Corporate FX Exposure & Global Tax Planning Strategies
Foreign Exchange Exposure Defined
Foreign exchange exposure is a measure of the potential for a firm’s profitability, net cash flow, and market value to change due to fluctuations in exchange rates. A key task for financial managers is to measure and manage this exposure, which can be assessed in several ways.
Understanding Transaction Exposure
Transaction exposure measures changes in the value of outstanding financial obligations incurred prior to a change in exchange rates but not due to be settled until after the exchange rates change. Thus, this type of exposure deals with changes in cash flows that result from existing contractual obligations.
Transaction exposure and operating exposure both arise from unexpected changes in future cash flows. However, transaction exposure is concerned with future cash flows already contracted for, while operating exposure focuses on expected (not yet contracted for) future cash flows that might change because an alteration in exchange rates has affected international competitiveness.
Transaction exposure measures gains or losses that arise from the settlement of existing financial obligations whose terms are stated in a foreign currency. Examples include:
- Purchasing or selling goods or services on credit when prices are stated in foreign currencies.
- Borrowing or lending funds when repayment is to be made in a foreign currency.
- Being a party to an unperformed forward contract.
- Otherwise acquiring assets or incurring liabilities denominated in foreign currencies.
Translation (Accounting) Exposure
Translation exposure, also known as accounting exposure, represents the potential for accounting-derived changes in owner’s equity. This occurs because foreign currency financial statements of foreign subsidiaries must be restated in the parent’s reporting currency to prepare worldwide consolidated financial statements.
The accounting process of translation involves converting these foreign subsidiary financial statements into the parent’s reporting currency (e.g., US dollar-denominated statements). This process can lead to a potential increase or decrease in the parent’s net worth and reported net income due to changes in exchange rates since the last translation. While the primary purpose of translation is to prepare consolidated statements, management also utilizes translated statements to assess performance and facilitate comparisons across subsidiaries.
Operating (Economic) Exposure
Operating exposure, also referred to as economic exposure, competitive exposure, or strategic exposure, measures the change in the present value of a firm. This change results from any alteration in the firm’s future operating cash flows caused by an unexpected shift in exchange rates.
Operating exposure analysis assesses the impact of changing exchange rates on a firm’s own operations over coming months and years, as well as on its competitive position relative to other firms.
Hedging Financial Price Risks
Multinational Enterprises (MNEs) possess a multitude of cash flows that are sensitive to changes in exchange rates, interest rates, and commodity prices. These three financial price risks are the subject of the growing field of financial risk management. Many firms attempt to manage their currency exposures through hedging.
A hedge involves taking a position—acquiring either a cash flow, an asset, or a contract (including a forward contract)—that will rise (fall) in value and offset a fall (rise) in the value of an existing position. While hedging can protect the owner of an asset from a loss, it also eliminates any gain from an increase in the value of the asset hedged against.
The value of a firm is the present value of all expected future cash flows, which are expected but not certain. Currency risk is the variance in expected cash flows arising from unexpected exchange rate changes. A firm that hedges these exposures reduces some of the variance in the value of its future expected cash flows.
Managing Transaction Exposure with Hedges
Foreign exchange transaction exposure can be managed by contractual, operating, and financial hedges. The main contractual hedges employ the forward, money, futures, and options markets.
Managing Translation Exposure
The main technique to minimize translation exposure is called a balance sheet hedge. This strategy requires an equal amount of exposed foreign currency assets and liabilities on a firm’s consolidated balance sheet.
Current Rate Method for Financial Statement Translation
The Current Rate Method is the most prevalent translation method today:
- Assets and Liabilities: Translated at the current exchange rate.
- Income Statement Items: Translated at the exchange rate on the dates they were recorded or an appropriately weighted average exchange rate for the period.
- Dividends (Distributions): Translated at the exchange rate on the payment date.
- Common Stock and Paid-in Capital: Translated at the historical exchange rate.
Gains or losses caused by translation adjustments are not included in the consolidated net income. Instead, they are reported separately and accumulated in a separate equity reserve account (on the balance sheet) with a title such as Cumulative Translation Adjustment (CTA). An advantage of this method is that the gain or loss on translation does not pass through the income statement, thereby reducing the variability of reported earnings.
Temporal Method for Financial Statement Translation
The Temporal Method for translation involves:
- Monetary Assets and Liabilities: Translated at the current exchange rate.
- Nonmonetary Assets: Translated at the historical exchange rate.
- Income Statement Items: Translated at the average exchange rate for the period.
- Dividends (Distributions): Translated at the exchange rate on the payment date.
- Common Stock and Paid-in Capital: Translated at the historical exchange rate.
A disadvantage of this method is that the gain or loss on translation is carried directly to current consolidated income, which increases the variability of consolidated earnings.
Proactive Policies for Exposure Management
Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated currency exposures. Five commonly employed proactive policies are:
- Matching currency cash flows
- Risk-sharing agreements
- Back-to-back or parallel loans
- Cross-currency swaps
- Contractual approaches
Diversifying Operations for Risk Mitigation
Diversifying operations means diversifying the firm’s sales, location of production facilities, and raw material sources. If a firm is diversified, management is pre-positioned to both recognize disequilibrium when it occurs and react competitively. Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies.
Diversifying the Financing Base
Diversifying the financing base means raising funds in more than one capital market and in more than one currency. If a firm is diversified, management is pre-positioned to take advantage of temporary deviations from the International Fisher Effect.
Matching Currency Cash Flows
Matching currency cash flows involves offsetting an anticipated continuous long exposure to a particular currency by acquiring debt denominated in that currency. This policy results in a continuous receipt of payment and a continuous outflow in the same currency.
Natural Hedges in Operations
A natural hedge occurs through the conduct of regular operations (e.g., with suppliers).
Risk-Sharing Agreements
Risk-sharing is a contractual arrangement in which the buyer and seller agree to “share” or split currency movement impacts on payments.
Back-to-Back (Parallel) Loans
A back-to-back loan, also referred to as a parallel loan or credit swap, occurs when two firms in different countries arrange to borrow each other’s currency for a specific period of time. It can be difficult for a firm to find a partner (counterparty) for the desired currency amount and timing. One of the parties may fail to return the borrowed funds at the designated maturity, although this risk is minimized because each party has 100% collateral (denominated in a different currency).
Currency Swaps Explained
In a currency swap, a firm and a swap dealer agree to exchange an equivalent amount of two different currencies for a specified period of time. This often involves two firms borrowing funds in the markets and currencies in which they are well known.
Contractual Hedges for Operating Exposure
Some MNEs now attempt to hedge their operating exposure with contractual hedges, such as taking long-term currency option positions designed to offset lost earnings from adverse changes in exchange rates. For example, Merck has purchased over-the-counter (OTC) long-term put options on foreign currencies versus the U.S. dollar as insurance against potential lost earnings from exchange rate changes.
The ability to hedge effectively depends on:
- The predictability of the firm’s future cash flows.
- The predictability of the firm’s competitor responses to exchange rate changes.
Multinational Tax Management
Tax planning for MNE operations is extremely complex but a vital aspect of international business. MNEs must understand not only the intricacies of their own worldwide operations but also the different structures and interpretations of tax liabilities across countries. The primary objective is the minimization of the firm’s worldwide tax burden.
National Tax Environments & Principles
Nations typically structure their tax systems along one of two basic approaches: the worldwide approach or the territorial approach.
The worldwide approach levies taxes on the income earned by firms that are incorporated in the host country, regardless of where the income was earned (domestically or abroad). An MNE earning income both at home and abroad would therefore find its worldwide income taxed by its home country tax authorities.
Territorial Tax Approach
The territorial approach focuses on the income earned by firms within the legal jurisdiction of the host country, not on the country of firm incorporation. This can result in a major gap in coverage if resident firms earn income outside the country but are not taxed by the country in which the profits are earned.
Understanding Tax Deferral
Tax deferral allows parent companies to defer claiming additional income taxes on foreign source income until it is remitted to the parent firm.
Role of Tax Treaties
Tax treaties provide a means of reducing double taxation. These are bilateral agreements, with the two signatories specifying what rates are applicable to which types of income, often resulting in reduced withholding tax rates.
Income Tax Basics
Income tax is the primary source of revenue in many countries.
Withholding Tax on Passive Income
Withholding tax is typically applied to passive income (e.g., dividends, royalties, interest) earned by a non-resident. Governments impose this as a minimum payment for earning income within their tax jurisdiction, knowing that the party will not file a tax return in the host country.
Value Added Tax (VAT)
A Value Added Tax (VAT) is a type of sales tax collected at each stage of production or sale of consumption goods, in proportion to the value added during that stage.
Other National Tax Types
Other national taxes, with varying importance from country to country, include:
- Turnover tax: A tax on the purchase or sale of securities.
- Tax on undistributed profits: A higher income tax rate on retained earnings of firms.
- Property and inheritance tax.
Foreign Tax Credit (FTC)
To prevent double taxation of the same income, many countries grant a Foreign Tax Credit (FTC) for income taxes paid to the host country. FTCs vary widely by country. A tax credit is a direct reduction of taxes that would otherwise be due; it is not a deductible expense because it does not reduce the taxable income.
Transfer Pricing Strategies
Transfer pricing, the pricing of goods, services, and technology transferred to a foreign subsidiary from an affiliated company, is a primary method of transferring funds out of a foreign subsidiary. These costs enter directly into the cost of goods sold component of the subsidiary’s income statement.
Fund Positioning Effect
A parent wishing to transfer funds can charge higher prices to its subsidiary to the degree that government regulations allow. A high transfer price allows funds to be accumulated in the selling country, illustrating the fund positioning effect.
Income Tax Effect on Transfer Pricing
A major consideration in setting a transfer price is the income tax effect. The goal is to:
- Minimize taxable income in a country with a high-income tax rate.
- Maximize taxable income in a country with a low-income tax rate.
Tax Havens and Offshore Financial Centers
Many MNEs have foreign subsidiaries that act as tax havens for corporate funds awaiting reinvestment or repatriation. Tax-haven subsidiaries, categorically referred to as international offshore financial centers, are partially a result of tax-deferral features on earned foreign income allowed by some parent countries.
Tax-haven subsidiaries are typically established in a country that meets the following requirements:
- A low tax on foreign investment or sales income earned by resident corporations and a low dividend withholding tax on dividends paid to the parent firm.
- A stable currency to permit easy conversion of funds into and out of the local currency.
- Facilities to support financial services, such as good communications, professionally qualified office workers, and reputable banking services.
- A stable government that encourages the establishment of foreign-owned financial and service facilities within its borders.