International Treasurer The Corporate Treasurer's Guide to Global Financial Management

September 5, 1994

Country briefing

China: Foreign Currency Controls

Part I: With the Chinese government eager to prevent an outflow of foreign exchange, MNCs have to work harder and smarter.

"If you understand the basic underlying phi­losophy that the Chinese authorities are adopt­ing," says an MNC Asian regional treasurer, " you can get around m any problems in China ." The current philosophy concerns for­eign exchange: How to keep as much of it in China as possible without discouraging benefi­cial foreign investment.

To keep tabs on foreign exchange and con­trol speculation on renminbi , Chinese authori­ties are discouraging foreign investors from transacting in the local currency. Instead, they require foreign MNCs to maintain a local account in non-RMB currency, which is debit­ed or credited for local transactions. Beijing is also requiring investors to maintain specific foreign currency reserves, which reduce work­ing capital and increase funding requirements.

Reserve requirements are set on a case-by­case basis, largely in accordance with the per­ceived need/benefit of the investment project in question. This is where understanding " the philosophy" comes into play: it opens the door for negotiation .

Treasurers backing beneficial projects (e.g., infrastructure) should press for lower reserve allotments. All treasurers should seek flexibili­ty in managing the reserves. Securing permis­sion for the use of holding companies to trans­fer surplus/deficit reserve positions between subsidiaries/ JVs or to m ake us e of intra­Chinese invoicing are two options.

In effect, FX reserve requirements are forced loans to the Chinese government, helping its own reserves while propping the RMB . Part II , appearing in the next issue, will look at some techniques being used to manage China's reg­ulations, improve local treasury management, and reduce country risk . -

In-house banks

Tate & Lyle's Finance PLC By Joseph Neu

The UK sugar and sweetener MNC uses a clas­sic in-house bank structure as the nexus for all its funding activities. It is run as a "service-dri­ven" profit center.

Tate & Lyle's group treasury function is divid­ed into two parts: corporate finance and an in-house bank. The in-house bank is a sepa­rate legal entity, Tate & Lyle International Finance PLC, and serves as the center for all group funding activities. It is used to achieve economies of scale with funding, repatriate funds and manage debt tax-efficiently, and deliver " free, " quality financial services to group operating companies worldwide.

In-house banking operations

Tate & Lyl e's in-house bank provides aJJ the services that might be expected of a small bank, including taking in deposits, on-lending group funds (cash recycling) , and foreign exchange services. The operating companies that use the in-house bank have full control over the tenor of deposits and borrowings (overnight out to five years), the amount, and the currency. This leaves the in-house bank to manage a significant portion of the group's interest rate and foreign exchange exposure.

Borrowing and lending rates are set by the in-house bank accord ing to benchmark mar­ket rates. For example, most money market operations with subsidiaries use LIBOR screen rates as a reference, adding 40 bp on one side and deducting 12.5 bp on the other. The 52 .5 bp margin is what the in-house bank uses to help cover its yield curve risk. Call money on deposit receives a fixed rate 1-2% under the base rate of the currency.

The in-house bank currently uses a refer­ence rate of 30 bp over LIBOR, for its own

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China: Foreign Currency Controls What efforts to retain foreign currency mean for country­level treasury.

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Tate & Lyle's Finance PLC The heart of a "ser­vice-driven" profit center.

page2

No Tax-Free German Income A German tax act closes loopholes for "dividend stripping."

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The Currency to Hedge Functional currency implications for US hedge accounting.

pageS

A Country-level Decision Matrix How to avoid unplanned invest­ments in emerging market economies.

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Embedded Options with Refinancings Why a reader should look at swaps and swaptions.

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Tate & Lyle

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medium-term borrowing, which for most of Tate & Lyle 's subsidiaries beats their local cost of funds.

The spread between the reference rate and the rate at which money is on-lent to group operating companies is a benefit of centralized funding and not considered to be a contribution of the in-house bank.

Incremental profits, or the direct contribution of the in-house bank are considered to be the gain (or loss) generated by its market view. In other words, if an operating company wish­es to borrow money for 6 months, the bank may borrow money for a 1 month term and roll over the debt. It also might use a future or FRA to hedge. The gain or loss on this strate­gy is the direct contribution of the in­house bank. Spreads from the banking operations are factored out of the in­house bank's performance evaluation.

The same method applies to foreign exc hange services. Each operating company must identify its FX exposure (w ith treasury consultation) and is obliged to cover it back into its local currency of account (most with the in­house bank). They get a screen rate, even for small-size transactions, and the in-house bank aggregates its expo­sures and lays them off in the market or takes on additional exposure in line with its market view.

Local managers are measured on their financial decisions (after interest but before tax) regardless of the subse­quent actions taken by the in-house bank. The in-house bank in turn is measured on how well it improves on these decisions. Decentralized deci­sion-making fits the philosophy of the Tate & Lyle group.

Corporate financing

In addition to its role in money-market and FX operations, the in-house bank also serves as the " heart" of longe r term corporate financings. If the Tate & Lyle group wishes to borrow money for a major capital spending project,

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acquisition, or dividend payout it will use Tate & Lyle International Finance to access the market (with a parent guarantee). That money will then be lent on to Tate & Lyle PLC (the parent) or one of the other holdin g companies- e.g ., Tate & Lyle, Inc.

The in-house bank serves as the nexus even when borrowing must be done through a local entity. For exam­ple , when tappi ng the US private placement market, Tate & Lyl e, Inc. tapped the market and on-lent the funds to the in-house bank. It in turn on-lent them to the appropriate non­US subsidiary.

The rate at which this money is on­lent from Tate & Lyle Internat ional Finance to UK holding companies is not the corresponding market rate, but a composite rate. The composite rate is a weighted average of the one-, three-, five-, and seven-year rates. The composite rate is set once a year, and incremental borrowings, or excess funds, in between use the LIBOR benchmarks until the reset date at which time th ese amounts are rolled in . Except ions are made for ce rtain specific capital projects.

This composite rate serves as trea­sury's benchmark as well. Treasury's performance is measured on its ability to beat this resetting index. Reset annually, the benchmark encourages a degree of flexibility as to how trea­sury hedges its exposure, and gives it an immediate sense of performance on the in-house bank's swap portfolio in particular. For whatever term the funds are needed, the in-house bank's goa l is to borrow them more cheaply than the rate of the benchmark index.

Given the size of these transactions, gains and losses against the composite benchmark are recorded in a separate account, somewhat analogous to a bank's treasury book.

Tax at the center

Tax proves an important reason why funds are funnelled through the in­house bank- Group Treasurer David Creed is also directo r of the group's

tax function . For one, in most jurisdic­tions, withholding tax rates for interest payments are better than those for div­idends.

More importantly perhaps is the fact that the in-house bank is considered a financial trader and taxed as such. Ta xat ion of financial instruments (while getting better) is complicated, uncertain, and somewhat archaic for UK corporates. Banks however enjoy a more advantageous and straight for­ward regime.

A relatively small number of corpo­rates, Tate & Lyle among them, have made the case to the UK revenue authority that their treasury opera­tions should be recognized as a finan­cial trader and taxed like a bank deal­ing at arm's-length.

This trader status is particularly impor­tant for a company that wishes to use swaps and other financial instruments to manage its debt portfolio .

For example, if the company were to borrow fixed-rate money from a Eurobond issue and swap it into float­ing rate debt as it did last Spring, both the swap and the bond would be held by the in-house bank. If treasury deter­min es that it is now more advanta­geous to have fixed-rate debt before the bond expires it can terminate the existing swap rather than changing the terms of the underlying bonds.

By holding them in one place it can record the profit or loss on the swap with greater ease and with more tax confidence than if the swap were held off-shore.

In-house banks also help solve a second UK tax problem: that of unre­lieved advanced corporation tax (ACT) credits. Companies in the UK often face this problem when the profits needed to cover their dividend pay­ments come from overseas revenues.

The ACT credit problem arises from the method used to withhold tax on dividends and prevent double taxa­tion. When a company declares a div­idend in the UK it has to pay 20% of that amount to the UK Revenue, dis-

In ternatio nal Treasurer/ September 5, 1994

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tributing the remainder to shareho lders. The actual method is more comp li cated, but stated simply, the shareholder gets a credit for the missing 20% (if his tax status allows) and the corporate having paid the 20 % tax in advance can recover the amount when it pays its corporation tax. If the corporate's UK tax bill is not sufficient to cover the amount of the c red it due, however, it cannot be used. A company can roll the credit over into the next year, yet if taxable income in the UK does not increase in subseq uent years, it accumu­lates substantia l ACT credits that it eventu­ally will be required to write off unused .

As a genera l rule, therefore, UK-based MNCs try to minimize intercompany divi­dend flows and opt for interest payments instead. They a lso seek to repatriate enough funds in the fo rm of interest income (whic h is tax deductible in the country of payment) to both cover current d ividend payments and shelter any ACT credits.

A costly center?

Despite the numerous advantages, run­ning an in-house bank can be costly. Tate & Lyle's in-house bank is staffed with 12 people. A staff separate from the group funct ions is needed to provide : the proper controls, generate arm's- length contracts (operations), maintain counterparty rela­tionships (banking area), record financial transactions (accounti ng), and most impor­tantly keep systems up-to-date (systems support) . "We learned from experience that you cannot rely on the head office for centra l services," notes Mr. Creed. This creates sign ifi cant overhead- about £1 million per year.

To help justify these costs, treasury is run as a profit center, but service is its first or i­entation. Mr. Creed ta lks about treasury as a "service-driven" profit center. Profits are merely a means to measure performance agai nst the benchmark market rates- just as service performance is measured w ith a questionnaire. The profit object ive is to cover t he over head cost of running treasury-so the group gets treasury service for free and not as he says " to make as much money as we can-" -Internationa l Treasurer/ September 5, 1994

Professional Guidance: Tax Planning

Tate & Lyle International Finance

The key characte ri st ics of Tate & Lyle's in-house bank are as fol­lows:

• Location: City of London

• Staff: 12- 4 dealers; 2 bankers; 2 accountants, 2 systems, and 2 operations.

• Overhead cost: £1 mi lli on p.a.

• Performance orientation: Service-oriented profit center. Profits from market views to cover overhead cost of serv ice center.

• Financial performance bench­marks:

Short-term operations: 40 bp over LIBOR (excludi ng margin).

Long-term funding: Compos ite index composed of 30% in one year debt, 30% in three-year, and 20% in five- and seven-year debt (fixed annua ll y).

• Non-financial performance benchmarks: Customer ranking on quality of adv ice, speed of execu­tion, and accuracy of documenta­tion.

• Customers: 55 subsid iary counterparties worldwide, and a holding company in each major country.

• Banking margin: 52.5 bp­adding 40 bp and deducting 12.5 bp.

• System: DEC workstations run­ning Econlntel Treasury applica­tion.

• Capitalization: £15 mil lion

Cross-border payments

No Tax-Free German Income? By Dr. Johannes K. Gabel Rogers & Wells

As the German economy emerges from recession, MNCs should note that they may not be able to expatri­ate profits from their German sub­sidiaries as tax efficiently as before.

On September 13 , 1993 the German Legis lature passed the In vestme nt Securement Act (the "Act") . A major premise of this Act was that non-resi ­dent taxpayers were expatriating the profits of their German subsidiaries relatively free from German income ta x. To prevent this, the Act intro­duced measures to close down two major methods of perceived tax avoid­ance.

Establishing thin capitalization rules

The first avenue to be closed invo lves "thin cap italizat ion ." Before the Act, MNCs could fund German sub­sid iaries with substantial debt and lit­tle equity. This allowed the parent to "strip" what would be otherwise divi­dends through the use of intercompa­ny loans. It could thereby convert tax­ab le, non-deduct ibl e dividends into tax-free, deductible interest expense.

German tax law did not attempt to restrict " thin capitalization" until 1987 w hen the German Finance Ministry sought to limit deductibility of interest where the debt/equity ratio exceeded 10:1 . This attempt was declared illega l by the German Federa l Tax Court.

Under the new leg i sl ation, th e court's decision has, in effect, been reversed. Indeed, the Act provides for significant limits on subsidi a ry debt/equity ratios:

• Shareholder debt whose interest is determined by sales or profits of a German subsidiary is now limited to 50% of equity (0.5:1).

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