Academic journal article Financial Management

Cross-Border Liability, Border Taxes, and Capital Structure

Academic journal article Financial Management

Cross-Border Liability, Border Taxes, and Capital Structure

Article excerpt

* The research in this paper was motivated by the chemical disaster that occurred in Bhopal in December 1984, which raised, and subsequently left unresolved, a crucial issue in international law: the issue of whether the liability of a multinational enterprises (MNE) is limited to the extent of its local assets in the host country (as Union Carbide, USA wished; see Mokhiber [25]) or whether it is the global entity as a whole that is liable, given that the damages exceeded local net worth (as the Government of India wanted when they introduced the legal concept of "multinational enterprise liability"; see Multinational Monitor [26]). (1) In this paper we explore the implications of the continuing void in the resolution of MNE liability for international corporate finance and international corporate taxation.

Under incomplete contracting, limited liability creates a difference between private and public valuations of investments resulting from the socialization of costs and privatization of benefits. This, in turn, provides and incentive for managers in the private sector to overinvest in risky technologies (see John and Senbet [16]). (2) The Bhopal chemical accident is just one example of cases where limited liability may engender socialization of costs. There are numerous other examples involving product liability suits, oil spills, nuclear accidents, etc.

With incomplete cross-border liability, the problem -- which we refer to as a "social agency problem" -- associated with cross-border investments of the multinational enterprise (MNE) is exacerbated, depending upon the quality of the technology transferred by the MNE. The problem manifests itself in the form of localization of costs while the benefits are globalized. Thus, in turn, creates the potential for conflict between the private firm (the MNE) and the host state, when the MNE from the "home" country invests across sovereign boundaries in a "host: country.

This agency conflict will result in attempts by the government to regulate the MNE differentially in order to counteract an implicit subsidy resulting cross-border liability, relative to other host country firms. However, we show that the extent and nature of this regulation -- which may seem discriminatory or inexplicable under conventional analysis, but which are seen as rational in our framework -- will depend on the nature of the technology that the MNE brings in relative to a domestic firm, and particular types of capital structure choice made by MNE's. In particular, we shall argue that a seemingly contradictory set of policies that are commonly observed in many host societies -- where the host government imposes a differential or apparently discriminatory border tax on the MNE while simultaneously offering it subsidized credit -- are rationalizable as a means of counteracting cross-border subsides. Our analysis sheds light on many issues of crucial interest to international corporate finance: differential capital structures, concessionary credit, and dividend-withholding (border) taxes, all of which are commonly prevalent in the multinational context.

The notion of limited liability lies at the core of corporate finance, since the corporate form and basic claim on its value, equity, are defined by it. Its history and impact in domestic corporate behavior have been studied previously (see the review in John, Senbet and Sundaram [17]). Though there have been some recent efforts at grappling with the issue in the MNE context, the implications of cross-border liability limitation have received scant attention (see John, Senbet and Sundaram [18]).

The problem is as follows: even if the international legal norms were clear on the extent and nature of cross-border liability (which they are not), there is no commonly applicable or agreed upon legal enforcement mechanism that participants engaged in the process of direct foreign investment (DFI) can have recourse to, in the event of conflict. …

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