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Session 6: Tax Considerations and Exchange Rates - Coggle Diagram
Session 6: Tax Considerations and Exchange Rates
Transfer Pricing
Happens whenever 23 companies that are part of the same multinational group trade with each other.
Not illegal
Transfer Mispricing - when manipulation of prices for goods or services traded between related entities to shift profits from high-tax to low-tax jurisdictions, reducing overall tax liabilities happens.
Illegal
Arms-length Principle
Transactions between related entities must be priced as if they were between completely independent parties in an open market, ensuring fair taxation and preventing profit shifting to low-tax jurisdictions.
Supposed to stop two related companies from artificially distorting the price of the trade that is recorded to minimise the tax bill.
Hard to implement
Because...
Could be no market comparisons for products to be made, so price isn't obvious,
Great scope for misunderstanding and for deliberate mispricing.
Ambiguous
Endorsed by OECD and United Nations Tax Committee - is used as basis for bilateral treaties between governments.
Alternate Approach: Unitary taxation
A method for taxing multinational corporations as a single entity based on their actual economic activity rather than where they book profits
Aim is to tax portions of a MNC's income without reference to how that enterprise is organised internally.
Obstacles
Path Dependency - international tax system is set up for arms-length approach, implementing new system would take great effort to change.
Vested Interests - as MNC's like having leeway to manipulate transfer pricing, they have strong interest against new methods.
Technical Issues - technical complexities in designing an appropriate formula and more work needs to be done in this area.
Foreign Exchange Market
where exchange rate is determined
Appreciation is when a currency increases in value.
Depreciation is when a currency decreases in value.
Demand for £ Abroad
More expensive the price of the £, the more foreign currency has to be exchanged to buy it.
Reduces quantity demanded
Demand will be downward sloping curve.
Higher price elasticity for demand of products means higher price elasticity for demand of £.
Demand for £ is derived from demand for UK products.
If demand of UK exports is price elastic, the effect of an increase in the value of the pound will be
greater,
Supply of £ to Foreign Currency Market
Derived from people and organisations exchanging £ for foreign currency.
When £ appreciates, gains purchasing power abroad, making imports cheaper, will increase demand for foreign goods.
When demand for import is price elastic, lower prices lead to a large rise in quantity demanded, so total spending on imports increases.
Supply of £ is upward-sloping.
When demand is price inelastic, quantity demanded raises slightly, so total spending on imports falls.
Supply is downward-sloping.
Reaching Equilibrium
Free market - exchange rate adjusts until quantity demanded = quantity supplied.
If exchange rate is too high...
Excess supply of currency.
Value of £ falls
Reduces quantity supplied and increases quantity demanded.
If exchange rate is too low...
Excess demand of currency
Value of £ increases.
Increases quantity supplied and reduces quantity demanded.
Shifts in Demand for Currency
Increase in demand -> demand curve shift right.
Increase due to...
Higher overseas income -> increase demand for UK exports
Higher UK interest rates -> attracts foreign investors.
Speculation -> investors buy £ expecting them to appreciate in the future.
Shifts in Supply for Currency
Increase in supply -> supply curve shift outward.
Increase due to...
Higher UK incomes -> increase in demand for imports -> more £ to be exchanged
Higher overseas interest rates -> investors move money out of UK.
Speculation -> traders sell £ expecting value to fall.
Why Changes in Exchange Rates Matter
Affect business's prices, sales, costs and profits.
When £ depreciates...
UK exports are cheaper -> increases overseas demand and boosts output, employment and economic growth.
When £ appreciates...
UK exports become expensive -> reducing sales -> lower profit margins.
Import costs can become cheaper.
McBurger Index
Compares the actual exchange rate with what it would need to be to keep prices of burgers in different countries comparable. A McDonald’s burger is chosen because it is a fairly standardized product in different countries.
Crude measure of what is known as ‘purchasing power parity’ (PPP). PPP is usually calculated by comparing the costs of similar baskets of goods;
Overcoming ER Problems
Managers can...
Focus on markets with the same currency.
Operate in multiple overseas market.
Buy currency in advance at a fixed rate.
Speculate in currencies.
Set contracts in the firm's own currency.
Impact of Change in Exchange Rate
Depends on...
what proportion of its sales are exported;
what proportion of its inputs are imported;
the degree of competition in the market from overseas businesses
how much the value of the currency has changed (and in what direction) against the currencies in its exports and import markets
the price elasticity of demand for exports and imports
the availability of alternative markets to export to or other suppliers to switch to
Government Intervention
To increase value of its own currency...
Buy its own currency -> increasing demand and raising its price. Limited by gov's reserves or ability to borrow.
Raise interest rates -> attracts foreign investors, increases demand of currency.
Euro
Benefits of Eurozone
No transaction costs when exchanging currencies within the zone.
Greater stability and easier planning.
Easier price comparisons across countries, increasing competition and reducing costs.
Drawbacks of Eurozone
Loss of national currency.
A shared currency value influenced by the economic performance of all member countries.
Loss of control over domestic interest rates.