José Viñals, IMF Financial Counsellor and Director, Monetary and Capital Markets Department
European Commission and ECB Conference on Financial Integration and Stability
Let me begin by thanking the Commission and the ECB for inviting me to speak to such a distinguished audience. My comments today are on the latest hot-button issue for policymakers—namely, macroprudential policy. I will begin by explaining what’s behind the hype, and why it is important—for Europe and the rest of the world. I will then discuss where the thinking on macroprudential policies is heading, and what we have learned to date on how to do it; and how not to do it.
Macroprudential policy: What it is and why it matters
When the global financial system was thrown into crisis, many policymakers were shocked to discover that they had lacked the tools to prevent problems in one part of the financial system from spiraling out of control.
We learned through this crisis that system-wide, or systemic, risks cannot be addressed through the traditional mix of macroeconomic policies and “microprudential” measures aimed at individual financial institutions. By focusing on the health of the financial system as a whole, macroprudential policy can improve the authorities’ grasp of the intricate web of connections between financial institutions, financial markets, and the macro-economy.
The new tools would enhance policymakers’ ability to cope with two, interrelated drivers of systemic risk:
(i) The risks associated with swings in credit and liquidity cycles, driven by procyclical forces such as leverage and herding behavior by financial institutions, non-financial firms, and households; and
(ii) The concentration of risk in certain financial institutions and markets that are highly interconnected within, and across, national borders.
Since then, progress has been made in developing macroprudential policies—the set of measures and institutional frameworks that is specifically aimed at containing risks in the financial system as a whole. This issue is one of the top agenda items at international forums. For example, the new bank capital framework under Basel III includes a countercyclical capital buffer aimed at addressing the pro-cyclicality of financial systems. To limit the risks associated with interconnectedness, the IMF has proposed a systemic capital surcharge and a systemic liquidity surcharge based on a financial firm’s marginal contribution to systemic risk.
Many countries have been experimenting with macroprudential policies. In Europe, for example, we have very recently seen the launch of the European Systemic Risk Board and various national institutional arrangements, such as the Financial Policy Committee in the UK, or the Financial Regulation and Systemic Risk Council in France. In the US, we have seen the establishment of the Financial Stability Oversight Council; and there have been similar institutional changes in emerging market economies such as Mexico and Malaysia. Some countries have sought to address risks in their real estate markets by putting limits on Loan-to-Value ratios (Hong Kong, Singapore, South Korea, and China). Others have used caps on Loan-To-Income ratios (Serbia), and caps on Debt-to-Income ratios (South Korea). Some countries have used direct monetary policy instruments to constrain credit supply during booms. These instruments include limits on the level, or growth rate, of aggregate credit or specific exposures (Serbia and Malaysia), and changes in reserve requirements (Brazil, Bulgaria, Colombia, China, India, and Saudi Arabia). There have also been fiscal policy measures such as stamp duties on property holdings to tame speculation in real estate markets (China, Hong Kong). Recent structural measures include the “Volcker-rule”, which would create a ban on proprietary trading for systemically important U.S. banks. In the European Union, we have seen structural policy proposals to restrict short selling and limit the use of certain derivatives in the event of a serious threat to financial stability.
As you can see, progress in developing macroprudential tools has been uneven. Therefore, greater efforts are needed to transform this policy patchwork into an effective—and internationally coherent—crisis prevention toolkit. That is why the Group of 20 leading economies asked the IMF, the Financial Stability Board, and the Bank for International Settlements to develop a coherent framework for this new policy.
Developing a coherent policy framework is a challenging task. National policymakers have been grappling with this, both at the conceptual level and in practical terms. We, at the IMF, have worked to clarify the concept of macroprudential policy and its role in preserving financial stability. So where are we now? And what have we learned? Let me make five separate points.
First, use it but do not abuse it
We need to lay out a clear understanding of what macroprudential policy is, and what it is not; and what it can and cannot do. Macroprudential policy seeks to limit systemic financial risks by using (primarily) prudential tools. These prudential tools are designed to prevent financial instability and the associated social and economic costs.
This system-wide perspective is very important, because of the so-called “fallacy of composition” of traditional prudential policy—that is, actions that are appropriate for individual firms may collectively lead to, or exacerbate, system-wide problems. The complexity of processes that can generate systemic risk, and the ease with which risk can migrate across the financial system, call for a focus on the whole range of financial institutions (banks and non-banks alike), instruments, markets, and infrastructures.
But macroprudential policy is no substitute for robust prudential policies of the traditional kind—now called microprudential policy, which primarily aims at ensuring the solidity of individual financial institutions—and is clearly no substitute for sound macroeconomic policy. Macroprudential policy needs to be defined narrowly, because it should not encourage expectations that cannot, and should not, be fulfilled. Strong regulation and effective supervision of individual financial institutions are necessary preconditions for effective macroprudential policies. And monetary and fiscal policies should remain the first line of defense against macroeconomic distortions and imbalances. As we develop macroprudential policies, we must be clear that this policy innovation should not be used as an excuse to avoid difficult, but necessary, macroeconomic choices.
Equally important, independence in other policy areas—including monetary and microprudential policy—should not be undermined in the name of macroprudential policy. The institutional arrangements in which macroprudential policy is embedded should not become a “Trojan horse”—undermining hard-won policy autonomy in other areas. Thus, macroprudential and other policies should be coordinated in a manner that is compatible with the achievement of each policy’s objectives. This will require appropriate separate mandates, and suitable governance and accountability structures.
Second, don’t leave it alone in the pursuit of financial stability
No matter how different policy mandates are structured, ensuring financial stability is a shared responsibility. Other policies, for which financial stability is—at most—a secondary objective, should not lose sight of the systemic consequences of their action, or inaction, and should not be a source of financial instability. An especially prominent role is played by microprudential policy and monetary policy, both of which affect the amount of risk the financial system is willing (and able) to bear. For example, the larger the buffers created by microprudential policy, the smaller the need for macroprudential policy to step in.
Macroprudential and other policies interact in complex ways that are not yet fully understood. Policy conflicts may arise. For instance, if monetary policy is loosened for a long period, macroprudential policy may want to become tighter to avoid excessive risk-taking. Or, if macroprudential policy encourages drawing down bank capital buffers in a downturn to sustain the flow of credit, microprudential policy may be inclined to keep buffers unchanged to guard against the heightened risks.
All this calls for mechanisms for coordination across policies. These may take an institutional form, such as a board, a committee or council, or other forms, such as a requirement for the macroprudential authority to be informed, or consulted, on key decisions by other policies, which also affect the financial system. Clearly, this should be done in a manner that fully respects the independence of monetary policy. Yet at some point, addressing systemic risks will also require policy action. Coordination will be particularly important in this context, because operational control over the instruments of macroprudential policy may, or may not, rest with the macroprudential body itself. The European Systemic Risk Board, for example, does not have direct control over policy instruments.
Third, one size does not fit all (but central banks should play a prominent role)
In the design of macroprudential policy frameworks, one size does not fit all. The tools to identify and monitor systemic risk, the operational toolkit, and the chosen institutional set-up will vary from country to country, depending on the level of development, financial structure, policy regime, and other historical and political factors.<
But some key features are already emerging. One is that central banks should play a prominent role. Central banks’ expertise in monitoring macroeconomic and financial market developments could help shape policies aimed at containing the build-up of systemic risks. And given their existing roles in monetary policy and payment systems, central banks are well placed to analyze systemic risks and the impact of individual bank failure. This analytical expertise can help achieve greater clarity about the benefits and costs of macroprudential policies. They also bring much-needed reputation and independence. Finally, central banks have strong institutional incentives to ensure that macroprudential policies are effective—because if they are not, central banks will have to take costly corrective measures.
In addition to the central bank, the regulatory and supervisory agencies need to be involved in an adequate manner. They would need to activate macroprudential policy tools in cases where such tools are not under the operational control of the macroprudential body. The involvement of finance ministries has its pros and cons: it would be valuable because of the importance of taking into account fiscal policy and some of its instruments. Finance ministries could also play a pivotal role in the discussion of legislative changes that may be required to mitigate systemic risks. However, there is one important risk associated with the strong role of finance ministries: because of election cycles and other political considerations, they may be reluctant to take the punch bowl away when the party gets going. This could lead to a crucial delay in the application of macroprudential measures. So, finance ministries should be involved, but in a way that does not jeopardize the process.
Fourth, we have a broad toolkit—let us now learn to use it
As I noted earlier, macroprudential policy uses primarily prudential tools to address systemic risk. Some of the key tools are being constructed specifically for this purpose—such as countercyclical bank capital charges that lean against the economic cycle, or systemic capital surcharges that grow as the systemic impact of individual financial institutions grows. There is also a range of tools that has already been used in some countries—such as traditional prudential tools adjusted specifically to address the build-up of systemic risk (the use of loan-to-value ratios to lean against housing bubbles is a good example). Because there are different dimensions of systemic risk and different aspects within them, the range of tools is potentially large.
How should these tools be used? One key issue is whether we should use rules, discretion, or a combination of both. Rules would help overcome the bias for inaction that is likely to arise, because the benefits of macroprudential policy (i.e., the absence of financial crises) are only evident in the long run. By contrast, the cost of macroprudential policy tends to be highly visible and is often felt immediately. Some form of discretion is also needed to help adjust policies to a financial sector that evolves rapidly, and where the specific sources of systemic risk are subject to change. A combination of both approaches may eventually emerge as the sensible choice—incorporating more rules than is the case for monetary policy; but leaving scope for some discretion to adjust to a dynamically evolving financial sector. The combination should reflect existing local conditions.
Because of the dynamic nature of financial systems, macroprudential policy requires continuous monitoring of a broad set of information—measures and indicators on the causes of financial crises, business and financial cycles, credit booms, and related sources of systemic risk. Macroprudential policy also includes measures to identify systemically important financial institutions, markets, instruments, as well as firms and activities that might be outside of the perimeter of regulation. Policymakers may never be able to rely solely on quantitative tools to identify and monitor systemic risk to guide their macroprudential actions. Hence the need for additional qualitative assessments, including supervisory assessments and market intelligence.
Lastly: macroprudential policy is necessary—but it is not a magic bullet
Macroprudential policy is in its infancy. Many issues remain unresolved. For example, how can systemic risk be measured? How strong is the evidence that macroprudential policies can, in fact, prevent or contain credit or asset price bubbles? What is the transmission mechanism of macroprudential policy? What are the policy conflicts, and how can they be resolved? How should micro- and macroprudential policies relate to each other? And how can we address the trade-off between stability and efficiency in macroprudential policy making?
This is a daunting task. It is worth noting that modern macroeconomics evolved in response to the policy limitations that were painfully underscored by the Great Depression. Macroprudential policy could prove to be the next quantum leap. To illustrate the challenge of developing a macroprudential policy framework, it is useful to draw some parallels to monetary policy. That policy has a precisely defined objective—price stability. In the case of macroprudential policy, systemic risk is multidimensional and difficult to measure and monitor. Monetary policy includes a well-defined set of policy tools. By contrast, there are multiple possible macroprudential instruments, many of which have never been applied in practice. Monetary policy transmission mechanisms are better understood, but we have yet to fully understand the equivalent mechanisms in macroprudential policy.
All this suggests that we need to be humble in our ambitions and recognize the limits of what can be achieved, at least in the near term. Some of the main challenges facing policymakers include the following:
• Creating a comprehensive analytical framework and a consistent set of policy tools, including through rigorous back-testing.
• Establishing macroprudential authorities, where they are not already in place, with clear mandates to enhance their accountability and reduce the risk of political pressures.
• Assuring that all systemic risks are addressed and all potential policy conflicts managed through cooperation among national authorities.
• Increasing international cooperation to ensure the consistent application of national macroprudential policies. Cooperation in macroprudential policies can reduce the scope for international regulatory arbitrage that may undermine the effectiveness of national policies. International cooperation is also needed to contain the risks associated with systemically important institutions that operate across borders. The new supervisory and resolution colleges for cross-border firms will play an important role.
In conclusion, I would like to stress that even the most effective macroprudential policy framework may not be a panacea for all problems related to systemic risk. To deal effectively with this destructive threat, macroprudential policy has to be supported by other policies relating to the financial sector and the macro-economy. This may require some changes in the way in which monetary policy and fiscal policies operate.
During the crisis, price stability was maintained. This is good news for monetary policy, which is the guardian of price stability. Yet the crisis has shown that some adjustments may be needed in many countries in the way in which monetary policy pursues its price stability objective. Specifically, it has to take better account of financial developments in the monetary policy analysis and decision making process, because our understanding of the financial sector and macro-financial linkages is far from adequate. Moreover, credit should be given a more important role, and monetary policy should non-mechanistically lean against the build-up of financial imbalances, especially when credit and asset prices are rising at the same time. Research conducted by the IMF1 suggests that adding credit growth to the monetary policy reaction function improves macroeconomic stability when the economy is hit by a financial shock. Policy reactions guided by the standard Taylor rule may be too weak in the face of loosened lending standards and credit accelerator effects.
We need a truly countercyclical fiscal policy, too. To some extent, counter-cyclicality is built into fiscal policy in the form of automatic stabilizers. However, the current crisis proved that this is not enough. In order not to become a source of fragility to the financial system and maintain an ability to support it in crisis situations, fiscal policy needs to accumulate sufficiently high surpluses in good times that can be used in bad times. This will require a substantial improvement in the quality of fiscal institutions and policy frameworks.
The IMF stands ready to support national and international policy reforms through its surveillance mandate and financial sector expertise. Our collaboration with the FSB and BIS will enhance our understanding of macroprudential policies. A joint progress report will be presented to the G-20 Leaders in November.
As I have tried to explain during my talk, while macroprudential policy is still in its infancy and is not the silver bullet that will avoid future crises, it is a most useful addition to policy frameworks aimed at preserving economic and financial stability Let’s use it properly!
1 (WEO Oct 2009 Ch.3)
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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