44

CHAPTER 19
International Accounting and Taxation
After studying this chapter, students should be able to:

> Discuss the various factors that influence the accounting systems
countries adopt.
> Describe the impact these national accounting differences have on
international firms.
> Analyze the benefits to international firms of harmonizing differences in
national accounting systems.
> Describe the accounting procedures used by U.S. firms engaged in
international business.
> Identify the major international taxation issues affecting international
business.
> Discuss the taxation of foreign income by the U.S. government.
Assess the techniques available to resolve tax conflicts among countries.

LECTURE OUTLINE

OPENING CASE: Mr. Anchovy Was Wrong

The opening case describes the merger and acquisition activity currently going on in
the accounting industry. Companies are rapidly merging and acquiring each other in an
effort to increase market share and better serve their clients.

Key Points

• While it is often assumed that the life of an accountant is dull, this case points
out that working for an international accounting firm today may in fact be quite
exciting. The accounting industry in the 1990s has been dominated by five firms.

• The five firms, collectively known as the Big Five, constantly seek new
customers from around the globe. As part of their effort to provide accounting,
auditing, and consulting services to most of the world’s largest MNCs, the
companies frequently find that they need to expand their operations to meet the
needs of their clients.

• Much of the expansion in the industry takes place through mergers and
acquisitions. Not only can firms increase their market share via this strategy, it also
45 > Chapter 19

allows them to be knowledgeable about each market in which their clients conduct
business.

• One drawback of the explosive growth in the industry is that firms must now
grapple with the difficult tasks of developing performance appraisal systems,
compensation programs and fringe benefits packages for each country.

Case Questions

1. The case suggests that the life of an accountant working for one of the Big Five
firms is anything but dull. What factors have contributed to making international
accounting an exciting profession?

Many students will have an attitude toward accounting similar to that of the Monty
Python character depicted in the case. Therefore, it may come as a surprise to
many, that today’s major accounting firms are actively expanding internationally.
However, when they consider the rapid growth of MNCs over the last decade or so,
they will quickly come to realize that as firms expand their operations to new
markets, their need for professional services around the globe also increases.

2. How could a harmonization of accounting practices help the Big Five?

A harmonization of accounting practices among countries would help the Big Five
by reducing the complexity in accounting practices that currently exists. Not only
would this simplify the accounting process, but it would also reduce the need for a
local presence in each market.

Additional Case Application

The case describes the merger and acquisition craze currently found in the
international accounting industry. The industry, dominated by just six firms, is
undergoing considerable change as the leading firms seek to expand their
operations in each of their clients’ markets around the world. They are attempting
to be in a position to provide their clients with knowledge of the tax laws and
accounting regulations in each country. The current situation in the accounting
industry is quite similar to conditions in the global advertising industry a few years
ago, when advertising companies sought to provide local expertise to clients
operating in several countries. Students can be asked to discuss the unique
challenges faced by firms providing services as they seek to maintain and expand
their client base. A key issue to consider is how service firms differ from
manufacturing firms in terms of having control over their expansion strategies.

CHAPTER SUMMARY

Chapter Nineteen explores international accounting and taxation. The chapter begins
with a discussion of why accounting practices differ among countries, then goes on to
consider the impact of harmonization efforts and the accounting practices used by U.S.
firms. Finally, issues related to taxation such as transfer prices and tax havens are
discussed.
 International Accounting and Taxation > 46

Teaching Note:
Because many students have the impression that accounting
and taxation are boring subjects, instructors may find that they
have to work a little harder to keep students interested during the discussion of this
chapter’s material. One way of keeping student interest high is to use an ongoing skit
(acted out by the students) throughout the lecture. Some students can be assigned to
play the role of a sleazy businessperson who is trying to dodge taxes by using
questionable accounting practices and tax havens. Other students can be asked to
play the role of a hard-nosed IRS agent bent on collecting taxes. Students can be
asked to play their roles using the information they are learning. Most students will
probably be surprised to learn how interesting the topic can be.

I. NATIONAL DIFFERENCES IN ACCOUNTING

Differences in national accounting philosophies and practices make it difficult for firms
to develop an accounting system that provides both the internal information required by
managers, and the external information needed by shareholders.

The Roots of Differences

• A country’s accounting standards and practices reflect the influence of legal,

cultural, political, and economic factors. Show Figure 19.1 here.
• In common law countries such as the U.S., accounting procedures typically
evolve from the decisions of independent standards-setting boards. However, in
code law countries such as France, accounting practices are determined by the law.
The enforcement of accounting practices is also impacted by a country’s legal
system.
• National culture may also play a role in a country’s accounting system. For
example, French firms, the text notes, produce a “social balance sheet” that details
their treatment and compensation of workers.
• Political ties between countries may impact a country’s accounting system in
that former colonies often follow procedures similar to those of their former rulers. A
country’s economic situation may direct its accounting system. For example, a
market economy’s system will be driven by profit- and cost-oriented information,
while a centrally planned economy’s system emphasizes output-oriented
information.
• Finally, capital markets may also affect national accounting standards. The text
provides examples of how capital markets in the U.S., Germany, and Japan affect
each country’s accounting system.

Differences in Accounting Practices

• Several national accounting differences could affect international businesses.

The text notes that valuation and revaluation of assets, valuation of inventories,
relations with tax collectors, and use of accounting reserves are particularly
important.
• Valuation and Revaluation of Assets. Because rules differ among countries
as to how a firm’s assets should be valued, firms are advised to exercise caution
when comparing the strength of balance sheets of firms from different countries.
47 > Chapter 19

The text illustrates this concept with examples of how assets are valued in the
Netherlands, Britain, Australia, Japan, and the U.S.
• Valuation of Inventories. Firms should be aware of how inventories are being
valued when comparing the performance of firms. For example, the text notes that
in general, U.S., Japanese, and Canadian firms can use either LIFO or FIFO to
value inventories, while in Great Britain and Brazil, only FIFO is normally used.
• Dealing with the Tax Authorities. A firm’s accounting records are important
because they are the basis on which taxes are assessed. The text examines how
laws in Germany, the U.S., and France affect companies’ tax burdens.
• Use of Accounting Reserves. Firms use accounting reserves to adjust for
foreseeable future expenses that affect their operations. Because countries have
different laws regarding the use of accounting reserves, it can be difficult to assess
a firm’s performance. The text notes the differences between the U.S. and
Germany regarding the use of accounting reserves.
• Other Differences. There are many other differences in how countries treat
accounting issues including the capitalization of financial leases, preparation of
consolidated financial statements, capitalization of R&D expenses, and treatment of
goodwill. Discuss Table 19.1 here.

Impact on Capital Markets

• The differences in accounting practices can distort the measured performance

of firms incorporated in different countries, making it difficult to assess the
performance of companies. The text provides examples of different accounting
practices followed by Japanese, U.S., Australian, and Japanese firms.

Impact on Corporate Financial Controls

• An MNC’s ability to manage its foreign operations may be complicated by

differences in accounting procedures. Most parent firms dictate what procedures
should be used, and, in addition, select the currency that will be used in assessing
performance. Most companies use a combination of the parent country’s currency
and local currencies.

Accounting in Centrally Planned Economies

• Because CPE accounting systems are designed to provide information about an

enterprise’s aggregate production, rather than profits and costs, international
businesses should exercise caution when examining financial statements
developed in CPEs. This problem may be magnified if firms are involved in joint
ventures with CPE counterparts. The text illustrates this concept with an example
involving Tungstram and General Electric.

II. EFFORTS AT HARMONIZATION

• There is an effort by many accounting professionals and national regulatory

bodies to harmonize accounting practices so that incompatibilities between
accounting systems are minimized.
• The International Accounting Standards Committee (IASC) is leading the
way in the harmonization effort. The IASC has members from professional
 International Accounting and Taxation > 48

societies from over 85 countries; however its effort is hampered by the fact that its
has no enforcement power.
• The EU has also initiated the harmonization of the accounting systems of its
member states. The objective of the EU is to reduce the total accounting costs of
European MNCs and facilitate performance assessments. The World Trade
Organization and IOSCO (an international organization of national securities
commissions) also support the adoption of international accounting standards.
• Efforts to harmonize accounting practices have been criticized by some
individuals who point out that the costs of retooling could be high and that such
efforts could diminish the competitiveness of some accounting firms.

III. ACCOUNTING FOR INTERNATIONAL BUSINESS ACTIVITIES

Most international firms must deal with two specific types of accounting problems: (1)
accounting for transactions denominated in foreign currencies; and (2) reporting the
operating results of foreign subsidiaries in the firm’s consolidated financial statements.

Accounting for Transactions in Foreign Currencies

• Transaction exposure (see Chapter 18) is the effect of exchange-rate

fluctuations on the economic benefits and costs of an international transaction.
U.S. firms, in accordance with FASB Statement 52, must account for international
transactions that are settled in a foreign currency using a two-transaction approach
in their financial statements. The text provides an example of the two-transaction
approach.
• The two-transaction approach highlights any foreign-exchange loss or gain
resulting from a sale or purchase.

Foreign-Currency Translation

• Because most foreign subsidiaries conduct their business using the local
currency, firms must convert their subsidiaries’ financial statements into their home
currency (see Chapter 18).
• Translation is the process of transforming a subsidiary’s reported operations
denominated in a foreign currency into the parent’s home currency. Consolidated
financial statements report the combined operations of a parent and its
subsidiaries in a single set of accounting statements denominated in a single
currency.
• An issue that is raised as a firm translates financial reports from one currency to
another is which exchange rate to use, the rate on the date the transaction
occurred (the historical rate), or the current rate. In the U.S., firms approach the
question by following FASB Statement 52. According to the statement, firms use
one of the following methods: cost, equity, or consolidation to treat foreign
investments. Discuss Table 19.2 here.
• Firms that have a portfolio investment in a foreign firm must use the cost
method, whereby the investment is recorded in the U.S. firm’s accounting record at
cost using the historical exchange rate.
49 > Chapter 19

• A U.S. firm that owns between 10 and 50 percent of a foreign firm’s stock must
use the equity method, whereby the initial investment in the foreign firm is
recorded using the historical rate, but subsequent profits or losses are recorded at
the rate prevailing when they occurred.
• When a U.S. firm owns more than 50 percent of a foreign firm, it must use the
consolidated method, which calls for the accounting records of the two firms to be
consolidated when the U.S. subsidiary reports operating results to shareholders and
the SEC. The process first involves restating the subsidiary’s financial statements
using U.S. GAAP, then the functional currency (the currency of the principal
economic environment in which the subsidiary operates) is determined.
• Depending on the subsidiary’s functional currency, one of two methods will be
used to translate the subsidiary’s financial statements into the U.S. dollar. The
current rate method is used if the subsidiary’s functional currency is the host
country’s currency, and the temporal method is used if the subsidiary’s functional
currency is the U.S. dollar.
• Under the temporal method, translation losses and gain appear on the firm’s
income statement, but under the current rate method, they appear as an adjustment
to shareholders’ equity.

• Applying the Current Rate Method to Income Statements. U.S. firms, in

accordance with FASB Statement 52, use the current rate method to show in their
income statements either the exchange rate on the day the transaction occurred or
a weighted average of exchange rates during the period the income statement
covers. Dividends are translated using the exchange-rate effective on the day they
are paid. Discuss Table 19.3 here.

• Applying the Current Rate Method to Balance Sheets. Assets and liabilities
on a subsidiary’s balance sheet are translated under the current rate method using
the exchange rate in effect on the date for which the balance sheet was prepared.
Equity accounts are treated on a historical basis. In addition, the firm makes an
entry known as the cumulative translation adjustment which makes the firm’s
assets equal to the sum of its liabilities and shareholders’ equity. Discuss Table
19.4 here.

IV. INTERNATIONAL TAXATION ISSUES

National accounting practices and national taxation policies are often closely related.
For firms, the goal is to take advantage of tax incentives, but avoid punitive taxes.

Transfer Pricing

• International businesses can reduce their overall tax burdens by using transfer
pricing and tax havens. Transfer pricing refers to the prices one branch or
subsidiary of a parent charges a second branch or subsidiary for goods or services.
Transfer prices can be calculated using a market-based approach, or a non-market
method.
 International Accounting and Taxation > 50

• Market-Based Transfer Prices. The market-based method utilizes prices

determined in the open market to transfer goods between units of the same
company. The text illustrates this concept with an example of how Hyundai uses
the approach.
• A primary benefit of the market-based approach is that it reduces conflict
between units over the appropriate price. Furthermore, the approach promotes the
MNC’s overall profitability by encouraging the efficiency of the selling unit.
• Nonmarket-Based Transfer prices. Nonmarket-based approaches set prices
through negotiations between the buying and selling units or on the basis of cost-
based rules of thumb. These methods may be used when no real market for the
product or service exists outside the firm; however, managers may waste time and
energy haggling over prices and the selling unit may be less efficient.
• Firms may be able to reduce their tax burdens by using nonmarket-based
transfer prices in a strategic manner. In addition, firms may be able to evade
restrictions on the repatriation of profits by carefully adjusting transfer prices.
Discuss Table 19.5 here.
• Governments, aware that firms may attempt to reduce their tax burdens through
the use of transfer prices, frequently scrutinize MNC policies to ensure that they
receive the taxes they are entitled to. One approach is to use an arm’s length test,
whereby government officials attempt to determine the price that two unrelated
firms operating at arm’s length would have agreed on.

Tax Havens

• MNCs also reduce their tax burdens by locating their activities in tax havens,
countries that impose little or no corporate income taxes. MNCs using tax havens
divert income from subsidiaries in high-tax countries to the subsidiary operating in
the tax haven country. The text provides an example of how a company might use
the Cayman Islands as a tax haven location.

Discuss Going Global:

The Ethics of Tax Havens and Transfer Pricing
This Going Global Box discussed whether the use of transfer
pricing and tax havens by international businesses is ethical.
The Box notes that from one perspective the strategy is not ethical, but from
another perspective it is. The Box fits in well with a discussion of transfer prices.

V. TAXATION OF FOREIGN INCOME BY THE UNITED STATES

Taxation of Exports

• In general, income earned by U.S. firms from export sales is treated the same
as income earned from domestic sales. The U.S. does, however, in an effort to
increase export activities, encourage firms to establish foreign sales corporations
(FSC). Firms that establish FSCs may be able to significantly reduce their income
taxes on earnings from export sales.
51 > Chapter 19

Taxation of Foreign Branch Income

• Any earnings of a foreign branch (an unincorporated subsidiary) of a U.S.

company create taxable income for the parent, regardless of whether or not the
earnings are repatriated to the parent.

Taxation of Foreign Subsidiary Income

• The deferral rule in the U.S. tax code allows earnings from foreign subsidiaries
to be taxed only when they are remitted to the parent in the form of dividends. The
rule’s intent is to stimulate international activity by U.S. companies.
• A controlled foreign corporation (CFC) is a foreign corporation in which U.S.
shareholders -- each of which holds at least 10 percent of the firm’s shares --
together own a majority of its stock. The income of a CFC is divided into active
income and passive income.
• Active income is income generated by traditional business operations such as
production, marketing, and distribution. Active income can be deferred. Subpart F
income or passive income is generated by passive activities such as the collection
of dividends, interest, royalties, and licensing fees. Passive income cannot be
deferred.

VI. RESOLVING INTERNATIONAL TAX CONFLICTS

International firms must comply with the tax codes in each country in which they
operate. In some cases however, tax conflicts may occur.

Tax Credits

• A tax credit may be granted by the home country to reduce the burden of dual
taxation of foreign subsidiary income by the home country and the host country.

Tax Treaties

• Many countries, in an effort to promote international business, sign tax treaties

with other nations. The U.S., for example, has more than 40 tax treaties with
foreign countries. The text provides some of the details of the U.S.’ treaty with
Germany.

“Bashing” of Foreign Firms

• International tax conflicts may occur when domestic politicians “bash” foreign
firms, accusing them of manipulating transfer prices to avoid taxes. The text notes
that the U.S. cracked down on its enforcement of transfer pricing rules in the late
1980s and early 1990s, yet was unable to collect a portion of what it originally
sought.

Discuss Bringing the World into Focus: Pity the Poor Tax
Man
This Going Global Box describes the efforts of the IRS to collect
taxes from MNCs using a tax loophole called “earnings
 International Accounting and Taxation > 52

stripping.” MNCs, however appear to be quite successful in outsmarting the IRS,

and are still using the loophole. This question fits in well with the discussion of
international taxation issues.

CA

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The Aramco Advantage

The closing case describes the so-called Aramco Advantage that allowed the Aramco
consortium of companies to make enormous profits, and the Internal Revenue
Service’s efforts to collect taxes on the revenues.

Key Points

• Aramco, a consortium of four U.S. oil companies, originally controlled Saudi oil
fields. Although the Saudi government eventually expropriated the oil reserves,
Aramco continued to play an active role in marketing Saudi oil.

• The so-called Aramco Advantage began in 1979 when Saudi Oil Minister
Yamani forbade the consortium to sell Saudi oil for more than the price set by
Yamani’s ministry. Yamani, fearing that high prices would only increase efforts to
find substitutes, wanted to keep prices low. Aramco complied with the request.
However, since the directive only pertained to the price of crude oil, each company
continued to sell refined products at market prices. Since they were buying the
crude oil for less than the market price, the refining operations soon turned in
sizable profits.

• The high profits came to the attention of the Internal Revenue Service, which
was quick to seek a cut. It argued that since the profits came from the marketing
activities of the companies, income should be transferred from the refining end of
the operations to the parent corporation, and taxes should be paid accordingly.

• The consortium did not agree with the IRS, and argued that they were making
the profits only as a result of complying with Yamani’s directive. The case went to
court, where a ruling in favor of the companies was made.

Case Questions

1. Which unit of Texaco really “earned” the Aramco advantage? Aramco itself?
Texaco’s foreign refineries? Texaco’s marketing operations? Or the parent
corporation?

The unit of the company that actually earned the advantage is open to debate.
Texaco argued that the benefits of the advantage would be captured by a company
operating further down the production-distribution chain and that, in fact, the parent
company was unable to benefit from the lower crude prices because it could not sell
the oil. The IRS disagreed, however, suggesting the parent company benefited
from the advantage. The U.S. tax court supported Texaco's interpretation, finding
53 > Chapter 19

that the profits generated by the advantage were earned by the company’s refining
operation.

2. Had Aramco sold the crude oil to Texaco’s U.S. refineries, would Texaco have been
able to avoid U.S. taxation on the Aramco advantage?

It appears that Aramco’s ability to avoid paying taxes on the income derived from
the advantage is directly linked to the fact that the company earned the profits in its
foreign refinery subsidiaries. However, had the company sold the crude to its U.S.
refineries, the profits would have shown up in a U.S. corporation, which then could
have led to a very different outcome.

3. Since Minister Yamani created the Aramco advantage in part in response to U.S.
diplomatic pressure, should Exxon and Texaco have been required to sell their
allotment of Saudi crude oil to their domestic refineries?

Students may look at this question from different perspectives. Some students are
likely to suggest that Aramco benefited from being in the right place at the right
time, and that since it was simply following orders, the government had no say in
what it did. Others however, may argue that because the advantage was a direct
result of political pressure, the government should have stepped in and required
Aramco to pass along the profits to the U.S. In the end, it will probably be a debate
as to whether the government has the right to tell businesses how to function.

4. The IRS’s lawyers argued that the appeals court ruling amounted to a “blueprint for
the evasion of U.S. taxes. [It] …. creates substantial tax incentives for United
States corporations to encourage or endure the adoption of profitable foreign 'legal
restrictions' that 'require' such corporations to avoid United States taxation." Do
you agree with the IRS position? Or is it just being a cry-baby because it lost?

Many students will probably take a stand against the IRS simply because they feel
the IRS already has too much power. Others, however, may feel that the
companies involved unfairly profited from a situation, and that since the advantage
was a direct result of political pressure, consumers should have benefited. Yet, they
will probably agree that even if the companies were forced to pay taxes on the
earnings, it is unlikely that consumers would have ever faced lower prices at the
pump.

Additional Case Application

The case examines the unique situation that Aramco found itself in when political
posturing on the part of the U.S. and Saudi Arabia resulted in a directive to keep
crude oil prices down. While it is clear the Aramco benefited from the directive, it is
unclear whether the IRS should have had a cut of the pie as well. Students can be
asked to play the roles of the companies involved and the IRS, then hold a court
session where each side states its case. Other students can be asked to play the
role of the judges involved.
 International Accounting and Taxation > 54

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1. What factors influence the accounting procedures a country adopts?

A country’s accounting procedures will reflect its legal, cultural, political, and economic
situation. For example, a common law country develops accounting practices via the
decisions of independent standards boards, while in a code law country accounting
practices are determined by law.

2. How do German firms use accounting reserves?

German firms are free to establish accounting reserves to be used for various potential
future expenses. Most German firms use accounting reserves aggressively since they
reduce the reported income on which taxes are based. Some firms use them to smooth
out fluctuations in their earnings flows; other use them to pay for future expenses such as
deferred maintenance, future repairs, or exposure to international risks

3. What problems do Western firms and investors face in analyzing the performance of firms
in Centrally Planned Economies?

Accounting systems in CPEs tend to focus on collecting information needed for central
planners. Information on issues such as revenues, costs, and profits is typically left out
since it runs counter to Marxist ideology. For example, China’s system is designed to
provide information about a firm’s aggregate production, but it ignores bad debts and
obsolete inventory. Thus, Western firms and investors face a difficult task when analyzing
the performance of CPE firms and may find that the host country’s system needs to be
modified.

4. What is the impact of differing accounting standards on the international capital market?

Differing accounting standards make it difficult to compare the financial reports of firms
from different countries. In addition, because the U.S. requires that companies listed on
the New York Stock Exchange (NYSE) follow strict accounting practices, the NYSE worries
that it might lose out to non-U.S. stock markets. The U.S. practices do, however, make it
easier for U.S. firms to borrow money from international lenders.

5. Which organizations are promoting the harmonization of national accounting standards?

The International Accounting Standards Committee (IASC) is one of the most important
organizations promoting the harmonization of national accounting standards. In addition,
the EU has been actively endorsing a harmonized accounting system for its member
states.

6. What is the two-transaction approach?

The two-transaction approach is used by U.S. firms in their financial statements. Under the
two-transaction approach, every international transaction has a debit entry and a credit
55 > Chapter 19

entry. The approach effectively distinguishes between the firm’s core business and its
management of transaction exposure.

7. How do firms establish prices for goods sold by one subsidiary to another?

Prices for goods sold by one subsidiary to another are called transfer prices. Transfer
prices are calculated using either the market-based method or a non-market based
method. The former method uses prices determined in the open market to transfer goods
between subsidiaries, while the latter method may use prices that have been set by
negotiations between the buyer and seller, or on the basis of cost-based rules of thumb.

8. How do U.S. MNCs benefit from the deferral rule?

U.S. MNCs benefit from the deferral rule because the rule allows earnings in foreign
subsidiaries to be taxed only when they are remitted to the parent in the form of a dividend.

9. Why are the IRS’s rules regarding CFCs so complicated? What kind of behavior is the IRS
trying to prevent?

A CFC is a foreign corporation in which U.S. shareholders together own a majority of its
stock. The IRS’s rules are complicated because it is walking a fine line between
stimulating U.S. firms’ international business activities, and limiting their ability to evade
U.S. taxes. The IRS is trying to prevent firms from establishing shell corporations in tax
havens that do little but allow the parent firm to defer taxes.

10. What mechanisms have national governments adopted to lessen the burden of foreign
government taxes on home country MNCs?

National governments have adopted various mechanisms to protect their firms from foreign
governments’ taxes. Tax credits may be given to a firm for income taxes paid to the host
country. Tax treaties with other countries may contain provisions for reducing the
withholding taxes imposed on firms’ foreign branches and subsidiaries.

Questions for Discussion

1. The Big Five have globalized primarily through mergers. What advantage does this growth
strategy offer these firms? What are the disadvantages of this approach to globalization?

A primary advantage of using mergers as a means of global expansion is that once the
merger is complete, the company is ready for operation. Companies do not have to
purchase or build facilities, develop a customer base, train employees and so forth.
However, firms may experience difficulty in marrying corporate cultures and coordinating
activities. Firms may experience problems related to compensation systems, employee
responsibility, and authority systems that might not be encountered with other forms of
global expansion.
 International Accounting and Taxation > 56

2. What impact would harmonization of national accounting standards have on international

businesses?

Most students will probably agree that harmonization of national accounting standards
would be beneficial to most international businesses. Not only would such an action
facilitate the accounting systems of individual companies, it would also make it easier to
compare the financial situations of rival companies. Some students may point out that
there may be resistance to such an action, however, by companies that have become
accustomed to a fair amount of flexibility in their accounting practices. Most indications are
that efforts to harmonize accounting standards are focusing on the fairly rigid system used
in the U.S. If this practice continues, U.S. firms who are already familiar with the system
may have an edge (at least in the short term) over foreign rivals.

3. What are the benefits of the two-transaction approach to international businesses and
international investors?

The two-transaction approach highlights any foreign-exchange loss or gain resulting from a
transaction. Thus, the success of the firm’s core activities are separated from its success
in managing foreign-exchange exposure. This is beneficial to companies because it
highlights areas where the firm could improve its operations. For international investors,
the approach can signal situations in which the firm is exposing itself to too much foreign
exchange-rate risk.

4. How can an international firm use transfer pricing to increase its after-tax income?

An international firm can use transfer pricing to increase its after-tax burden by adjusting
transfer prices to avoid paying high ad valorem tariffs (i.e., by reducing the transfer price to
the buying unit so that the basis on which the tariff is calculated is lower), and by adjusting
transfer prices to avoid paying high corporate taxes (i.e., by showing high profits in low tax
countries and low profits in high tax countries).

5. The U.S. tax code distinguishes between active and passive income in permitting the
deferral of foreign subsidiaries’ income. Why has it made this distinction? Why is the
distinction important? If tax havens were eliminated, would the tax code need to continue
to distinguish between active and passive income?

The distinction has been made between active and passive income because without such
a distinction, firms would have an incentive to shift their profits to tax haven countries. By
limiting the ability of companies to do this, the U.S. maintains its capability of collecting its
“fair share” of taxes. Most students will probably agree that if tax havens were eliminated,
the distinction would become a moot point, but the problem of tax avoidance on the part of
MNCs would continue, just in another form.

6. Is the use of transfer pricing in order to reduce a firm’s taxes ethical? Why or why not?

Transfer pricing refers to the intracompany pricing of goods and services. Firms have often
been accused of unfairly manipulating transfer prices in an effort to reduce their tax
burden. Some students will probably agree that this is unethical behavior because it
represents a deliberate effort by firms to avoid taxes. Other students, however, will
probably take the perspective that as long as the firm follows the rules relating to transfer
57 > Chapter 19

prices, any reduction in taxes is a bonus. Students sharing this perspective will probably
suggest that the gain is simply a result of “knowing how to play the game.”

7. Are U.S. firms at a competitive disadvantage because they can’t use accounting reserves
as German firms do?

Accounting reserves are often used by firms to adjust for foreseeable future expenses that
could impact their operations. The U.S. does not view their use favorably, and therefore
American firms can use them only on a limited basis. German firms, however, do not face
these restrictions, and actively use the accounts. Most students will probably agree that
this difference indeed creates an uneven playing field between firms from the two
countries.

Hunti

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NG
B:

H
w
T

o
L

g
n
s
e
x
a

Essence of the exercise

This exercise requires students to access the websites of Austria, Switzerland, and Italy to
identify which country has the most favorable tax situation for a company that is seeking to
establish foreign operations. Students are asked to write up a report detailing the payroll
taxes and incomes taxes in each country, and whether there are any advantages to
opening as a subsidiary rather than a branch.

B
O

G
K

A
B

U
S

S
L
L

L
I

Essence of the exercise

This exercise asks students to obtain various pieces of information related to a firm’s financial
situation from the company’s most recent annual report.

Answers to the follow-up questions.

Teaching Note:
This exercise asks students to select a company of their choice, obtain the
company’s most recent annual report, and respond to very specific questions
related to the financial situation of the company. In fact, because of the specific nature of the
follow-up questions, no answers are given here. If the exercise is to be used in class
discussion, instructors may wish to assign a particular company to the entire class, or divide
the class into groups and assign a company to each group.

Other Applications
This Building Global Skills exercise asks students to consider a firm’s translation gains and
losses, transaction gains and losses, and tax situation. Instructors may wish to ask students to
expand on the exercise by scanning various trade publications such as the Wall Street Journal
to find examples of companies that have reported foreign-currency transactions gains or
losses, or translation gains or losses. In addition, students may want to find examples of how
companies are affected by the tax code of different countries.