Prospering in the European Community: three EC initiative to ensure it.
In response to the dynamic events taking place in the European Community, many U.S. companies are now taking an even closer look at their interests there. They're identifying the parameters governing both the internal restructuring of their EC operations and the external restructuring taking place in their industries through strategic alliances--mergers, acquisitions, joint ventures, partnerships--designed to give them the pan-European market position they desire. While some commentators have doubted the practicality of internal and external restructuring on the current scale, the fact is that, almost daily, another example of corporate restructuring in the EC is announced in the business press.
Whatever the business strategies companies choose for Europe, they will benefit from developing responses now to the impact the changing competitive environment will have on their financial functions.
There are several important areas of future EC developments that will have a profound effect on operations in the Community and therefore on financial executives. This article deals with three of these areas: the creation of a European currency, the development of EC-wide corporate structures, and corporate taxation. A second article, to be published in the November/December issue of Financial Executive, will deal with the harmonization of financial reporting and accounting standards and the investment incentives and aids offered by member states to encourage inbound investment.
A European currency
The persistence of national currencies throughout the EC clearly impedes the full realization of the potential benefits of the single-market program.
As a result, there is renewed interest in a European currency. A survey of European business leaders undertaken last year by Ernst & Young in conjunction with the Association for the Monetary Union of Europe (reported in A Strategy for the Ecu, Kogan Page, London, 1990) showed that 83 percent were in favor of a common currency. In recent years, the ecu has increasingly taken on this role, having grown significantly as a financial instrument and, to a lesser degree, as a means of payment.
There are many incentives for establishing a common currency. Business will gain by the elimination of the costs of currency management, financial hedging, and uncertainty in investment and trading. On the other hand, introduction of a new currency is costly--costly to business and financial institutions, which will have to convert their information systems procedures; to owners of coin-and note-operated machines; to governments, which will have to reprint bills and mint new coins; and to the public at large.
Evaluating these costs and benefits is difficult. A recent study by the European Commission estimated that elimination of multi-currency handling would reduce the cost of intra-EC transactions by ecu 15 billion (about U.S.$19 billion as of mid July 1990). A common currency would also eliminate the "opportunity costs" that result when investments are not undertaken in the present multi-currency system because of uncertainty about long-term exchange rates. These and other cash and non-cash benefits should, however, outweigh the costs of change.
What are the alternatives?
There are two alternatives to consider: a common currency or a single currency. A common currency, such as the present basket ecu, could fulfill most of the requirements for a European currency. However, the necessity of operating in a larger economic environment in which wages and non-traded goods and services are still paid in local currencies would prevent reaping the full benefits that would be realized with a single currency system.
A single currency offers the following advantages to business:
* As a common unit of account, a single currency (potentially the ecu) would provide companies that have operations in more than one member state with one currency for accounting purposes, thus simplifying administrative procedures and aiding efficiency and transparency.
* As a common store of value, it would reduce long-term uncertainty and encourage cross-border investment.
* As a common means of payment, it would enable companies to dispense with exchange-rate costs and risks when dealing with non-domestic clients or suppliers in Europe.
Any currency that is accepted as standard, however, must have political neutrality in order to ensure that it is generally acceptable. And it must be effective as money, which requires confidence and trust and, hence, central bank backing. West Germany has repeatedly stressed that the future European currency, which it agrees could be the ecu, should be backed by an independent European central bank committed to price stability. West Germany's monetary union with East Germany has not reduced its commitment to EC economic and monetary union, although how soon this will be feasible politically is in question.
The French have a long-standing commitment to the ecu as a future currency of Europe. Why? Because they see it as the only practical alternative to a de facto Deutschemark zone.
In the U.K., the debate has focused more on the loss of political sovereignty that European monetary union entails than on the currency. This concern was first about whether and when the U.K. should enter the exchange-rate mechanism of the European monetary system, and later about the proposals of the European Commission, which involve harmonization of monetary policies through a central European bank.
Nevertheless, the U.K. appears to have relatively little trouble with the concept of a common currency for Europe, provided it is based on a market-driven approach and emerges from competition among existing currencies. The U.K. approach does not attract much support elsewhere in Europe, however, on the grounds that it does not eliminate the multi-currency system and all the uncertainties that accompany it.
The picture that emerges from all this is that, whereas certain existing currencies are widely used in Europe, notably the Deutschemark and, of course, the U.S. dollar, any existing national currency is likely to be politically unacceptable as the single currency of Europe. The most likely candidate, therefore, is the ecu. The Ernst & Young study for the Association for the Monetary Union of Europe concluded that, while the ecu's current competitive advantage is its political neutrality, its disadvantage lies in its shortcomings as an effective means of payment. Few companies currently use the ecu internally for accounting purposes, let alone externally in paying suppliers.
Notwithstanding this, the study also concluded that business would begin to take the ecu seriously if the member states were committed to its use as currency, with European central bank backing. In short, familiarity would breed respect. The study sets out a timetable of events leading to the introduction of the ecu as the single currency for Europe in 1997, at the earliest. This may seem fanciful, but stranger things have happened in recent months!
Corporate structures in
the European Community
While the main thrust of the single-market program is to remove trade barriers between member states, and therefore to increase competition among companies on a pan-European basis, the consequence of this program is inevitably a major restructuring of industries within the Community. In 1989, some 1,300 cross-border deals took place, involving companies in the EC and European Free Trade Association (EFTA) countries, for a total disclosed value of ecu 45 billion (about U.S.$57 billion as of mid July 1990).
The majority of these deals were made in the second half of the year, fueled by a significant increase in acquisition activity by U.S. companies (which spent some ecu 14 billion to strengthen and extend their penetration in Europe). For the first time in many years, U.S. companies lead the way in Europe, followed by France, West Germany, and the U.K. In contrast, Japan, still feeling its way, made acquisitions amounting to only ecu 1.5 billion, generally preferring instead to set up start-up operations to increase its coverage of Europe's markets.
As for target nations, the U.K. was the preferred location, especially by U.S. companies. The country accounted for some ecu 21 billion, or just under half of the total deal value in 1989. West Germany accounted for ecu 6 billion and France for ecu 5 billion.
Despite the volume of takeover activity in Europe last year, which is continuing this year, the current corporate legal and tax regimes in the individual countries are still sufficiently different to make cross-border deals more difficult than comparable interstate deals in the U.S. The European Commission, keen to see this restructuring of industry within the Community, recently made a number of proposals relating to corporate structures and taxation which, when passed, should improve matters.
In lieu of joint
Some members states have taken the initiative in setting up entities that encourage cross-border business development. Two examples are the Belgium Coordination Center and the Dublin Financial Center. The Commission has also made two proposals designed to assist cross-border cooperation. First, the EC regulation on European Economic Interest Groupings (EEIGs), which came into force last year, partially remedies the unsatisfactory situation of having 12 different approaches to company law and corporate taxation across the Community. EEIGs are designed to overcome what has always been the chief drawback of joint ventures--their lack of a sound legal basis. Thus, because many business analysts and commentators believe that joint ventures offer companies a better mixture of market access and low risk than do takeovers, which are often speculative and costly, the EEIG may play an invaluable role.
An EEIG must comprise at least two members whose head offices or main activities are in different member states. Once registered in a member state, an EEIG will be able to operate without any further formalities across the entire EC. While the EEIG has separate legal status, its members have joint and several liability for its debts.
Apart from the requirements that a member should be located in the EC, there is no restriction on the nationality of members. Thus, the EC-based subsidiary of a U.S. company could be a member of an EEIG.
The activities of an EEIG have to be related to the economic activities of its members and must not be more than ancillary to those activities. Thus, while companies cannot combine their main business interests, they can use an EEIG in many other ways to improve their profits or otherwise enhance their operations.
For example, EEIGs will be particularly useful for activities that are too costly for one company alone but that become economically feasible if carried out in cooperation with partners. Research and development is an obvious example. Similarly, the ability to combine resources will enable members to benefit from economies of scale and thus improve international competitiveness. Another common use is likely to be for temporary consortia to bid for large, public-sector contracts, which will be important as public procurement opens up in the EC. Finally, cooperation via an EEIG will provide a useful way for companies to get to know each other without going through the trauma of a full-scale merger.
Apart from joint ventures, and now EEIGs, the only way to set up business operations abroad is to take over or merge with a local firm or to set up a new company or branch. None of this is straightforward.
The awkwardness of existing means of cross-border cooperation arises mainly from the fact that participants are governed by national law in each country in which they have operations. Complying with different legal requirements in different countries can be an expensive and frustrating task. For this reason, the establishment of holding companies with merged or acquired subsidiaries or branches in different countries will continue to be the form of most multinational business operations.
There is hope, however. If adopted, the Commission's recently proposed European company statute will have a major impact on the way multinational business operates in Europe. The Commission's proposal, first put forward in 1975, provoked considerable opposition mainly because it supported employee participation in management. Now that the completion of the single market is imminent, the Commission has refloated the idea in modified form, and the consultation process has started again.
Under the EC proposal, the European company will be a legal entity governed by uniform European company law. As such, the concept is the logical extension of the processes that have given rise to the EEIG.
The European company is not yet an option, nor does it seem likely to be in the short term. In the meantime, the EEIG provides the only supra-national legal instrument available for cross-border cooperation in Europe.
Recent taxation proposals in the EC
The Commission has experienced difficulty in introducing proposals for direct and indirect taxation, largely because of the impact these proposals have on national sovereignty of member states. As a consequence, the Commission has decided not to pursue harmonization through imposition of uniform tax rates. Instead, it is seeking mutual recognition and coordination of national tax policies. Under the EC's current approach, each member state will continue to manage its own fiscal affairs, while the Commission will continue to attempt to remove barriers and to ensure that national policies do not inhibit intra-state trade and investment.
The main features of the Commission's tax proposals, which were approved by the finance ministers of the member states in June, are included in three EC directives to take effect on January 1, 1992.
Capital gains tax--The first of these directives deals with the taxation of capital gains resulting from cross-border mergers and acquisitions in which at least one of the participating companies is dissolved or in which contributions of assets lead to the formation of a new parent company. Member states now agree that the solution to this problem lies in deferring the tax until the acquiring companies realize the gain on the transfer of stock or assets. The Commission is concerned that no tax should result from the merger itself and that the tax rights of the member state in which the transferring company is domiciled are safeguarded for the future.
Elimination of double taxation--In the second of these directives, the Commission proposes the elimination of double taxation of parent companies and subsidiaries operating in different member states. Thus, dividends received by a parent in one member state from its subsidiaries in another will not be taxed in both. Germany, in particular, has resisted this proposal because Germany has a split-rate system on distributed and non-distributed profits. The Commission recently revised the proposed directive to permit Germany to continue to levy a withholding tax on profits distributed to parent companies in other member states at reducing levels until 1996, at which time it will no longer be allowed to withhold tax on cross-border dividends.
Other cross-border issues--The Commission's third directive in taxation deals with double taxation resulting from other cross-border issues, such as transfer pricing. For over 10 years, tax authorities of the member states have cooperated under the EC's mutual assistance directive, designed to deal with international tax evasion.
Under the directive, member states exchange information to assist in determining the correct tax liability in a particular case, either on request or spontaneously as an act of good neighborliness. Notwithstanding this cooperation, it is sometimes difficult to resolve these issues. Thus, the third directive on taxation provides for the use of an independent arbitration commission if member-state tax authorities fail to reach an agreement to eliminate the double taxation. Tax authorities, and probably the taxable entity (although not a part of the procedure), must agree to be bound by the decision of the arbitrators.
Other corporate tax proposals are in the pipeline from the Commission that, if adopted, will ensure that companies operating on a pan-European basis are not penalized compared with those operating on purely a national level. These proposals include the harmonization of the bases on which taxable profits are computed, the permissibility of parent companies to set off losses incurred by their branches or other affiliates set up in other member states, and the elimination of withholding tax at source on interest and royalties paid by a subsidiary in one member state to its parent in another (on lines similar to the dividend proposal referred to above).
A word to the wise
Each of the matters discussed above will have some future implication for financial executives of companies that have--or plan to have--operations within the EC.
What is clear is that, although the pace of change is uncertain, there is more than enough justification for financial executives to start thinking now about the reorganization of their finance functions in the Community and to participate in the overall restructuring process. Over the next few years, life certainly will not be dull.
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|Title Annotation:||Special Report: International|
|Author:||Mead, Richard D.W.|
|Date:||Sep 1, 1990|
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