Remarks – Timothy Lane
Deputy Governor of the Bank of Canada
Presented to: Canadian Pension & Benefits Institute
Vancouver, British Columbia
I would like to talk to you today about risk.
I know that risk is ever-present in your work, as you fulfill your commitments to the beneficiaries and sponsors of your pension plans. Important risks surround the investment performance of those plans, as well as the value of pension liabilities. All of you are, no doubt, acutely aware of these risks, which have become much more pronounced over the past few years.
At the Bank of Canada, we also focus on risk as part of our commitment to Canadians. Our mandate demands that we take an economy-wide perspective on risk. In setting monetary policy to achieve our 2 per cent target for inflation, we assess the risks to the real economy and inflation. In our work promoting a stable financial system, we assess the various risks to financial stability, both in Canada and globally. It is on these risks to financial stability that I would like to focus my remarks today.
The global financial crisis was a watershed. During the crisis, many financial system risks materialized and new risks emerged. I will talk briefly about the pre-crisis setting—the Great Moderation—when risks were perceived to be diminishing. I will then discuss how this complacency was shattered, the risks that materialized and the actions being taken to address those risks. Finally, I will talk about new risks that have emerged in the global financial environment, which stem from the “two-speed” recovery of the global economy.
I would like to use this discussion today to illustrate two main points. First, the sources of risk are evolving, and continuous effort is needed to identify and track risks as they evolve. Second, risk can come from unexpected sources. That means we must strive to ensure that the Canadian and the global financial systems are resilient enough to withstand the impact of unexpected events. At the Bank of Canada, we are working on both of these fronts.
The Great Moderation
Let me begin by talking about the “Great Moderation. ” For much of the past quarter-century, conventional wisdom held that the global economy was becoming increasingly stable. In the advanced countries, inflation had been tamed, recessions were milder than in the past and financial stability seemed assured. Ironically, that view was reinforced by the bursting of the dot-com bubble in 2001, which may have shaken the financial markets and given a number of you some sleepless nights but was seen as a test of the resilience of the global financial system. The Great Moderation was believed to be, at least in part, the product of sound economic policies and a sophisticated financial system that could transform and reallocate risks efficiently.
Emerging-market economies had quite a different experience during that period. Mexico, Korea, Indonesia, Thailand, Russia, Brazil and Argentina all suffered devastating crises that arose from a combination of financial system weaknesses, unsustainable public debt and external imbalances.
Then, during the last decade, the emerging-market economies, too, became progressively more stable. In most cases, they persevered in setting their public finances in order, in cleaning up their financial systems and in undertaking bold reforms to unfetter their dynamic economies. They made use of a benign global environment to reduce their external debts and build up international reserves.
There were still concerns about vulnerabilities—notably the global current account imbalances—but the risks were widely underestimated.
The 2008 Crisis
When the global crisis did occur, it started in an unexpected place: not on the periphery, but at the very core of the global economy, in the world’s most sophisticated financial system. As stresses began to appear in the U.S. subprime-mortgage market, many knowledgeable people thought that those stresses would be easily contained, since the problem loans were relatively small and securitized so that the risk could be borne by well-informed, diversified and adequately financed investors. In the autumn of 2008, however, as we all know, this turned into a global cataclysm, which spread through the world economy and financial system. Liquidity dried up as institutions became afraid to lend to one another. Their balance sheets deteriorated as they held fire sales of assets, and investors worldwide fled from risky assets.
With the resulting credit crunches and massive loss of wealth, the financial stresses triggered the “Great Recession”—the most severe since the Second World War. In this recession, no country escaped unscathed. However, the emerging-market economies were slower to be drawn into recession and quicker to recover than the advanced economies.
The global economy is now in a two-speed recovery. Emerging-market countries have resumed robust growth. But in many of the advanced economies, notably the United States and Europe, economic growth has been sluggish, as households, firms and financial institutions continue to repair the damage to their balance sheets. As I will discuss later, this two-speed recovery creates a new configuration of risk in the global financial system.
Here in Canada, the financial system proved more robust than in other advanced economies, although problems with asset-backed commercial paper could have had very serious ramifications had it not been for timely official intervention. The Bank of Canada had to inject substantial amounts of liquidity into the system to keep core funding markets functioning. Nonetheless, Canada suffered a severe recession, mainly because of the collapse in our exports.
The recovery is now well under way, both in Canada and globally. Indeed, in Canada, we are already in an expansion, as we have surpassed pre-crisis levels of economic activity and employment. But we must still ask how the crisis happened, and what must be done to avoid a recurrence.
What happened in the crisis?
Perhaps the biggest surprise of the crisis was the fact that defaults of subprime mortgages in the United States—a small segment of that country’s housing market—could cause the global financial system to unravel. As events unfolded in the autumn of 2008, we were reminded that the global financial system is bound together by an extensive web of interconnections. These interconnections among financial institutions and markets can spread trouble to unexpected places and cause small shocks to have outsized effects.
The financial crisis highlighted three main weaknesses in the way that the system handled risk.
- First, many financial institutions were excessively leveraged, had inadequate cushions of capital to absorb losses and insufficient liquidity to function in stressed market conditions.
- Second, the complex and opaque web of securitized lending and derivatives markets, which were believed to help the economy better manage and distribute risk, instead turned out to transmit and amplify that risk.
- Third, financial institutions that were “too big to fail” had diminished incentives to manage risk and, ultimately, shifted those risks to taxpayers.
These vulnerabilities were permitted to build up—or were even fostered—by the perception of diminishing risks in the Great Moderation. Financing patterns that appeared well-constructed in the context of ever-diminishing risk turned out to be imprudent once the system came under stress. Regulation fell well behind financial innovation.
The global response
The global financial reforms launched by G-20 leaders are designed to address the three weaknesses I have just discussed. First, to reduce the incidence and severity of financial crises, financial institutions will be required to have more ample cushions of capital and liquidity. Second, steps will be taken to reduce the risk that financial markets become channels of contagion. And third, mechanisms to deal with the too-big-to-fail problem will be made more robust. I will briefly discuss each of these elements.
The centrepiece of the agenda for global financial reform is the new Basel III rules on capital and liquidity. These rules substantially increase the loss-bearing capital that financial institutions must hold, combined with required liquidity ratios and a limit on leverage. In addition, a countercyclical buffer will be established so that capital is built up in good times, which can subsequently be available to absorb losses.1
On financial markets, a key step is to strengthen market infrastructure to reduce systemic risk. The G-20 leaders agreed to require clearing and settlement of over-the-counter derivatives through central counterparties, and to increase transparency in those markets—which proved to be a channel of financial contagion during the crisis. A central counterparty is also being established in Canada for clearing repurchase agreements (repos), a key form of short-term financing.
A related issue is market-based financing, including securitized lending. Work has begun under the auspices of the Financial Stability Board to define the sector, to develop the data and methodology to systematically monitor it, and to develop policy options.2
To address the too-big-to-fail problem of systemically important financial institutions, work is under way to ensure that they are appropriately supervised and adequately capitalized to absorb losses, and to establish a framework for resolution in the event that they do fail.
So this, in a nutshell, is what is being done to address the weaknesses underlying the 2008 crisis, with a view to creating a more resilient global financial system. I will now go on to discuss a new pattern of risks that has emerged since the recession.
Risks in a Two-Speed Global Recovery
As I have already mentioned, the current global recovery is operating at two speeds, with robust growth in emerging-market economies and anaemic growth in the advanced economies. This two-speed recovery, accompanied by a widening of global economic imbalances, is at the centre of a new configuration of risks to global financial stability. These risks comprise sovereign risks, financial fragility, the search for yield, and related stresses in emerging-market economies and foreign exchange markets.
Twice a year, the Bank of Canada publishes its Financial System Review (FSR), which examines developments in the financial system with a view to identifying potential risks to its overall soundness. This publication also highlights the efforts of the Bank, and other domestic and international regulatory authorities, to mitigate those risks. The pattern of risks I am going to discuss was examined in our December 2010 issue. We are continuing to track them and will provide an updated assessment in June.
Sovereign risks have become increasingly prominent in a number of advanced economies. Many countries entered the crisis with weak fiscal positions and then were further weakened by the effect of low growth on tax revenues and the costs of economic stimulus and the bailouts of financial institutions. These problems are most acute in the peripheral countries of Europe—notably Greece, Ireland and Portugal. But many advanced economies still have precarious public finances and will need to persevere to address these problems.
Canada’s fiscal position, in contrast, is stronger than that of most other advanced economies. Moreover, the domestic financial sector has limited direct exposure to the sovereign debt of peripheral euro-area countries. Nevertheless, there are a number of potential channels through which the Canadian financial system could be adversely affected by sovereign debt problems elsewhere, such as higher funding costs and a decline in asset-price valuations.
The low growth of many advanced economies has led to lingering financial fragility. The outlook for banks in Europe—and, to a lesser extent, the United States—continues to be clouded. Although many banks around the world made substantial progress in repairing their balance sheets, some remain unusually strained. They are also exposed to vulnerable economic sectors, notably residential and commercial property markets. In some cases, their funding positions are fragile, subject to fragile investor confidence.
With the weak growth of the major advanced economies, interest rates in a number of those economies are at extraordinarily low levels and are expected to remain so for an extended period. While stimulative monetary policy is needed to support the global economic recovery, this “low-for-long” scenario creates risk for the global financial system, and for the pension industry in particular.
As you know, institutional investors such as insurance companies and pension funds are often expected—or in some cases even required by contract or mandate—to deliver a target rate of return. In many cases, these targets are now unrealistic and can be met only by taking on more risk than is prudent. Changes in accounting rules, which use low, risk-free interest rates to discount liabilities while valuing assets at current market prices, increase the pressure to achieve these high returns on a continuous basis.
This is a particular instance of the “search for yield” that often accompanies a long period of very low interest rates. It may be associated with excessive credit creation and undue risk-taking as investors seek higher returns, leading to the underpricing of risk and unsustainable increases in asset prices. A number of other developments—the record issuance of high-yield debt securities in the United States, the rebound of capital flows into emerging-market economies and the popularity of commodity exchange-traded funds in recent quarters—are consistent with this pattern.
The influence of sustained low interest rates in major advanced economies on risk-taking behaviour is a powerful dynamic that bears watching.
Global imbalances are linked to the three risks I have just described and also pose some additional risks to the global financial system. The counterpart of these imbalances is that surplus countries in many cases are resisting upward pressure on their currencies and this is resulting in domestic inflationary pressures. As the authorities try to bottle up these inflationary pressures, that puts further stress on their financial systems. There is also the risk that the needed exchange rate adjustment, when it does come, will be disorderly.
Resolving global imbalances requires that the United States and other deficit countries boost domestic savings in a timely and sustained manner. At the same time, surplus economies—particularly the emerging economies of Asia—need to undertake structural reforms to bolster internal sources of growth in order to reduce their reliance on external demand. Greater exchange rate flexibility is also an essential part of the solution.3
These are some of the main risks to financial stability that we see emerging in the two-speed global recovery. Let me now talk briefly about how the Bank of Canada is working to sharpen its analysis of risks.
Strengthening Risk Assessment
At the Bank of Canada, we are developing new risk-assessment tools and models that capture the diverse sources of risk and help us understand how they propagate through the financial system. While the Bank is making important progress in this area, we are not alone. The International Monetary Fund and the Financial Stability Board, as well as central banks and academics, are also making significant efforts in this area.
Improvements in risk-assessment frameworks will focus on detecting vulnerabilities in the financial system. The Bank of Canada is thus developing a more rigorous empirical analytic framework to complement our current analysis and market intelligence. It may be that a single model of the financial system is neither practical nor realistic. Given the complexity of the financial system, a suite of models combining a number of analytical tools, approaches and indicators could provide the best avenue for success.
While we are working to identify key risks, recent events have reminded us that we have to expect the unexpected. The earthquake and tsunami in Japan are examples of the kind of shocks that nobody had foreseen. Another example is the—no less seismic—political unrest of the Middle East.
Clearly we can’t anticipate every shock. That’s why it so important to ensure that the financial system is more robust, so that it can withstand the shocks that will occur. Resilience, therefore, is the main goal of the G-20 reform agenda.
Allow me to conclude. Risk is ever-present, but its nature and sources change over time.
Complacency is itself a source of risk—and indeed, the Great Moderation sowed the seeds of its own destruction as vulnerabilities were allowed to build up.
This calls for vigilance in assessing the shifting nature of risk. The Bank of Canada continues to evaluate risks, sharing its assessment with other public institutions, international counterparts and the private sector.
But we must also expect the unexpected. The only defence against the unexpected is the development of a more resilient financial system—and the current set of financial reforms will do just that.
1. The Bank of Canada’s research report on the costs and benefits of the new rules can be found at <http://www.bankofcanada.ca/2010/08/secondary-page/strengthening-international-capital-and-liquidity-standards-a-macroeconomic-impact-assessment-for-canada-2/>. [←]
2. See “Shadow Banking: Scoping the Issues–A Background Note of the Financial Stability Board,” Financial Stability Board, 12 April 2011 <http://www.financialstabilityboard.org/publications/r_110412a.pdf>. [←]
3. All are key goals of the G-20 Framework for Strong, Sustainable and Balanced Growth. Canada co-chairs the committee monitoring the implementation of policies under this framework. [←]
Source: Bank Of Canada www.bankofcanada.ca
Lockdown 2.0 – Here’s how to be the best-looking person in the virtual room
suggests “the product you’re creating is not the camera, the lens or a webcam’s clever industrial design. It’s the subject, you, which is just on e part of the entire image they see. You want that image to convey quality, not convenience.”
Technology experts at Reincubate saw an opportunity in the rise of remote-working video calls and developed the app, Camo, to improve the video quality of our webcam calls. As part of this, they consulted the digital photography expert and author, Jeff Carlson, to reveal how we can look our best online.
It’s clear by now that COVID-19 has normalised remote working, but as part of this the importance of video calls has risen exponentially. While we’re all used to seeing the more casual sides of our colleagues (t-shirt and shorts, anyone?), poor webcam quality is slightly less forgivable.
But how can we improve how we look on video? We consulted Jeff Carlson for some top tips– here is what he had to say.
- Improve the picture quality of your call
The better your camera, the higher quality your webcam calls will be. Most webcams (as well as currently being hard to get hold of and expensive), are subpar. A DSLR setup will give you the best picture, but will cost $1,500+. You can also use your iPhone’s amazing camera as a webcam, using the new app from Reincubate, Camo.
Jeff’s comments “The iPhone’s camera system features dedicated coprocessors for evaluating and adjusting the image in real time. Apple has put a tremendous amount of work into its imaging software as a way to compensate for the necessarily small camera sensors. Although it all works in service of creating stills and video, you get the same benefits when using the iPhone as a webcam.”
Aidan Fitzpatrick, CEO of Reincubate explains why the team created Camo, “Earlier this year our team moved to working remotely, and in video calls everyone looked pretty bad, irrespective of whether they were on built-in Mac webcams or third-party ones. Thus began my journey to build Camo: an iPhone has one of the world’s best cameras in it, so could we make it work as a webcam? Category-leading webcams are noticeably worse than an iPhone 7. This makes sense: six weeks of Apple’s R&D spend tops Logitech’s annual gross revenue.”
- Place your camera at eye level
A video call will never quite be the same as a face-to-face conversation, but bringing your camera up to eye level is a good place to start. That can involve putting your laptop on a stand or pile of books, mounting a webcam to the top of your display screen, or even using a tripod to get the perfect position.
Jeff points out, “If the camera is looking down on you, you’ll appear minimized in the frame; if it’s looking up, you’re inviting people to focus on your chin, neck, or nostrils. Most important, positioning the camera off your eye level is a distraction. Look them in the eye, even if they’re miles or continents away.”
Low camera placement from a MacBook
- Make the most of natural lighting
Be aware of the lighting in the room and move yourself to face natural lighting if you can. Positioning the camera so any natural light is behind you takes the light away from your face, which can make it harder to see and read expressions on a call.
Jeff Carlson’s top tip: “If the light from outside is too harsh, diffuse it and create softer shadows by tacking up a white sheet or a stand-alone diffuser over the window.”
Backlit against a window Facing natural light
- Use supplementary lighting like ring lights
The downside to natural lighting is that you’re at the mercy of the elements: if it’s too bright you’ll have the sun in your eyes, if it’s too dark you won’t be well lit.
Jeff recommends adding supplementary lighting if you’re looking to really enhance your video calls. After all, it looks like remote working will be carrying on for quite some time.
“The light can be just as easy as a household or inexpensive work light. Angle the light so it’s bouncing off a wall or the ceiling, depending on your work area, which, again, diffuses the light and makes it more flattering.
Or, for a little money, use a softbox or a shoot-through umbrella with daylight bulbs (5500K temperature), or if space is tight, LED panels. Larger lights are better for distributing illumination– don’t be afraid to get them in close to you. Placement depends on the look you’re going after; start by positioning one at a 45-degree angle in front and to the side of you, which lights most of your face while retaining nice shadow detail.”
In some cases, a ring light may work best. LEDs are arranged in a circle, with space in the middle to put the camera’s lens and get direct illumination from the direction of the camera.
- Centre yourself in the frame
Make sure you’re getting the right angle and that you’re using the frame effectively.
“You should aim for people to see your head and part of your torso, not all the space between your hair and the ceiling. Leave a little space above your head so it’s not cut off, but not enough that someone’s eyes are going to drift there.”
- Be mindful of your backdrop
It’s not always easy to get the quiet space needed for video calls when working from home, but try as best you can to remove anything too distracting from your background.
“Get rid of clutter or anything that’s distracting or unprofessional, because you can bet that will be the second thing the viewers notice after they see you. (The Twitter account @RateMySkypeRoom is an amusing ongoing commentary on the environments people on television are connecting from.)”
A busy background as seen by a webcam
- Make the most of virtual backgrounds
If you’re really struggling with finding a background that looks professional, try using a virtual background.
Jeff suggests: “Some apps can identify your presence in the scene and create a live mask that enables you to use an entirely different image to cover the background. While it’s a fun feature, the quality of the masking is still rudimentary, even with a green screen background that makes this sort of keying more accurate.”
- Be aware of your audio settings
Our laptop webcams, cameras, and mobile phones all include microphones, but if it’s at all possible, use a separate microphone instead.
“That can be an inexpensive lavalier mic, a USB microphone, or a set of iPhone earbuds. You can also get wireless lavalier models if you’re moving around during a call, such as presenting at a whiteboard in the camera’s field of view.
The idea is to get the microphone closer to your mouth so it’s recording what you say, not other sounds or echoes in the room. If you type during meetings, mount the mic on an arm instead of resting it on the same surface as your keyboard.”
- Be wary of video app add-ons
Video apps like Zoom include a ‘Touch up your appearance’ option in the Video settings. This applies a skin-smoothing filter to your face, but more often than not, the end result looks artificially blurry instead of smooth.
“Zoom also includes settings for suppressing persistent and intermittent background noise, and echo cancellation. They’re all set to Auto by default, but you can choose how aggressive or not the feature is.”
- Be the best looking person in the virtual room
What’s important to remember about video calls at this point in time is that most people are new to what is, really, personal broadcasting. That means you can easily get an edge, just by adopting a few suggestions in this article. When your video and audio quality improves, people will take notice.
Bringing finance into the 21st Century – How COVID and collaboration are catalysing digital transformation
By Keith Phillips, CEO of TISATech
If just six or seven months ago someone had told you that in a matter of weeks people around the world would be locked down in their homes, trying to navigate modern work systems from a prehistoric laptop, bickering with family over who’s hogging the Wi-Fi, migrating online to manage all financial services digitally, all while washing their hands every five minutes in fear of a global pandemic… You’d think they had lost their mind. But this very quickly became the reality for huge swathes of the world and we’re about to go through that all over again as the UK government has asked that those who can work from home should.
Unsurprisingly, statistics show that lockdown restrictions introduced by the UK government in March, led to a sharp increase in people adopting digital services. Banks encouraged its customers to log onto online banking, as they limited (and eventually halted) services at branches. This forced many customers online as their primary means of managing personal finances for the first time.
If anyone had doubts before, the Covid-19 pandemic proved to us the importance of well-functioning, effective digital financial services platforms, for both financial institutions and the people using them.
But with this sudden mass online migration, it’s become clear that traditional banks have struggled to keep up with servicing clients virtually. Legacy banking systems have always stilted the digitisation of financial services, but the pandemic thrust this issue into the limelight. Fintech firms, which focus intently on digital and mobile services, knew it was only a matter of time before financial institutions’ reliance was to increase at an unprecedented rate.
For years, fintechs have been called upon by traditional players to find solutions to problems borne from those clunky legacy systems, like manual completion of account changes and money transfers. Now it is the demand for these services to be online coupled with the need for financial services firms to cut costs, since Covid-19 hit the economy.
Covid-19 has catalysed the urgent need to bring digital transformation to a wider pool of financial services businesses. Customers now have even higher expectations of larger institutions, demanding that they keep up with what the younger and more nimble challengers have to offer. Industry leaders realise that they must transform their businesses as soon as possible, by streamlining and digitising operations to compete and, ultimately, improve services for their customers.
The race for digital acceleration began far before the recent pandemic – in fact, following the 2008 financial crisis is likely more accurate. Since the credit crunch, there has been a wave of new fintech firms, full of young, bright techies looking to be the next big thing. Fintechs have marketed themselves hard at big conferences and expos or by hosting ‘hackathons’, trying to prove themselves as the fastest, most innovative or the most vital to the future of the industry.
However, even during this period where accelerating innovation in online financial services and legacy systems is crucial, the conditions brought about by the pandemic have not been conducive to this much-needed transformation.
The second issue, which again was clear far before the pandemic, is that fact that no matter how nimble or clever the fintechs’ solutions are, it is still hard to implement the solutions seamlessly, as the sector is highly fragmented with banks using extremely outdated systems populated with vast amounts of data.
With the significance of the pandemic becoming more and more clear, and the need for better digital products and services becoming more crucial to financial services firms and consumers by the day, the industry has finally come together to provide a solution.
The TISAtech project was launched last month by The Investing and Saving Alliance (TISA), a membership organisation in the UK with more than 200 leading financial institutions as members. TISA asked The Disruption House, a specialist benchmarking and data analytics business, to create a clearing house platform for the industry to help it more effectively integrate new financial technology. The project aims to enhance products and services while reducing friction and ultimately lowering costs which are passed on to the customers.
With nearly 4,000 fintechs from around the world participating, it will be the world’s largest marketplace dedicated to Open Finance, Savings, and Investment.
Not only will it provide a ‘matchmaking’ service between financial institutions an fintechs, it will also host a sandbox environment. Financial institutions can pose real problems with real data and the fintechs are given the space to race to the bottom – to find the most constructive, cost-effective solution.
Yes, there are other marketplaces, but they all seem to struggle to achieve a return on investment. There is a genuine need for the ‘Trivago’ of financial technology – a one stop shop, run by an independent body, which can do more than just matchmaking. It needs to go above and beyond to encompass the sandboxing, assessments, profiling of fintechs to separate the wheat from the chaff, and provide a space for true collaboration.
The pandemic has taught us that we are more effective if we work together. We need mass support and collaboration to find solutions to problems. Businesses and industries are no different. If fintechs and financial institutions can work together, there is a real chance that we can start to lessen the economic hit for many businesses and consumers by lowering costs and streamlining better services and products. And even if it is just making it that little bit easier to manage personal finances from home when fighting with your children for the Wi-Fi, we are making a difference.
What to Know Before You Expand Across Borders
By Sean King, Director of International Tax at McGuire Sponsel
The American retail giant, Target Corporation, has a market cap of $64 billion and access to seemingly limitless resources and advisors. So, when the company engaged in its first global expansion, how could anything possibly go wrong?
Less than two years after opening its first Canadian store in 2013, Target shut down all133 Canadian locations and terminated more than 17,000 Canadian employees.
Expansion of an operation to another country can create unique challenges that may impact the financial viability of the entire enterprise. If Target Corporation can colossally fail in its expansion to Canada, how might Mom ‘N’ Pop LLC fare when expanding into Switzerland, Singapore, or Australia?
Successful global expansion requires an understanding of multilayered taxes, regulatory hurdles, employment laws, and cultural nuances. Fortunately, with the right guidance, global expansion can be both possible and profitable for businesses of any size.
Any company with global ambitions must first consider whether the company’s expansion outside of the U.S. will give rise to a taxable presence in the local country. In the cross-border context, a “permanent establishment” can be created in a local country when the enterprise reaches a certain level of activity, which is problematic because it exposes the U.S. multinational to taxation in the foreign country.
Foreign entity incorporation
To avoid permanent establishment risk, many U.S. multinationals choose to operate overseas through a formal corporate subsidiary, which reduces the company’s foreign income tax exposure, though it may result in an additional level of foreign income tax on the subsidiary’s earnings. In most jurisdictions, multinationals can operate their business in the foreign country as a branch, a pass through (e.g., partnership,) or a corporation.
As a branch, the U.S. multinational does not create a subsidiary in the foreign country. It holds assets, employees, and bank accounts under its own name. With a pass through, the U.S. multinational creates a separate entity in the foreign country that is treated as a partnership under the tax law of the foreign country but not necessarily as a partnership under U.S. tax law.
U.S. multinationals can also create corporate subsidiaries in the foreign country treated as corporations under the tax law of both the foreign country and the U.S., with possibly two levels of income taxation in the foreign country plus U.S. income taxation of earnings repatriated to the U.S. as dividends.
Under U.S. entity classification rules, certain types of entities can “check the box” to elect their classification to be taxed as a corporation with two levels of tax, a partnership with pass-through taxation, or even be disregarded for U.S. federal income tax purposes. The check the box election allows U.S. multinationals to engage in more effective global tax planning.
Toll charges, transfer pricing and treaties
When establishing a foreign corporate subsidiary, the U.S. multinational will likely need to transfer certain assets to the new entity to make it fully operational. However, in many cases, the U.S. multinational cannot perform the transfer without recognizing taxable income. In the international context, the IRS imposes certain outbound “toll charges” on the transfer of appreciated property to a foreign entity, which are usually provided for in IRC Section 367 and subject to various exceptions and nuances.
Instead, the U.S. multinational may prefer to license intellectual property to the foreign subsidiary for a fee rather than transfer the property outright. However, licensing requires the company and foreign subsidiary to adhere to transfer pricing rules, as dictated by IRC Section 482. The U.S. multinational and the foreign subsidiary must interact in an arms-length manner regarding pricing and economic terms. Furthermore, any such arrangement may attract withholding taxes when royalties are paid across a border.
Are you GILTI?
Certain U.S. multinationals opt to focus on deferring the income recognition at the U.S. level. In doing so, they simply leave overseas profits overseas and delay repatriating any of the earnings to the U.S.
Despite the general merits of this form of planning, U.S. multinationals will be subject to certain IRS anti-deferral mechanisms, commonly known as “Subpart F” and GILTI. Essentially, U.S. shareholders of certain foreign corporations are forced to recognize their pro rata share of certain types of income generated by these foreign entities at the time the income is earned instead of waiting until the foreign entity formally repatriates the income to the U.S.
The end goal
Essentially, all effective international tax planning boils down to treasury management. Effective and early tax planning can properly allow a company to better achieve its initial goal: profitability.
If global expansion is on the horizon for your company, consult a licensed professional for advice concerning your specific situation.
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