Dividend policy in multinationals and transfer pricing: formula sheet

Key formulas

Dividend payout ratio

Payout ratio = Dividends ÷ Earnings after tax

Retention ratio = 1 − payout ratio. Use the same period for both figures.

Dividend cover

Dividend cover = Earnings after tax ÷ Dividends

Cover is the inverse of the payout ratio. Low cover means little room for reinvestment.

Free cash flow to equity (FCFE)

FCFE = Cash from operations − tax − capital investment needed to maintain and grow − interest paid + net new debt

A common test of how much could be paid out. Dividends above FCFE need extra funding.

Sustainable growth (Gordon growth)

g = b × r, where b = retention ratio and r = return on reinvested equity

Assumes a constant retention ratio and return. It is a model, not a certainty.

Dividend valuation model

Ex-div share value P₀ = D₀ × (1 + g) ÷ (Ke − g)

Applies when growth g is constant and Ke > g. Use ex-dividend price.

Net remittance after withholding tax

Net dividend = Gross dividend × (1 − withholding tax rate)

Then compare with any tax credit or extra home-country tax due on the foreign dividend.

Residual dividend

Dividend = Earnings available − equity-funded part of positive-NPV investment

Equity-funded part = investment × (1 − target debt share), if the firm funds investment at a target gearing.

After-tax cash from a dividend

Dividend received net = Dividend − withholding tax − additional parent tax (after any credit)

Dividends are paid from profit after local corporate tax. Check whether the double tax treaty gives credit for underlying tax.

Net group cash from a tax-deductible payment

Net group cash = Payment − withholding tax − max(0, parent tax on the payment − withholding tax credit)

Use for royalties, management charges and interest when withholding tax is creditable. The payment is deductible, so no local tax arises on that amount. Do not add a local tax saving to this cash figure. To compare routes, compare total group tax on the same pre-tax profit. If withholding tax is not creditable, say so and treat it as an extra cost.

Tax credit on foreign tax

Extra parent tax = max(0, parent rate − foreign tax rate) × foreign taxable income

With full credit, the parent pays only the shortfall if the foreign rate is lower. If the foreign rate is higher, no extra tax is due and normally the excess is not refunded.

Transfer price effect on group tax

Change in group tax = Change in profit shifted × (rate in the country gaining profit − rate in the country losing profit)

Shifting profit to the lower-tax country reduces group tax. Tax authorities may adjust prices that are not at arm's length.

Net cash received after WHT

Net cash = Gross remittance × (1 − WHT rate)

Use the treaty rate if one applies, not the domestic rate.

Total tax with credit relief

Total tax = higher of (host tax + WHT) and (home tax rate × grossed-up income), only when credit for both host tax and WHT is available and capped at the home tax liability on the grossed-up income

Credit for underlying tax depends on the country's rules and the treaty. If only WHT is creditable, add host tax to the home tax left after the WHT credit. If foreign tax is higher than home tax, there is usually no refund.

Extra home tax payable

Extra home tax = max(0, home rate × taxable amount − foreign tax credit)

Check the credit limit. Credit is usually capped at the home tax on that income.

Time value of blocked funds

Real value = Blocked amount ÷ (1 + r)ⁿ, converted at the expected future exchange rate

Use for cash blocked for n years. Discount at a suitable rate and use forecast rates.

Minimum transfer price

Minimum = seller's marginal cost per unit + opportunity cost per unit to the group

If the seller has spare capacity, opportunity cost is zero. If the seller is at full capacity, opportunity cost is the contribution lost on external sales.

Maximum transfer price

Maximum = lower of (buyer's net marginal revenue, external purchase price)

Net marginal revenue is selling price less the buyer's own further costs. Use the same quality and quantity as the transfer.

Transfer decision rule

Transfer if minimum price ≤ maximum price

Any price between the two leaves both divisions better off compared with not trading, if each is judged on this price.

Market-based price adjusted

Adjusted market price = external price − costs saved on internal sales

Savings might include selling, delivery, bad debt and packaging costs.

Cost-plus price

Transfer price = cost per unit + mark-up % × cost per unit

State whether cost is variable or full cost. The choice changes the result and the behaviour.

Divisional profit

Division profit = (transfer price − own costs) × units for seller; (final selling price − transfer price − own costs) × units for buyer

The sum of both divisions' profit is unaffected by the transfer price, before tax.

Group tax effect of a price change

Change in group tax = (Profit moved × tax rate in country gaining profit) − (Profit moved × tax rate in country losing profit)

The gaining country is the one that receives the extra profit. The losing country is the one whose profit falls. A negative result is a tax saving. Group pre-tax profit is unchanged. Only the tax rates matter, before any duties or withholding taxes.

Profit shifted by transfer price

Profit shifted = (New transfer price − Old transfer price) × units transferred

A higher price moves profit to the seller and away from the buyer.

Arm's length principle

Transfer price should equal the price between independent parties in comparable circumstances

Tax authorities can adjust profits where the price differs.

Common OECD methods

Comparable uncontrolled price; resale price; cost plus; transactional net margin; profit split

Choose the method that best fits the facts. Know what each compares.

Import duty effect

Duty = Transfer price × duty rate

A higher transfer price increases duty, which offsets the tax saving.

Quick revision

• Dividend policy in a group is driven by the parent's cash needs, subsidiary investment needs, tax and legal limits.
• Main repatriation routes: dividends, royalties, management charges, loan interest, loan repayments and transfer prices.
• Interest is usually tax deductible for the subsidiary, while dividends are paid from after-tax profit.
• Withholding tax can reduce cash received, and double tax relief may recover some of it. Use the rules given in the question.
• Compare routes on after-tax cash to the parent, not on headline amounts.
• Blocked funds can be used locally, invested in the host country, or moved through other routes such as loans or fees.
• Exchange controls and local company law may limit dividends or other payments.
• Transfer pricing aims include goal congruence, performance measurement, autonomy and tax or cash management.
• Common methods: market-based price, cost-plus, and negotiated price.
• Tax authorities can adjust transfer prices that are not at arm's length.
• Minority shareholders in a subsidiary can limit how much profit you can shift through pricing.
• Always end with a clear recommendation and name the risks.

Common mistakes

• Listing dividend theories without applying them to the scenario. Fix: Pick the theory that fits the facts, quote a fact from the scenario, and state the consequence for the decision.
• Treating the parent's dividend and the subsidiary's dividend as the same decision. Fix: Separate them. The subsidiary decision is about remittance and tax. The parent decision is about shareholders and signalling. Link the two through group cash.
• Treating all payments as deductible for the subsidiary. Fix: Mark each route as deductible or not before calculating. Only royalties, management charges and interest normally reduce local taxable profit.
• Ignoring withholding tax. Fix: Always list withholding tax as a separate line for each route and check whether it is credited in the parent's country.
• Adding WHT to home tax without credit relief Fix: Compute home tax on the gross income, deduct the foreign tax credit, and pay only any positive balance.
• Treating all payments as non-deductible Fix: State that royalties, fees and interest usually reduce host taxable profit, while dividends are paid from after-tax profit.
• Using full cost as the minimum price when the seller has spare capacity. Fix: Use marginal cost plus opportunity cost. With spare capacity the opportunity cost is zero, so the minimum is marginal cost.
• Forgetting the opportunity cost when the seller is at full capacity. Fix: Add the contribution lost on external sales to marginal cost. With a perfect market this equals the market price.
• Moving profit in the wrong direction. Fix: Write seller and buyer first, then ask which country has the lower rate.
• Saying group pre-tax profit rises. Fix: State that pre-tax profit is unchanged and only the tax charge falls.

Exam tips

• Always tie theory to scenario facts. A sentence that quotes the company's tax rate, controls or shareholder mix earns more than a textbook definition.
• Show the arithmetic of remittances clearly: gross dividend, withholding tax, extra home tax, net cash. Marks go for each step even if the final figure is off.
• Cover both sides of the argument. Say what supports a higher payout and what supports retention, then give a clear recommendation.
• Use the professional skills marks. Give a short, well-structured recommendation, show commercial awareness and note risks such as currency, regulation and shareholder reaction.
• If tax rates are given, use only those. State any assumption you make, such as full credit for foreign tax.
• Use a clear table-style layout in your workings, with one line for each tax, so the marker can award method marks.
• State your assumptions about tax credit and withholding tax. If the question is silent, say what you assume.
• After the numbers, add at least two non-tax points such as legal caps, minorities, host government reaction or exchange risk. These earn the professional marks.