.

(2) Direct Subsidiaries:-

This is another popular method of entry into foreign business. Through this route, companies set up direct subsidiaries into foreign nations and hold the entire management of the entity into their own hands. This is popular in countries allowing 100% FDI in some sectors.

(3) Joint Ventures & Mergers:-

A joint venture gets established, when two or more companies, come together to form one separate entity, but their individual operations still exist. In most countries this is done so that one domestic company can come together with a foreign one and both can function independently and with one another at the same time.

On the other hand, in mergers the existence of the companies is no longer independent but they form a different entity altogether.

Transfer Pricing and their benefits:-

When a single parent company has multiple areas of operations, the concept of transfer pricing comes into play. Transfer pricing is an accounting strategy used to price their own goods and services among parent and subsidiaries. Examples of this include patent rights and other components, the pricing of which are changed to accommodate for profits.

For example, consider a situation in which a company operates in a high tax environment and also in a low tax country. In this case, a subsidiary operates in a high tax environment and makes a profit of 10,000$ (Just an assumption) if the tax rates of the country are at a high percentage, say 30% then they would have to pay 3000$ as taxes to the government.

On the contrary, if the parent company charged a transfer price from the subsidiary for using its patents for 11000$ in the fiscal year, it would report a loss of 1000$ and would have to pay no charges to the government. This price can be altered also from time to time.

The extra earning of the foreign parent company would be relatively charged lesser taxes say 10% and the profits would then pile on

Thus, transfer pricing is an accounting practice in which, a company alters the pricing of patents, trademarks and other equipment which it provides to the subsidiary to avail tax benefits respectively.