Chapter 1
Toyota’s
Global Expansion
In November 2004, Hiroshi Okuda,
Chairman of Toyota Motor Corp. of Japan, announced that the company
was going to build another factory in North America, raising the number
of factories producing parts or assembling cars and trucks in North
America to 14. As of May 2004, Toyota manufactured parts and assembled
cars in 51 overseas manufacturing companies in 26 countries/locations.
In 1980, the company had only 11 production facilities in 9 countries,
so it was essentially servicing the world market through exports from
Japan. Since 1980, however, the company has committed more energy
and resources into foreign production.
Toyota, the second largest
auto manufacturer in the world, is moving aggressively to overtake leader
General Motors in terms of volume. In 2004-2005, GM sold 7.4 million
vehicles worldwide, and the company expects to increase sales to 8.5
million vehicles by 2006. Even though Toyota’s major manufacturing
base is in Japan, with 12 plants located closely together around Toyota
City in Aichi Prefecture, it is expanding its manufacturing capabilities
to every corner of the world, including Russia. However, it is
clear that Toyota is betting more on production in countries outside
of Japan. Although Toyota hopes to produce 3.8 million vehicles
in Japan by 2006, it plans on doubling its foreign output to 6 million
vehicles sometime in the future. It currently produces more vehicles
in Japan than it does in its overseas plants, and it exports more of
its domestic production than is sold inside of Japan.
Toyota is known for its commitment
to low cost, high quality, and just-in-time inventory, which implies
that it must be close to its main suppliers. A major reason for
the company’s success in Japan is its close proximity to key suppliers,
such as Nippon Denso, which allows it to schedule the delivery of parts
as soon as they are needed in the assembly operations.
One of Toyota’s major advantages
is its strong cash position. Its cash and short-term investments
totaled $30 billion in 2004, even though GM’s cash and short-term
investments at the end of the 3rd quarter 2004 were nearly double that
at $58.623 billion, down slightly from the same quarter a year earlier.
However, Toyota’s strong earnings and cash positions are in contrast
to GM, which is constrained by weak credit ratings, rising health-care
and pension costs, and losses in its automotive division. Toyota
expects to use its strong financial position to expand operations worldwide
and increase its commitment to R&D, especially in safety, automation,
and environmentally friendly vehicles, such as the Prius, one of its
hybrid cars.
In spite of its strong commitment
to future growth, Toyota has some challenges. Its net profits
in the second quarter of 2004 dropped from ¥301.9 billion a year earlier
to ¥297.4 billion. Toyota reports its financial information in
yen, although it reports earnings according to U.S. generally accepted
accounting principles due to its active presence on global capital markets
and the universal acceptability of U.S. GAAP.
Operating in global markets
is a challenge for Toyota. Since it is a Japanese company that
reports financial information in Japanese yen, it is subject to exchange
rate fluctuations. In particular, the yen has been strong relative
to the U.S. dollar, so earnings of its U.S. operations have fallen in
yen terms in recent years when translated from dollars back to yen.
In addition to the strong yen, Toyota and other companies operating
in the U.S. market have struggled with high gasoline prices and high
competition, which have cut into profit margins. Toyota has also
suffered with high raw materials costs, both inside Japan and in its
other operations worldwide. It is important for the company to
do well in North America, because it accounts for about two-thirds of
the Japanese car industry’s profits on an operating level. Given
Japan’s rapidly aging population and the sluggish economy, Toyota
and other Japanese car manufacturers will have to do well in the United
States to survive.
Toyota services U.S. markets
through significant exports from Japan as well as assembly inside North
America. Because Canada, the United States, and Mexico are
members of the North American Free Trade Agreement, parts and final
vehicles can be moved from one country to the other duty-free, as long
as the North American content is at least 62.5% of total cost.
It has plans to assemble the Tacoma in Mexico; it assembles the Corolla,
Matrix, and RX33 in Canada; and it assembles the Corolla, Tacoma, Avalon,
Camry, Solera, Tundra, Sequoia, and Sienna in the United States. It
is firmly committed to manufacturing cars and trucks in developing countries,
especially Thailand, and it is making a big push to assemble in China.
It also has plans to expand in South America, probably in Brazil where
it already produces the Corolla, and it plans to expand into Russia,
which would then join Poland and the Czech Republic as former members
of the Soviet Union that have production facilities.
Another factor influencing
Toyota’s growth abroad is the opening of the European Union.
In 1999, the EU countries finally opened the doors to Asian car makers,
and their market share rose from 14.8% to 17.4% at the expense of Ford,
GM, Volkswagen, and other European manufacturers. Due to high wages
in Europe, which have reached $40.68 per hour for average wages including
health-care costs, Asian auto makers are increasingly establishing assembly
operations in Eastern Europe, where wages are significantly lower.
In Poland, for example, wages are only $8.63 per hour. Thus it
appears that Toyota’s strategy of making vehicles in Poland, the Czech
Republic, and Russia makes sense. If the sluggish European market
can recover, Toyota may have a bright future there.
Questions
Why do you think
Toyota is expanding so aggressively outside of Japan instead of focusing
more on manufacturing in Japan and exporting to other countries?
What are the risks
it faces in expanding its overseas manufacturing?
Where do you think
Toyota should put its next plant in North America, and what factors
should it consider in making that decision?
What are some of
the major accounting issues that Toyota faces as it expands its global
reach?
What are the pros and cons
to Toyota of issuing its financial statements according to U.S. GAAP?
Chapter 3
EU Conversion
Spain’s accounting system
has historically been heavily tax-oriented. With the EU’s adoption
of IFRS, however, it will be required to have a reporting system substantially
different from its tax system.
La Rodonda Company is trying
to anticipate some of the problems it might face with the conversion
to IFRS.
Questions
How might its goals
of accounting change with the adoption of IFRS?
What should it do
to aid the transition?
What problems is
it likely to encounter and how can it mitigate them?
Chapter 4
Developing
Countries
Belarus attained its independence
in 1991 after being a constituent republic of the USSR (now Russia)
for 70 years. However, in 1995, the government reinstated “market
socialism” and issued controls over prices and currency exchange rates.
It also gave the state the right to control private enterprises. Accounting
standards have been of little concern in the past. However, with
a struggling economy, it is becoming increasingly important that Belarus
develop accounting practices that will instill confidence in the country’s
companies. Many hope that Belarus will follow its western predecessors
and embrace a free-market economy.
Describe the ideal accounting
system for Belarus.
Questions
What values should
the country emphasize with its system?
What needs to happen
in order for the system to succeed?
Chapter 5
Hanson and
ICI (United Kingdom)
In May 1991, Hanson, the United
Kingdom’s most notoriously acquisitive corporation, purchased a 2.8
percent stake in ICI, the United Kingdom’s largest manufacturer and
the world’s fourth-largest chemical corporation. Amid speculation
about the possibility of a takeover bid, the comparative performance
of the two companies was a significant issue because of the claims of
the respective management concerning their relative efficiency and success.
From an accounting perspective,
it is possible to assess performance in terms of both U.S. and U.K.
GAAP because Hanson and ICI are listed in the United States and are
required by the SEC, under Form 20-F, to provide reconciliation data.
The comparative data below show net income and shareholders’ equity
data for the period 1998–2002 in accordance with both U.K. and U.S.
GAAP, together with the data for long-term debt.
Questions
Calculate the “conservatism”
index and returns on equity for Hanson and ICI for the period 1998–2002
under both U.K. and U.S. GAAP.
Does it appear that
U.S. GAAP is more or less conservative than U.K. GAAP? What could be
the main reasons for this?
To what extent do
the results affect your assessments of comparative corporate performance?
Calculate the debt-equity
(leverage or gearing) ratio for both corporations under both U.K. and
U.S. GAAPs.
To what extent are
the results likely to affect your assessment of the comparative riskiness
of investing in Hanson and ICI?
ICI and Hanson:
Comparative Data Under U.K. and U.S. GAAP
(in £)
1998
1999
2000
2001
2002
ICI
Net
Income
U.K. GAAP
83,000,000
252,000,000
(228,000,000)
80,000,000
179,000,000
U.S. GAAP
(44,000,000)
53,000,000
(456,000,000)
13,000,000
9,000,000
Shareholders'
Equity
U.K. GAAP
149,000,000
244,000,000
(216,000,000)
(364,000,000)
499,000,000
U.S. GAAP
3,557,000,000
3,373,000,000
2,828,000,000
2,568,000,000
2,805,000,000
Long-term
Debt
3,144,000,000
1,503,000,000
1,616,000,000
1,304,000,000
1,709,000,000
Hanson
Net
Income
U.K. GAAP
338,500,000
302,200,000
236,400,000
278,800,000
187,400,000
U.S. GAAP
365,100,000
317,900,000
256,700,000
302,300,000
(628,600,000)
Shareholders'
Equity
U.K. GAAP
1,592,300,000
1,847,000,000
2,420,600,000
2,720,800,000
2,660,200,000
U.S. GAAP
2,520,600,000
2,733,200,000
3,369,000,000
3,556,500,000
2,605,800,000
Long-term
Debt
1,007,000,000
1,005,700,000
1,634,100,000
1,599,300,000
972,300,000
Chapter 6
Infosys Technologies
(India)
One of India’s new high-technology
companies is Infosys, specializing in software development. Infosys
is now listed on the NASDAQ, the first Indian company to be listed in
the United States. While Infosys discloses more information than most
Indian companies, as required by the SEC, the company voluntarily discloses
a substantial amount of additional information, including a value-added
statement, an economic value-added statement, brand valuations, current
cost financial statements, and an “Intangible Assets Score Sheet”.
Questions
Discuss the reasons
why Infosys might want to disclose additional information voluntarily.
Under what circumstances
could voluntary disclosures by Infosys give rise to a competitive advantage
rather than disadvantage?
Chapter 7
European
Adoption of IFRS
Recently, the European Commission
approved a proposal for the members of the European Union to use IFRS
for consolidated statements starting in January 2005. Bomfrader,
a company in England, is concerned about implementing the new standards
into its company. All of its accountants are masters in understanding
English Accounting Standards, but do not know much about the new standards
that will be implemented in 2005. Imagine you are the CEO of Bomfrader,
Mr. Jackson. You call together a meeting with the CFO and the
accounting department.
Questions
What is your agenda
for the meeting? In other words, what issues do you feel are most
important to address?
Create a task plan
for converging to IFRS. Be sure to include the following:
What are the most
important things to do first?
How will you educate
your employees on the new standards?
Should you converge
to IFRS all at once, implement IFRS standards one by one, or try to
use both standards concurrently until you can switch?
What other problems
are you likely to face and how can you mitigate them?
IAS 39
For many, the European Union’s
regulation to adopt IFRS as of January 2005 seemed too good to be true.
Until this point, the IASB had experienced limited success with regard
to actual implementation of their standards. Although most countries
supported the efforts of the IASB, many insisted on abiding by their
own standards. The European Union’s adoption of IFRS triggered
other countries to follow suit and consider adopting IFRS as their national
standards. Now, more than 90 countries will be adopting IFRS in 2005.
Although this appears to be
a big step for the IASB, the harmonization is not perfect. The
European Union has had problems approving all standards for implementation.
Specifically, the French and the Italians will not approve IAS 39 unless
certain changes are made to its rules. IAS 39, which addresses
financial instruments, requires that banks mark their derivative hedge
positions to market. The French and Italians argue that this requirement
will introduce high levels of false volatility in their earnings because
interest rates will be marked to market while the underlying assets
will not. The other European nations were against the idea of
creating a carved-out standard because they believe it undermines the
international standardization project. In spite of these oppositions,
the European Commission has created and approved a proposal to carve
out two IAS 39 sections—the prohibition of hedge accounting for core
deposits and the fair value option. Regarding the proposal, the
EU said,
“IAS 39 does not sufficiently
take into account the way in which many European banks operate their
asset/liability management, particularly in a fixed interest rate environment.
The limitation of hedges to either cash flow hedges or fair value hedges
and the strict requirements concerning the effectiveness of those hedges
make it impossible for those banks to hedge their core deposits on a
portfolio basis and would force them to carry out important and costly
changes both to their asset/liability management and to their accounting
system.... Those provisions of IAS 39, which prevent portfolio hedging
of core deposits on a fair value measurement basis, and which can be
clearly identified, should not be adopted because they do not meet the
conditions set out in Article 3(2) of Regulation (EC) No 1606/2002 and
in particular the criteria of understandability, relevance, reliability
and comparability required of the financial information needed for making
economic decisions.”
IAS 39 introduces an option
to record all financial assets and liabilities at fair value. However,
the IASB has recently published an Exposure Draft (a consultation paper)
which proposes an amendment to IAS 39 in order to restrict the fair
value option contained in the standard. The proposed amendment is a
direct response to concerns expressed by the European Central Bank,
by prudential supervisors as well as by securities regulators which
fear that the fair value option might be used inappropriately. This
proposed amendment is currently debated in public and a final version
will most likely not be available before the end of 2004. The provisions
in IAS 39 relating to that fair value option, which are also distinct
and separable from other parts of the standard, should not be considered
applicable, because of the uncertainty surrounding the final version
of those provisions. As soon as the IASB has completed its work on this
issue, and normally no later than by the end of 2005, the Commission
will examine the resulting amendments to IAS 39 with a view to their
endorsement, in the light of the conditions set out in Article 3(2).
The proposed “carve out”
not only allows fair value hedging of core deposits, but also extends
the range of items that can be designated as hedged items and relaxes
the effectiveness test requirements for hedges.
Questions
Discuss the potential
influence that the EU will have over the IASB because of their decision
to adopt IFRS. How does this undermine the goal of the IASB?
What are the arguments
for the EU adopting IAS 39 as is?
What are the arguments
for the EU adopting a modified version of IAS 39?
Discuss the relative
importance of international convergence and country-specific standards
that meet the country’s needs.
Chapter
8
Multigroup
(Switzerland)
Multigroup, a pharmaceuticals
MNE based in Switzerland, decided to prepare consolidated financial
statements for the first time. As there were no Swiss legal requirements
regarding consolidation, Multigroup had to decide what accounting principles
to use for its subsidiaries, joint ventures, and associates around the
world. Multigroup’s subsidiaries, all majority owned, were located
in the United States, the United Kingdom, France, and Germany. A 50
percent-owned joint venture was located in the Netherlands. There were
also interests in Associated Corporations at 30, 35, and 40 percent
in the United States, the Netherlands, and Japan, respectively. In addition,
there had been the recent acquisition of Bizcorp in the United States
for a cash consideration of 750 million Swiss francs. The book value
of the net assets of Bizcorp at the date of acquisition were 600 million
Swiss francs, but at fair value they were valued at 670 million Swiss
francs.
Questions
Discuss the possible
alternative accounting treatments of Multigroup’s subsidiaries, making
special reference to U.S., U.K. and IASB GAAP. What is your recommended
treatment?
Discuss the possible
alternative accounting treatments of Multigroup’s joint venture in
the Netherlands. What is your recommended treatment?
3.Discuss the possible alternative
accounting treatment for Multigroup’s associated corporations. What
is your recommended treatment?
Chapter 9
BMW (Germany)
BMW is a German-based automobile
company with a strong worldwide brand name. Besides automobiles,
BMW manufactures motorcycles and is involved in financial services.
In 2003, BMW disclosed some segment information by both line of business
and geographical area as shown below, some of it on a voluntary basis.
Questions
Why do you think
BMW would disclose segment information voluntarily when there is no
compulsion to do so?
Critically evaluate
the meaning and significance of the geographical segments identified
by BMW and the segment information disclosed. How useful is financial
statement analysis based on these segments likely to be?
What explanations
might there be for BMW’s approach to geographical segment identification?
Discuss some alternative
bases for identifying geographical segments. What criteria could
you use to support your choice?
Chapter 10
Coca-Cola
(United States)
In its 1999 annual report,
Coca-Cola describes the impact of foreign exchange on its operations
as follows:
“Our international operations
are subject to certain opportunities and risks, including currency fluctuations
and government actions. We closely monitor our operations in each country
and seek to adopt appropriate strategies that are responsive to changing
economic and political environments and to fluctuations in foreign currencies.
We use approximately 60 functional currencies. Due to our global operations,
weaknesses in some of these currencies are often offset by strengths
in others. In 1999, 1998, and 1997, the weighted-average exchange rates
for foreign currencies, and for certain individual currencies, strengthened
(weakened) against the U.S. dollar as follows:
Year
Ended December 31,
1999
1998
1997
All currencies
Even
(9%)
(10%)
Australian
dollar
3%
(16%)
(6%)
British pound
(2%)
2%
4%
Canadian
dollar
Even
(7%)
(1%)
French franc
(2%)
(3%)
(12%)
German mark
(2%)
(3%)
(13%)
Japanese
yen
15%
(6%)
(10%)
These percentages do not
include the effects of our hedging activities and, therefore, do not
reflect the actual impact of fluctuations in exchange on our operating
results. Our foreign currency management program mitigates over time
a portion of the impact of exchange on net income and earnings per share.
The impact of a stronger U.S. dollar reduced our operating income by
approximately 4 percent in 1999 and by approximately 9 percent in 1998.
Exchange gains (losses)-net
amounted to $87 million in 1999, ($34) million in 1998 and ($56) million
in 1997, and were recorded in other income-net. Exchange gains (losses)-net
includes the remeasurement of certain currencies into functional currencies
and the costs of hedging certain exposures of our balance sheet.”
Questions
Which translation
methodology or methodologies does Coca-Cola use?
Given the methodology
it uses, would you expect it to have translation gains or losses in
1997? In 1998? In 1999? Can you find any information in the chapter
to help determine its actual gains or losses in those years? Were your
answers consistent with what actually happened to Coca-Cola during those
years?
Explain how Coca-Cola
could use the translation methodology that it does and still have exchange
gains and losses that show up in income as explained in the last paragraph
above.
Chapter 15
Xerox Corporation
Chances are you’ve heard
of “the document company”. Xerox Corporation is a U.S. MNE based
in Connecticut. Xerox manufactures, sells, and leases document imaging
products, services and supplies in over 130 countries. In 2000, Xerox
employed approximately 92,500 people worldwide.
Xerox was a leading technological
innovator for several decades, but by the late 1990s, the company was
confronting intense product and price competition from its overseas
rivals. The investment climate of the 1990s added to pressures on Xerox.
Companies that failed to meet Wall Street’s earnings estimates by
even a penny often were punished by significant declines in stock price.
In addition, compensation of Xerox senior management depended significantly
on their ability to meet increasing revenue and earnings targets. Between
the first quarter of 1997 and the fourth quarter of 1999, Xerox met
analysts’ expectations every quarter. However, the reported results
were fraudulent. In June 2002, Xerox reported restated revenues of $18.8
billion and a restated net loss of $273 million for the year ended December
31, 2000.
Although Xerox management used
many accounting tricks to increase earnings, the bulk of the fraud was
based on improper revenue recognition from it sales-type leases of equipment
and services. When a client purchased equipment from Xerox (e.g. a copy
machine), it signed a contract to pay a fixed monthly fee covering the
cost of the equipment, service, and financing. Under U.S. GAAP, the
portion of the lease attributed to the sale of equipment can be recognized
immediately as revenue (Xerox called this portion “the box”). The
other portion, attributable to the sale of ongoing services and financing
of the lease, must be recognized throughout the life of the lease. Between
1997 and 2000, Xerox improperly pulled forward nearly $3.1 billion in
equipment revenue and pre-tax earnings of $717 million by reallocating
revenue to “the box” to accelerate its recognition. This was done
in two ways. First, Xerox reduced the discount rate used to get the
value of the equipment—a technique called ROE. By reducing the discount
rate, the present value of the equipment, which can be recognized immediately
as revenue, was increased. Second, revenue was increased by a process
called “margin normalization.” Suppose the U.S. market provided
Xerox with the highest gross margin, say 20%. At the end of a reporting
period, Xerox management would take the sales in Brazil, with a margin
of less than 20%, and adjust it up to 20% to increase sales and income.
These manipulations were directed by top management, including the CFO
of Xerox.
Although accounting for lease
revenues requires a significant amount of judgment and is prone to periodic
adjustments to discount rates other inputs, Xerox management made these
adjustments without any rationale other than to meet quarter-end targets.
For example, the typical discount rate to price similar equipment in
Brazil was 20%. However, management at headquarters would adjust the
rate down to 6% to increase the value of the equipment, which could
be recognized as revenue in the present period. The motive behind all
these accounting manipulations was simple: to “bridge the gap” between
actual performance and analyst expectations. The chart below shows the
difference between EPS by proper standards and what earnings were by
using fraudulent accounting.
Xerox’s auditor during this
period was KPMG. KPMG International is one of the largest public accounting
firms in the world, with over 700 offices in 152 countries. KPMG International
employed over 100,000 people in 2002 and had worldwide revenues of $10.7
billion. The firm was Xerox's auditor for approximately 40 years, through
the 2000 audit. KPMG was paid $26 million for auditing Xerox's financial
results for fiscal years 1997 through 2000. It was paid $56 million
for non-audit services during that period.
While Xerox management was
deceiving the public through accounting manipulations, KPMG apparently
had many opportunities to uncover the fraud—yet year after year the
auditor issued a clean opinion on the financial statements. Of particular
interest are the many red flags raised by the auditors of Xerox’s
foreign subsidiaries.
For example, KPMG Canada told
the managing partner that the ROE model was “not supportable” and
posed an ”unnecessary control risk with regard to accounting records.”
In addition, KPMG's Brazilian affiliate warned that the manipulation
of discount rates to value equipment was using rates that were significantly
below the market rates actually realized in Brazil.
KPMG Brazil warned that this
“fine tuning” increased the risk of fraudulent financial reporting
and that the pressure imposed on Xerox Brazil by headquarters to meet
revenue and profit goals increased audit risk. KPMG Brazil also informed
the partner that Xerox in Brazil did not adequately document how accounting
estimates were calculated. Similarly, KPMG Tokyo in 1999 objected to
the use of the ROE formula by Fuji Xerox because it did “not match
the actual status” of Fuji's business. KPMG U.K. warned in 1998 that
that use of a 15% ROE was not appropriate for Europe. Despite these
warning, the engagement partner never required Xerox to formulate and
apply a valid method of estimating its discount rate.
In connection with margin normalization,
KPMG U.K. voiced numerous concerns about implementing margin normalization
on Xerox lease accounting in Europe because there was no objective basis
for equalizing margins based on “little hard evidence.” The U.K.
office told the partner that Xerox was “playing ‘follow my leader’—whoever
has the highest sales margins being the leader.” In 1999, KPMG Brazil
insisted that there were sufficient stand-alone service contracts in
Brazil to calculate actual margins on service, rather than accept for
reporting purposes margins based on U.S. leases. Xerox officers at headquarters
said that the Brazilian auditors were wrong and that they were not to
discuss margin normalization with local Xerox personnel. By the end
of 1999, Xerox had imposed restrictions on KPMG discussions of margin
normalization with local managers in both Brazil and Europe.
When the managing partner finally
decided to confront Xerox management about these issues, the CFO asked
KPMG to remove the partner from the Xerox audit team. KPMG complied
with the CFO’s request. It was not until 2001, when the SEC had already
begun its investigation of the irregularities, that the auditor requested
Xerox’s audit committee to investigate the companies accounting practices.
In 2002, after the SEC filed
a complaint accusing Xerox management of fraud, the company settled
with the SEC for $10 million, the largest fined imposed to a company
up to that date. In 2003, the SEC filed a complaint against KPMG accusing
several of the engagement partners of fraud. As of the writing of this
case, the complaint hadn’t been resolved.
(Sources: SEC Complaint 17465
vs. Xerox Corporation, and SEC Complaint 17954 vs. KPMG)
Questions:
Explain in your
own words the accounting manipulations used by Xerox to accelerate revenue
recognition from its sales-type leases.
Although hindsight
is 20/20, do you think it was easy for the auditor to detect the fraud?
What are some of the difficulties the auditor may have faced in doing
so?
Why do you think
the engagement partner ignored the repeated issues raised by KPMG’s
foreign affiliates? How does this reflect the difficulty of conducting
an MNE audit?
Do you think the
risks involved in auditing Xerox are unique, or do they apply to all
MNE audits? Justify your answer.
Many of the issues
involved in the Xerox fraud were related to internal controls. Section
404 now requires the auditor to specifically audit internal controls
and issue an opinion on their effectiveness. Do you think auditing internal
controls would have prevented the fraud from occurring? Why or why not?
Chapter 16
Midwest Uniforms
Midwest Uniforms Inc. manufactures
and sells cloth and disposable uniforms. The company also launders and
delivers uniforms to hospitals, medical laboratories, and doctors’
offices. The corporation is organized in the state of Michigan and operates
three plants there—one that manufactures disposable uniforms and related
supplies such as caps and masks; one that manufactures reusable cloth
uniforms; and a plant that launders, presses, and delivers clean uniforms.
The company is owned by the
Fulton family. Daniel Fulton, age 60, and his wife, Lauren, age 59,
jointly own 40 percent of the corporation’s one vote per share common
stock. The Fultons’ son, Michael, owns 20 percent of the common stock,
their daughter, Meghan, owns 20 percent of the stock, and a family trust
holds the remaining 20 percent for five grandchildren. Daniel manages
the plant that manufactures disposable uniforms while Michael runs the
cloth uniform plant, and Meghan manages the plant that launders and
delivers uniforms.
During the early 1980s, the bulk of the demand for the company’s disposable
and cloth uniforms came from the Midwest. In the late 1980s, the company
saw increased demand for its disposable uniforms from outside the region
and outside the United States. In the past few years, the company has
started to supply disposable uniforms to companies in the hazardous
waste cleanup industry. It expects sales of disposable uniforms to hazardous
waste companies to triple during the 1990s. The corporation had $4 million
in revenue in 1992, of which $1,500,000 was attributable to the sale
of disposable uniforms.
Midwest Uniforms’ manufacturing
plants are working at near capacity. The company has considered closing
its laundering facility and converting it to a manufacturing plant.
Many of its cloth uniform customers have indicated, however, that the
company’s ability to launder and deliver clean uniforms is one of
the reasons they purchase uniforms from Midwest. The company also has
considered expanding each of the manufacturing plants, since it has
adequate land at each location. Because the demand for its cloth uniforms
is still predominantly from the Midwest while the demand for the disposable
uniforms is becoming worldwide, Daniel Fulton has suggested that the
company consider converting the disposable uniform plant to a cloth
uniform plant and building a new disposable uniform manufacturing facility
elsewhere.
Daniel would like the company
to build a disposable uniform plant in Puerto Rico. He and his wife
are nearing retirement age and feel that if they located to a warmer
climate, they would be able to work well beyond the age of 65. His estimates
indicate that it would be less expensive to build the plant in Puerto
Rico than in the Midwest and that labor costs could be reduced by at
least 25 percent and operating costs could be reduced by at least 20
percent.
The facility in Puerto Rico
would operate as a branch of Midwest Uniforms. The raw materials would
be shipped to Puerto Rico from the supplier in the United States and
the uniforms, caps, masks, etc., that are manufactured would be shipped
directly from the plant to customers worldwide. Daniel’s research
indicates that taxes are lower in Puerto Rico and that the United States
provides a tax credit for foreign income taxes.
Michael Fulton is concerned
about the potential labor unrest in Puerto Rico. He wants the company
to organize a subsidiary in Hungary and call it Global Uniforms Inc.
Since Hungary left communism, it has been forced to deal with terrible
pollution problems, as have other countries in the former eastern bloc.
In fact, the pollution problems of these countries are a major obstacle
to joining the European Community (EC) since they must first comply
with the environmental rules of the EC. Michael feels that by locating
a plant in eastern Europe, the corporation will be able to take advantage
of the emerging markets in that area and, as a result, more than triple
its sales of disposable uniforms and supplies. His research also indicates
that the corporation could cut labor costs by 30 percent and operating
costs by 25 percent by locating in Hungary.
Michael is particularly interested
in sheltering income from taxation so that the grandchildren in the
family will have adequate funds to attend college and graduate school.
He believes that organizing a foreign subsidiary would save the corporation
taxes since his research indicates that a foreign corporation’s U.S.
shareholders are not taxed on the corporation’s income until it is
distributed to the shareholders as a dividend. He would like, if possible,
to leave all the foreign earnings in the foreign company until the grandchildren
are ready to attend college. He proposes that 20 percent of the stock
of the subsidiary be owned by the family trust and 80 percent by Midwest
Uniforms Inc.
Meghan, on the other hand,
would like the corporation to expand the two existing manufacturing
plants and continue to manufacture the disposable products in the United
States. She is concerned that the U.S. taxation of worldwide income
would actually result in a higher overall tax liability for the corporation.
She believes that the corporation can increase its exports through sales
offices located in foreign countries.
The current and projected revenue
and expenses of Midwest Uniforms are included in Exhibit 1.
The estimates assume that the
plants will remain in the United States.
(This case was prepared by
Kathleen E. Sinning of Western Michigan University as a basis for class
discussion rather than to illustrate either effective or ineffective
handling of a situation. All rights reserved to the author. Permission
to use this case was obtained from the author.)
Tax Considerations of Doing
Business in Puerto Rico1
In Puerto Rico, a corporation
is considered to be a domestic corporation if it is organized under
the laws of Puerto Rico and a foreign corporation if it is organized
under the laws of another jurisdiction. A corporation is considered
to be a resident of Puerto Rico if it is incorporated under the laws
of Puerto Rico or, in the case of a foreign corporation, it if is engaged
in a trade or business in Puerto Rico. A Puerto Rican corporation is
taxed on its worldwide income. A resident foreign corporation is taxed
on all Puerto Rican source income and certain foreign income connected
with Puerto Rican operations.
A corporation can use either
a calendar or fiscal year in calculating its tax liability. Corporate
tax is imposed at a flat rate of 22 percent. A surtax is imposed on
taxable income, after a deduction of $25,000, at the rates indicated
in Exhibit 2. There is no provision in Puerto Rico for filing consolidated
returns. A controlled or affiliated group of corporations is limited
to one surtax exemption that must be allocated among the members of
the group.
A branch operating in Puerto
Rico is taxed at the same rates as a corporation and is entitled to
the same deductions and credits. Branches of foreign corporations are
subject to income tax only on their Puerto Rican source income and on
income effectively connected with a trade or business within Puerto
Rico. In addition, foreign corporations doing business in Puerto Rico
are subject to a branch profits tax (BPT). The BPT is 25 percent (10
percent for hotel, manufacturing, or shipping operations) and is applied
to amounts deemed to be repatriated from the branch in Puerto Rico.
The deemed dividend will generally be triggered if the branch has earnings
and profits generated in Puerto Rico that are not reinvested in Puerto
Rico. The BPT is not applicable to those corporations deriving at least
80 percent of their gross incomes from Puerto Rican sources.
To encourage industrialization
in Puerto Rico, certain activities (basically manufacturing, export,
maritime freight transportation, and certain service industries) may
obtain partial exemption from income and property taxes and 60 percent
exemption from municipal license taxes. The municipal license taxes
are 0.3 percent of gross receipts. The exemption can be obtained for
a period of 10 to 25 years depending on the location of the business
within the island. For purposes of the partial income exemption, Puerto
Rico has been classified into four industrial zones. The periods and
rates of exemption are included in Exhibit 3. In addition, the two principal
harbors in Puerto Rico have been classified as foreign trade zones and
foreign or domestic goods may be entered without a formal U.S. customs
inspection and without the payment of any duties or excise taxes.
Tax Considerations of Doing
Business in Hungary2
A company is considered a resident
of Hungary if it is incorporated in and has its head office in Hungary.
A foreign company cannot trade through a branch in Hungary, but it can
open a representative office, a service office, or a construction site.
Resident corporations are taxed
on their worldwide incomes. A business profits tax of 40 percent is
levied on all Hungarian business entities. The tax rate is affected
by tax incentives that are intended to encourage foreign investment
in manufacturing corporations. The incentives are in the form of rebates.
The tax rates after the rebates are included in Exhibit 4.
Entities subject to the business
profits tax are not subject to other income taxes. Business entities
of foreign ownership, however, are subject to an additional 4.5 percent
levy on the business profits tax base.
A foreign company that trades
in Hungary is subject to a corporate tax of 40 percent of the taxable
income. The taxable income of a representative office is deemed to be
90 percent of the total of 6 percent of Hungarian sales made by its
parent company and 90 percent of 5 percent of sales made outside Hungary
if the representative office was involved.
Questions
If the corporation
builds a plant in Puerto Rico, can it use the foreign tax credit for
any foreign taxes that it pays? Can the credit be used for taxes paid
to Hungary?
If the corporation
decides to build a plant in Puerto Rico, is there any other U.S. tax
provision that it can use in lieu of or in addition to the foreign tax
credit?
If the corporation
organizes a subsidiary in Hungary, will the income of the corporation
be subject to U.S. taxation? If so, when and how? Will the controlled
foreign corporation rules apply to a subsidiary organized in Hungary?
Exhibit 1Current and project
Revenue and Expenses
Plant
1992
1993
1994
1995
Disposable uniforms
Revenues
$1,500,000
$2,000,000
$2,750,000
$3,500,000
CGS
400,000
550,000
745,000
945,000
Operating expenses
500,000
666,000
915,750
1,165,500
Cloth uniforms
Revenues
2,000,000
2,500,000
2,750,000
3,000,000
CGS
600,000
750,000
825,000
900,000
Operating expenses
500,000
625,000
688,000
750,000
Laundry
Revenues
500,000
550,000
600,000
650,000
CGS
100,000
110,000
120,000
130,000
Operating expenses
200,000
220,000
240,000
260,000
Exhibit 2Corporate Surtax
Rates in Puerto Rico
Surtax
Net Income
Over
Not Over
Tax on Column 1
Percentage on Excess
$0
$75,000
--
6
75,000
125,000
$4,500
16
125,000
175,000
12,500
17
175,000
225,000
21,000
18
225,000
275,000
30,000
19
275,000a
--
39,500
20
a In the case of a corporation
whose net income subject to tax exceeds $500,000 for any taxable year,
a tax of 5 percent of net income subject to tax in excess of $500,000
is imposed to phase out the benefits of the graduated tax rates.
Exhibit 3Periods and Rates of
Exemptions from Puerto Rico Taxes
Industrial
Zones
1-5 years
6-10 years
11-15 years
16-20 years
21-25 years
1. High industrial
development
90%
90%
None
None
None
2. Intermediate industrial
development
90%
90%
90%
None
None
3. Low industrial development
90%
90%
90%
90%
None
4. Vieques and Culebra
90%
90%
90%
90%
90%
Exhibit 4Business Profits Tax
Rates in Hungary
Type of
Entity
Rate
Standard rate for corporations
40%
Manufacturing entity
owned more than 30% by foreigners
First 5 years
16%
Second 5 years
24%
Manufacturing entity
owned more than 30% by foreigners in a priority industry
First 5 years
0
Second 5 years
16%
1 Sources: Price Waterhouse, New York
(1991). Corporate Taxes, A Worldwide Summary, and Coopers & Lybrand
(1991). 1991 International Tax Summaries, A Guide for Planning and Decision.
New York: Wiley.
2 Same sources as in note 1