What have we learned about financial markets and regulations?
Speech by José Manuel González-Páramo, Member of the Executive Board of the ECB, XXVII Reunión Círculo de Economía, Sitges
It is a pleasure to have the opportunity to speak at this prestigious forum today. The first round of the meetings of “Círculo de Economía” took place exactly 50 years ago (in 1961), constituting a very unique event in Spain at that time. Since then, these meetings have provided an excellent forum to exchange views and ideas on issues of European and global relevance. Today we meet at a time of multiple challenges for our world, so I am sure that inspiring discussions will take place.
For more than three years we have been focused on the challenges that the financial crisis has posed to our economies and our societies. Still, recent developments in European sovereign debt markets as well as ongoing economic difficulties in some euro area countries remind us that the crisis is not over yet. While the ECB continues to confront, in a decisive manner, the tensions in financial markets, it is also involved in the reform of the global financial system that is currently in progress.
I would like to lay out today what I believe are the core areas of the regulatory reform, detailing what has been achieved and what remains to be done.
Let me start by saying that under the leadership of the G20, a remarkable amount of work has been done by the Financial Stability Board (FSB) and the Basel Committee regarding financial reform. In Europe, the European Commission has also adopted several new pieces of legislation and many more are underway in order to strengthen the regulatory and supervisory framework.
I believe that we can identify the following key areas of the financial reform: First, strengthening the resilience of financial institutions. This includes the introduction of the Basel III framework for banks, eliminating the too-big-to fail problem as well as ensuring adequate oversight of the shadow banking system. Second, increasing transparency and mitigating the pro-cyclicality in financial markets and finally, third, introducing macro-prudential supervision, which can be considered as the missing link in the pre-crisis era. The crisis has shown the need for a systemic perspective of the financial system that takes into account the interactions within the system as well as with the real economy.
1. Strengthening the resilience of financial institutions.
Let me first start with Basel III, which constitutes the cornerstone of regulatory reform for the banking sector. While Basel II was very much focused on a single ratio (capital to risk-weighted assets), Basel III takes a more comprehensive approach, addressing deficiencies of Basel II and further strengthening the armoury of prudential requirements. Let me highlight the main elements of the new Basel III framework:
Basel III provides for higher minimum capital requirements, a stricter definition of eligible capital and more transparency. The crisis highlighted the urgency of establishing a common definition of capital. The fact that the definition of what constituted Tier 1 capital was neither transparent nor harmonized across countries, contributed to a generalised loss of confidence in the quality of regulatory capital. In addition, it proved necessary to increase the overall level and loss-absorbing capacity of the capital held by banks.
Moreover, Basel III introduces also entirely new concepts, such as non-risk-based leverage ratios and mandatory liquidity requirements. The leverage ratio will offer a transparent measure to the market that will complement the risk-based capital calculations and introduce additional safeguards against model risk and measurement error. The new liquidity buffers will ensure, in the short term, that banks hold sufficient high quality liquid assets to withstand an acute stress. In the longer term, the buffers will increase banks’ incentives to use more stable sources of funding on a structural basis.
Lastly, beyond the micro-prudential dimension of regulation – typically represented by institution-specific solvency requirements – Basel III also introduces macro-prudential elements, most prominently the capital buffer regime. This constitutes an important safeguard to protect the banking sector from periods of excessive aggregate credit growth.
Let me say that, while generally supporting the underlying objectives of the regulatory reform, the industry has been critical towards the new capital requirements. The industry is of the view that Basel III will increase costs for banks, reduce profitability, lead to credit supply restrictions and, ultimately, hurt the economy . Theory and historic experience however demonstrate that those claims are partly based on misconceptions that are important to dispel. Although I will not elaborate in detail, let me highlight the following:
In the long run, benefits brought by the enhanced capital and liquidity regulation can be substantial. They include a reduction in the frequency of crises and hence on the expected output losses associated with systemic events. The new framework should also improve the level playing field for the international banking sector. This is expected to help financial institutions to save costs and to encourage cross-border activities. In turn, this should result in a more efficient financial sector and also bring benefits to non-financial corporations and households through higher competition and increasing availability of financial services.
In the short term, given that financial markets are characterized by information asymmetries and frictions, the new regulatory requirements will most likely imply some transitional costs on the economy through tighter credit conditions. Adverse effects are however expected to be moderate, notably if they are spread over a long implementation period. Estimates by the BCBS as well as by the ECB concluded that a 1 percentage point increase in the capital ratio implemented over eight years would result in a moderate cumulated reduction of GDP of around 0.15 percentage points. Indeed, the new measures will therefore only become fully effective on 1 January 2019. This long phasing-in period should provide the banking sector ample time to adjust to the new regulatory requirements and prevent disruptions in credit flows.
Looking forward, it is of the essence that Basel III is properly implemented at the global level. In addition, it is important that the proposals on the leverage ratio and liquidity risk framework are rigorously calibrated, so that any unintended consequences for individual banks, the banking sector, and financial markets can be timely addressed.
Second, it is important that work is kept apace on systemically important financial institutions, or so-called SIFIs. The financial crisis has evidenced that large, complex and cross-border banks pose exceptionally high risks on the financial system and society at large. By virtue of their “too big to fail” status, these financial institutions assume a systemic dimension which, in the event of a crisis, results in large wealth transfers from taxpayers to the banking system.
Against this background, the G20 has endorsed an ambitious program that aims at reducing the probability of default of a SIFI. As a key priority, it has been agreed that SIFIs should have higher loss absorbency capital beyond Basel III standards. The purpose of these requirements is threefold: first, to increase SIFIs resilience to adverse shocks; second, to internalise the costs of distress they impose on the financial system; and third, to restore proper incentives with respect to their risk-taking.
Let me also highlight that a key element of the SIFI policy framework is to develop strengthened resolution frameworks to ensure that all financial institutions can be resolved safely and quickly, without destabilising the financial system and exposing the taxpayer to the risk of loss.
The FSB is focusing on the identification of the key elements of effective resolution regimes, which will identify the essential features that national resolution regimes for financial institutions, including non-bank financial institutions, should have. Let me mention that the EU is actively participating in the ongoing work and is also taking these global initiatives into account in the design of the European framework.
Third , another important area where work needs to progress relates to the so-called “shadow banking system” . The financial crisis evidenced that systemically important pockets developed in the financial system without any regulatory oversight. A better understanding of the interconnections between regulated and unregulated entities is needed. Moreover, it is important to bear in mind that the introduction of more stringent capital requirements for credit institutions may provide further incentives to shift activities outside the regulatory perimeter.
For this reason, the regulatory reform should not only focus on regulated banks. It should instead be based on a comprehensive system that extends in a proportional way to all actors, intermediaries, markets and activities that embed potential systemic risk.  In this area the identification of data gaps and putting in place an effective monitoring framework as well as reinforce the accounting rules on consolidation internationally are key.
2. Increasing transparency and mitigating the pro-cyclicality in financial markets
I would now like to touch upon the measures taken with regard to the regulation of financial markets. Here, reform must ensure greater transparency for the various market segments and products, sufficient competition in all markets, and attenuate as much as possible the pro-cyclicality that derives from information asymmetries, structural features such as ratings, market phenomena such as herding and short selling practices. In this speech I will focus in particular on improvements in the regulation of OTC markets.
Private financial markets cannot function properly unless there is enough information and reporting both to market participants and to relevant regulators and supervisors. The financial crisis evidenced the increasing opaqueness of the financial sector and the resulting counterparty risk externality. Regulatory initiatives that are underway to remedy these issues are therefore of utmost importance.
Let me begin by highlighting the importance of establishing an appropriate regulatory framework for OTC derivatives . OTC derivatives markets have grown exponentially in size over the past decade and they are closely related to the underlying cash, bond and equity markets. However, the development of risk management practices for these products has not kept pace with their growing use and systemic importance as the financial crisis demonstrated in a number of instances, such as the Lehman default and the near-defaults of AIG and Bear Stearns.
Against this background, regulators are currently working to address three issues in particular. First, to foster market transparency through reporting of all transactions to trade repositories, which in turn will disseminate the related data to regulators and the public in line with their information needs. Second, to mitigate counterparty risks through use of central counterparties for sufficiently standardised and liquid products. Third, to ensure the safety and soundness of OTC derivatives central counterparties and trade repositories, given the concentration of risks in these new infrastructures.
• In the EU, the forthcoming EU Regulation for OTC derivatives, central counterparties and trade repositories is the key initiative to implement these objectives. However, given the global nature of OTC derivatives markets, the EU framework will only be effective if it is consistent with legislative initiatives in other jurisdictions and cross-border cooperation among authorities in ensured. To this end, the new EU rules should be fully in line with the global supervisory and oversight standards for financial market infrastructures that are currently being reviewed by the Committee on Payment and Settlement Systems (CPSS) and the Technical Committee of the International Organization of Securities Commission (IOSCO). The CPSS and IOSCO issued a consultative report entitled ‘Principles for financial market infrastructures’ last March and their guidance is expected to be finalised in early 2012.
Another important initiative relates to the enhanced oversight of Credit Rating Agencies (CRA’s) and the need to reduce the mechanistic reliance on external ratings. Ratings are crucial to investors’ decisions and are deeply embedded in the regulatory architecture. It is therefore essential that ratings that are independent, objective and of the highest possible quality, as shortcomings in rating activity can erode market confidence and adversely affect financial stability. Moreover, the crisis has evidenced that ratings downgrades have contributed to the pro-cyclicality of the financial sector.
In the EU, the Credit Rating Agencies Regulation was adopted in 2009 and regulators and credit rating agencies are currently preparing for implementation of these rules. In our Opinion, the ECB supported the need to reduce reliance on external credit ratings. This could be pursued via two main avenues: first, firms should be required to undertake their own due diligence and internal credit risk assessment. Second, supervisors should focus on developing rules to appropriately combine internally developed credit judgment and external input with varying weights depending on the specific characteristics of the credit exposures. In addition, we fully support initiatives by the European Commission to enhance transparency and disclosure of the rating process and in launching a debate on enhancing competition.
3. Introducing macro-prudential supervision
The aim of macro-prudential supervision is to mitigate and prevent systemic risks to financial stability on the basis of identified vulnerabilities and systemic risk assessments. The financial sector regulations before the crisis very much focused on limiting each institution’s risk seen in isolation rather than on aggregate or systemic risk. As a result, financial institutions were encouraged to pass their risks around the system and to unregulated entities, increasing the vulnerability of the system to large macroeconomic shocks. In Europe, in particular, the crisis highlighted the absence of a proper framework for macro-prudential oversight.
Against this background, a new European System of Financial Supervision entered into force on 1 January 2011. Alongside with national supervisory authorities, who will continue to be responsible for day-to-day supervision of firms, three European Supervisory Authorities have been created – respectively for the banking, insurance and securities markets. A new body, the European Systemic Risk Board (ESRB) has become responsible for macro-prudential oversight of the EU financial system. The primary task of this new body is to monitor the EU’s financial system as a whole identifying sources of systemic risk, and to issue risk warnings and policy recommendations addressing systemic risks. The ECB President will chair the ESRB and the ECB will provide analytical, statistical and logistical support to the ESRB, as well as its Secretariat.
The establishment of the ESRB is a key milestone in how Europe deals preventively with systemic risks. It forms part of wider initiatives across the world, including in the US with the establishment of the Financial Stability Oversight Council.
The European System of Financial Supervision is still in the starting-up phase and it will need time to establish itself. As regards the ERSB I believe that there are three key conditions in order for it to reach its full potential. The first is the need for an adequate infrastructure to identify and analyse systemic risks, which demands state-of-the-art analytical tools. And here I believe the ECB is well-equipped to support the ESRB with its analytical expertise. The second, given the non-binding nature of the warnings and recommendations, is building-up a strong reputation. Indeed, credibility will be key in ensuring addressees implement the recommendations. Also here, I firmly believe that the expertise of the members sitting around the table, in particular the expertise of central banks in analysing financial stability will be crucial in successfully building up this reputation. And finally the third relates to the need to cooperate and exchange information effectively among all members of this new European System of Financial Supervision. The experience of the European System of Central Banks will also prove useful, in this context.
Let me conclude by mentioning that substantial progress has been achieved in key areas of regulatory reform. However, our work is not finished and there is no room for complacency.
In order for the new regulatory regime to be effective, a coherent and consistent implementation of the reforms at a global level is of paramount importance. Only then can regulatory arbitrage be prevented and a level playing field ensured. At the European level the three European Supervisory Authorities have an important task in ensuring a consistent implementation of the regulations.
We cannot forget that the financial crisis and its aftermath have been one of the most disruptive events in decades, causing massive economic and social costs. Tensions originating from a relatively small segment of the international financial market evolved into a global crisis, revealing deficiencies in the regulatory framework which must be addressed. In the aftermath of the crisis, industrialized and developing nations pledged to adopt a common approach to reinforce the resilience of the financial system and ensure its sustainable contribution to growth.
We cannot lose sight of this shared mission and responsibility. Determination and consistency in the implementation of these reforms is therefore now crucial.
I thank you for your attention.
Institute of International Finance (2010): “Net Cumulative Economic Impact of Banking Sector Regulation: Some new Perspectives”, October 11, 2010
Acharaya and Richardson (2009): “Restoring Financial Stability”, Wiley Finance.
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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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