Page 265 - DMGT514_MANAGEMENT_CONTROL_SYSTEMS

Management Control Systems

Notes 14.3.1 Tax Haven

A tax haven country is one that has a low corporate income tax and low withholding tax rates on
passive income. Some major tax haven countries are the Bahamas, Bahrain, Bermuda, British
Virgin Islands, Cayman Islands, Channel Island and the Isles of Manama.
Tax havens were once useful as locations for an MNC to establish a wholly owned “Paper”
foreign subsidiary that in turn would own the operating foreign subsidiaries of the MNC. In this
arrangement, dividends could be routed through the tax haven affiliate, but the taxes due on
them can be deferred until a dividend was declared by the tax haven subsidiary. Nowadays, the
benefit of a tax haven subsidiary has been reduced because of two reasons:
1. Present corporate income tax rate of the parent company is not high in comparison to
most non-tax haven countries, thus eliminating the need for deferral.
2. Rules governing controlled foreign corporations have effectively eliminated the ability
to defer passive income in a tax haven foreign subsidiary.
14.3.2 Fronting Loans

A fronting loan is a loan between a parent and its subsidiary channelled through a financial
intermediary, usually a large international bank. In a direct intra-firm loan, the parent company
lends cash directly to the foreign subsidiary and the subsidiary repays it later. In a fronting loan,
the parent company deposits funds in an international bank, and the bank then lends the same
amount to the foreign subsidiary. Thus, a US firm might deposit $ 100,000 in a London bank. The
London bank then lends that $100,000 to an Indian subsidiary of the firm. From the bank’s point
of view, the loan is risk-free because it has 100% collateral in the form of the parent’s deposit.
The bank ‘fronts’ for the parent, hence the name. The bank makes a profit by paying the parent
company a slightly lower rate on its deposit than it charges the foreign subsidiary on the
borrowed funds.

Firms use fronting loans for two reasons. First, the fronting loan can circumvent the host
company’s restrictions on the remittance of funds from a foreign subsidiary to the parent
company. A host government might restrict a foreign subsidiary from repaying a loan to its
parent in order to preserve the company’s foreign exchange reserves, but is less likely to restrict
a subsidiary’s ability to repay loan to a large international bank, since stop payment to an
international bank would hurt the company’s credit image whereas, withdrawing payment to
the parent company would probably have minimal impact on its image. Consequently,
international business sometimes use fronting loans when they want to lend funds to a subsidiary
based in a country with a fairly high political turmoil that might lead to restrictions on capital
flows (i.e., when the level of political risk is high.)
A fronting loan can be structured to provide tax advantages. For example, a tax haven (Bermuda)
subsidiary i.e., 100% owned by the parent company deposits $ million in a London based
international bank at 8% interest. The bank in turn lends $ 1 million to a foreign operating
subsidiary at 9% interest, (corporate tax rate is 50%). Under this arrangement, interest payment
net of income tax will be as follows:

1. The foreign operating subsidiary pays $90,000 interest to the London Bank which is
equivalent to other tax costs of $45,000.
2. The London bank receives the $90,000. It retains $10,000 for its services and pays $80,000
interest on deposit to the Bermuda subsidiary.
3. The Bermuda subsidiary receives $80,000 interest on deposit tax free.

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