Business

What a Minnesota mining lawsuit teaches us about global trade

If Shakespeare had written about 21st century business, the phrase “How sharper than a serpent’s tooth it is to have a thankless subsidiary!” might have entered history.

A lawsuit by a northeast Minnesota mining company, Essar Steel Minnesota, against its former parent, Essar Global Fund, is the latest step in a drama that began in 2007, when the India-based parent steel company bought an existing iron ore mine here.

In that boom, it announced plans for a new plant that would have included a modern steel mill.

Those plans collapsed along with global commodities prices. Now there are unpaid contractors, unmet loan payments and stiffed taxpayers. The shakeout was messy. While the local operation is still nominally a subsidiary of the Mumbai-based parent, the lawsuit is part of an effort to completely sever the U.S. business, including a partially completed $2 billion plant, from the parent.

That is the largest construction project in state history, one with big short-term economic effects and potentially important long-term ones.

The economics relevant for us today in the lawsuit “transfer pricing,” accounting that all international corporations must do. This potentially also applies to tariffs on imports from Mexico.

The lawsuit alleges that the parent company charged its U.S. subsidiary hundreds of millions of dollars for materials and services that it did not, in fact, provide. This took money directly from the subsidiary and indirectly from local vendors and taxpayers and then transferred the money back to India.

This specific case might constitute fraud, but manipulating payments within a corporation to reduce taxes or transfer capital is a common practice.

It started when international commerce was between companies rather than within them. Centuries ago, traders perfected the arts of “under-invoicing” and “over-invoicing.” Abuses of transfer pricing arose from these.

Consider a Brazilian coffee merchant who sold 500 tons of coffee to a U.S. buyer for $400 per ton. That could be paid for with a $200,000 check. But all international transactions had to be run through Brazil’s central bank.. The exporter might desire minimizing sums involved. So he might say, “We will invoice you at only $300 per ton. You pay that $150,000 and I’ll deposit it here And we’ll also send a ‘supplemental invoice’ for $50,000. Deposit that in our bank in Miami.”

The exporter would have reduced his income in Brazil and surreptitiously moved $50,000 out of the country. This was against the law. But the risk was small and such “under-invoicing” was common.

Or, a Brazilian manufacturer might buy 5,000 electric motors from Germany at $250 each. The Brazilian buyer could say, “We owe you $125,000. But please invoice the motors at $350. We’ll pay $175,000 through the Bank of Brazil. In a couple of months issue a ‘corrected’ invoice and send it with a $50,000 ‘refund,’ to our agent in Switzerland.” The Brazilian manufacturer just increased their deductible expenses for taxes by $50,000 and moved that amount to a Swiss bank via “over-invoicing.”

What was a practice between international traders is even easier within a company that moves goods or services between different divisions of itself.

Ford long manufactured 4-cylinder engines in Brazil used in its assembly plants around the world, my home town. Ford’s Brazilian subsidiary is legally a separate corporation, but entirely owned by the parent in Michigan.

If Brazilian Ford sells 50,000 engines to U.S. Ford, a payment is due. But how much? You can tabulate aluminum, labor and sundry components precisely. But how do you amortize the factory itself? How do you value per engine costs of durable machinery his is particularly knotty if Brazilian inflation is 70 percent a year and all book values are irrelevant.

If you want to move money from the United States to Brazil, the engines are worth $4,000 each. To move it from Brazil to the U.S., say $2,000. These both are “transfer prices” that any competent accountant can justify to the IRS. Just stay within a plausible range. You cannot price them at $20 each, nor at $10,000, but you have great leeway.

Developing corporation-wide marketing efforts is a big part of the fast-food industry. Brand names, logos and other intellectual property are worth billions. So if McDonald’s has its European headquarters in Amsterdam or Dublin, it can charge its French and German subsidiaries large sums for using the label “Big Mac” or for the image of Ronald McDonald. Profits in those higher tax countries go down and those in lower-tax Ireland or the Netherlands go up.

Every international corporation has to determine transfer prices to keep books. This can be used or abused. Abuse can become fraud, either against tax authorities or against the local partners or creditors of a subsidiary in another country as alleged in this lawsuit.

What about tariffs on imports from Mexico? Say Germany-based Audi’s Mexican subsidiary manufactures there but sells most of its cars in the United States. When Audi’s Mexican entity sells to its U.S. entity, what value is entered on the customs declaration? The lower the sum declared, the fewer dollars on which any hypothetical 35 percent “border tax” much be paid. A lower price will reduce profits in Mexico, but increase them in our country.

Yes, there is not much room to play with on values of high-end autos. You cannot list an A6 at $5,000. But don’t assume that some play won’t occur. And yo-yoing exchange rates introduce much room for games. The higher border taxes are, the greater the incentive for manipulating the numbers that go on invoices and tariff declarations. And the greater the incentives for corruption.

St. Paul economist and writer Edward Lotterman can be reached at boise@edlotterman.com.

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