Like domestic capital budgeting decisions, foreign investment decisions require to be
evaluated on the basis of their cash flow requirements (in order to carry out them) and
their cash flow (CFAT) generating capacity in the future years.
Assuming that the subsidiary is an independent company and calculations are to be
performed in the local currency where the subsidiary is located, determination of cash
outflows as well as cash inflows related to the project is a simple exercise. In fact, it is
similar to domestic investment decisions.
When foreign investment decisions are to be evaluated from the perspective of parent (in
the currency of parent MNC), the analysis should be based on the cash flows expected to
be remitted to the parent and not on the basis of CFAT generated by the project. In
practice, more often than not, there exists a difference between the two sets of cash flows.
This difference arises primarily due to tax regulations, exchange controls, inflation and
currency fluctuations. Besides, it is often customary to charge fees for technology
transfer, management/supervisory fees and royalties from the subsidiary unit. Though
they are treated as project expenses by the subsidiary, they in fact constitute returns (cash
inflows) to the parent MNC.
- Effect of Taxes
First, the local government of the country (where a subsidiary is located) taxes profits. In
most of the countries, there are specific provisions for taxing the profits earned by
subsidiaries of foreign companies. As per the tax laws of the country, a subsidiary pays
corporate taxes. If tax concessions are granted to encourage foreign investments, foreign
subsidiaries in such situations, may be subject to lower tax rates.
Second, apart from corporate taxes, it is not uncommon for local governments to impose
withholding taxes on that part of profits which is remitted in the form of dividends to the
parent. These withholding taxes can sometimes be avoided if the company repatriates
profits in the form of loan repayment and not in the form of dividend payments.
Third, some governments (to avoid double taxation) allow tax credits (partial or total) for
foreign income taxes and for withholding taxes paid. Again, in this respect, tax laws vary
from country to country. It is useful to note in this regard that many nations also operate
on the basis of special tax treaties which further adjust the amounts that may be paid or
withheld in those countries.
Finally, legislation (particularly in developing countries) often requires that a part of the
profits be retained (as a matter of policy to achieve certain goals, say, to help in making
more funds available for development).
When there are restrictions (not uncommon in developing countries) on the repatriation
of income, only remittable cash flows are relevant from the parent’s perspective.
Thus, restriction on the movement of funds of the subsidiary’s profits may entail severe
adverse impact on the profitability/acceptability of foreign direct investment.