The IMF's Statistical Systems in Context of Revision of the United Nations' A System of National Accounts
Chapter

8 Proposed Treatment of Reinvested Earnings on Direct Investment

Author(s):
Vicente Galbis
Published Date:
September 1991
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Author(s)
Geoffrey J. Robertson

The Expert Group Meeting on External Sector Transactions for the Revision of the United Nations' A System of National Accounts (SNA) held in Washington, D.C., in March-April 1987 (hereafter referred to as the External Sector Group) drew the following conclusions with regard to reinvested earnings on direct investment:

Most members of the Group agreed that both the external and the domestic sector of the national accounts, like the balance of payments, should include international flows of reinvested earnings attributable to direct investors. Direct investment and reinvested earnings on direct investment would be as defined in the OECD “Detailed Benchmark Definition of Foreign Direct Investment.” The Group, furthermore, strongly recommended that a full accounting for reinvested earnings should be prepared for consideration of other groups in the SNA review process, specifically the Group on Financial Flows and Balances, and that, in that accounting particular attention should be drawn to the implications for saving and national disposable income.

Neither for the balance of payments nor for the external sector of the national accounts is there any reason to extend this treatment to portfolio investment.

The Meeting of the Balance of Payments Compilers Group held in Paris in November 1987 (hereafter referred to as the BOP Group) reached essentially the same conclusion.

This paper, prepared in response to the above recommendation of the External Sector Group, addresses some reservations held by some experts about the inclusion of reinvested earnings on direct investment in the transactions accounts of the SNA. The paper addresses the treatment of reinvested earnings on direct investment in the current SNA, the IMF's Balance of Payments Manual (BPM), and the UN Provisional Guidelines on balance sheets;1 the reasons for the proposed change to the SNA in this regard; the proposed method of calculation of reinvested earnings on direct investment; the presentation of reinvested earnings on direct investment in the revised SNA; some practical issues associated with the compilation of reinvested earnings on direct reinvestment; and offers some concluding remarks.

I. Current Treatment

The BPM recognizes and includes reinvested earnings on direct investment as transaction flows. Although the current SNA does not include such transactions, it recognizes both the importance of direct investment and reinvested earnings on direct investment. In paragraph 8.100 the SNA states:

It may also be desirable to add entries to the Accounts III in order to classify certain categories of transactions further. Additions to the items exhibited in the Accounts III which warrant consideration are indicated below. . . .

Saving. Where a significant number of enterprises in a country are branches or subsidiaries of non-residents, it will be valuable to sub-divide the saving, entries 3.7.1 and 5.7.1, of the relevant institutional sector(s) in order to indicate the amount of saving of (direct investment in) these corporate and quasi-corporate enterprises. The division of saving into the retained income of foreign-owned branches and subsidiaries and the saving of other corporate and quasi-corporate enterprises may be of interest in the case of financial and/or non-financial enterprises.

The SNA also states (footnote 1 to Table 26 in Annex 8.3) that

Data should also be furnished in memoranda to the table on the saving (retained income) of subsidiaries and branches of residents which are located abroad and of the resident subsidiaries and branches of nonresidents.

The UN Provisional Guidelines do not mention direct investment explicitly. In their discussion of subsidiaries (paragraph 6.43), however, they recognize that resident subsidiaries do not have a net worth independent of their nonresident parent enterprises. In this respect the UN Provisional Guidelines are closer to the BPM and are inconsistent with the SNA, which currently attributes all retained earnings of resident companies to resident corporate sector saving. It is useful to quote paragraph 6.43 of the UN Provisional Guidelines in full:

6.43. A special situation arises in the valuation of corporate equity securities of a parent company in its resident or non-resident subsidiaries which are not included in the same statistical unit as the parent. (It should be recalled that, by definition, the parent company should own 50 per cent or more of the corporate equity securities in each of the subsidiaries.) Unlike the usual stockholders, the parent company can take possession of the net worth of the subsidiaries by selling its interest in them. Furthermore, the parent company controls the magnitude of subsidiaries' net worth as it determines the amount of dividends that they pay and thus fixes the amount of saving that they retain. It is therefore appropriate to consider that the subsidiaries do not have any independent net worth and that the value of the parents' equity securities in the subsidiaries is equivalent to the difference between the total value of the subsidiaries' assets less the total value of the subsidiaries' liabilities, including only the value of any minority interests in the case of corporate equity securities. The value of the equity securities held by the minority interests may be determined from the market value of the shares.

Direct investment in the BPM (paragraphs 408 and 409) is defined as follows:

408. Direct investment refers to investment that is made to acquire a lasting interest in an enterprise operating in an economy other than that of the investor, the investor's purpose being to have an effective voice in the management of the enterprise. The foreign entity or group of associated entities that makes the investment is termed the direct investor. The unincorporated or incorporated enterprise—a branch or subsidiary, respectively—in which direct investment is made is referred to as a direct-investment enterprise.

409. The benefits that direct investors expect to derive from their voice in management are different from those anticipated by portfolio investors having no significant influence over the operations of the enterprises. From the viewpoint of the direct investors, enterprises often represent units in a multinational operation, the overall profitability of which depends on the advantages to be gained by deploying the various resources available to the investors in units located in different economies. Direct investors are thereby in a position to derive benefits in addition to the property income that may accrue on the capital that they invest, e.g., the opportunity to earn management fees or other sorts of income. Such extra benefits are not likely to be realizable in the short run, so that the investors' association with the enterprises can be expected to continue for a considerable period. In contrast, portfolio investors are primarily concerned about the safety of their capital, the likelihood of an appreciation in its value, and the return that it is bringing them. They will evaluate the prospects separately with respect to each independent unit in which they might invest and may often shift their capital with changes in these prospects.

The BPM states (paragraph 295) that reinvested earnings on direct investment “covers the earnings of branches and other unincorporated direct-investment enterprises (excluding any part that can be identified as having been remitted) and the direct investor's portion of earnings of incorporated direct-investment enterprises that are not formally distributed.” In paragraph 299 it states that “reinvested earnings of direct-investment enterprises should be recorded in the balance of payments for the period in which they are earned,” because, as paragraph 300 explains, “reinvested earnings represent the net income accruing during a given period.” Paragraphs 301 to 303 set out the method of calculation, which provides that earnings should be calculated net of taxes, depreciation, and capital gains or losses. That is, the method is consistent with the SNA's concept of operating surplus adjusted for the receipt of property income and current transfers and the payment of interest, taxes, and current transfers. Paragraphs 304 and 305 set out the reasons for the inclusion of retained earnings as an income flow in the current account and concurrently as an imputed capital flow in the capital account of the balance of payments. Specifically, paragraph 304 notes, among other points, that

Unremitted earnings of branches and other unincorporated direct-in vestment enterprises, and the direct investor's portion of earnings of incorporated direct-investment enterprises that are not formally distributed, are conceived of as providing additional capital to the enterprise, thus increasing the value of an economy's stock of foreign assets and liabilities.

An important feature of the treatment of reinvested earnings on direct investment is that reinvested earnings of an enterprise are attributable to the direct investor in proportion to the direct investor's equity share. For example, in the case of a corporation in which a direct investor owns all the ordinary shares or voting stock, all the reinvested earnings of the enterprise are attributable to the direct investor. However, if the direct investor has, say, only a 35 percent equity, then only 35 percent of the reinvested earnings are attributable to that investor. This recognizes the axiom that the influence of the direct investor increases with a higher equity share. For example, in the case of a wholly owned subsidiary, the direct investor would not need to consult other owners. Where the direct investor has a 51 percent equity, then consultation with other significant shareholders would be normal; if there were no such shareholders, the direct investor would still need to show concern about the investment interests of portfolio shareholders. With less than a 50 percent equity, the direct investor would normally either be consulted in the operation of the enterprise or, if the direct investor had a controlling interest, would still need to be concerned about the interest of other shareholders. This proportioning of reinvested earnings to direct investors according to their equity share also allows for situations in which there are several direct investors in one enterprise.

The BPM, while providing guidelines on direct investment, does not provide a set of definitive operational rules on the borderline between direct and portfolio investment. To provide more explicit rules on this and to deal with various practical issues arising with direct investment, a “Detailed Benchmark Definition of Foreign Direct Investment” was prepared in 1983 by the Organization for Economic Cooperation and Development (OECD) Group of Financial Statisticians, at the request of the Committee on International Investment and Multinational Enterprises of the OECD.2

II. Reasons for the Proposed Change to the SNA

Users of balance of payments statistics have long recognized the importance of direct investors and have attempted, in various ways, to measure the impact of such investors on the balance of payments. The IMF's Executive Board, in discussing the Final Report of the Working Party on the Statistical Discrepancy in World Current Account Balances,3 strongly endorsed the desirability of compiling and presenting statistics on reinvested earnings on direct investment as an integral part of the balance of payments and urged countries to undertake efforts in this regard.

Because of their influence in various enterprises operating in an economy, direct investors can have a significant impact in many countries on the nature, size, and direction of current and capital account flows measured in the balance of payments. Their influence is also important in decisions that are taken concerning whether enterprises distribute or retain income earned. From a behavioral standpoint, analysts have felt that, given the influence of direct investors in this way, there appears to be little difference between a situation involving the distribution of earnings in a formal sense and their subsequent investment in the enterprise as equity capital, and the situation in which profits are simply ploughed back into further expansion of the enterprise. From an analytical viewpoint both situations imply international flows of capital. The current BPM treatment endeavors to make explicit this aspect as it relates to the decision making of the foreign direct investor. In practice it is sometimes difficult for branches of direct investors to distinguish between remitted and unremitted profits. In these circumstances, in some countries compilers treat the total earnings (less taxes and the like) of the branch as distributed profits and then include the movement in the head-office account in relation to the branch as concomitant capital flows.

Direct investment and reinvested earnings on direct investment are also important in a national accounts context. As pointed out above, the current SNA recommends that saving should be separated into that attributable to direct-investment enterprises and that attributable to other enterprises. It also recommends that reinvested earnings on direct investment be treated as a memorandum item. The proposal to change the treatment of reinvested earnings on direct investment would take this recognition a step further. The Expert Group Meeting on Production Accounts and Input-Output Tables (Vienna, March 1988) recommended that, in the revised SNA, data for corporate enterprises should be compiled separately for foreign-owned and resident-owned enterprises. For the purposes of identifying foreign-owned enterprises it recommended that reference should be made to the concept of direct investment (see Chapter 12 in this volume). Their recommendation recognizes the analytical importance of the distinction between “foreign-managed” and “domestically managed” enterprises and, if implemented, would assist in the derivation of reinvested earnings as transactions flows in the compilation of national accounts.

The proposal to measure reinvested earnings on direct investment would mean that property income from and to abroad would include these reinvested earnings. Other aggregates such as national disposable income, saving, net lending, and the like would consequently change. Saving, for example, would include reinvested earnings on direct investment from abroad but would exclude reinvested earnings on direct investment to abroad. The proposal recognizes that direct investors have a key influence on the decision whether earnings should be reinvested or repatriated. Section IV sets this out more fully.

Certain objections to the proposed change have been made in various forums on conceptual grounds. Some national accounts statisticians feel that saving as currently measured in the SNA for corporate and quasi-corporate enterprises ought to remain intact. Furthermore, in their view, if the measure of saving is changed to include reinvested earnings on direct investment attributable to direct investors, then logically it should be further changed to include reinvested earnings that are attributable to portfolio investors. This would mean excluding reinvested earnings attributable to nonresident portfolio investors from the measurement of saving. Although this view has some merit, the current SNA treatment reflects that it is corporate enterprises and not portfolio investors who decide on the distribution and retention of income earned by enterprises. This view is retained under the proposed change. However, it recognizes that in the case of direct-investment enterprises this decision is made largely by nonresident corporate enterprises rather than domestic corporate enterprises.

Some national accounts statisticians have reservations about the proposed change because in their view it leads to inconsistent treatment of domestic investors and foreign direct investors. In some enterprises, certain resident individuals or coalitions of resident individuals own and exercise a key influence over the operations of enterprises akin to that of direct investors. To treat domestic investors consistently with foreign direct investors, it is argued that in such cases the enterprises' saving should be attributed to the household sector. In response, although some individuals control or have an effective voice in the management of certain enterprises, usually these individuals would be influenced by corporate or entrepreneurial considerations rather than household considerations. Therefore, there is no inconsistency in the proposed treatment between domestic and foreign investors.

Thus, it is reasonable to advance the proposed treatment without attributing the remaining saving either to portfolio investors (and hence households) or, in the case of certain entrepreneurs, to their households.

A further reservation that is sometimes raised is that, in particular enterprises, a direct investor's influence may be less than a resident's influence. This may be true in some enterprises, but most direct-investment enterprises are usually wholly foreign-owned or have majority foreign ownership. In any case, the reinvested earnings of direct-investment enterprises under the proposal are attributable to the direct investor in proportion to the direct investor's ownership interest. This apportioning of reinvested earnings is taken up in Section III.

Some objections have been raised to the proposal on practical grounds. Because of data limitations, not all countries have been able to include estimates for reinvested earnings and its offset, reinvestment of earnings, in their balance of payments accounts. It should be pointed out, however, that many countries have been improving their data sources. Several of these practical issues are discussed below.

Possibly the strongest argument for the proposed change is that economists and statisticians at the national level, reflecting both their user requirements and extensive experience, have both reaffirmed that reinvested earnings on direct investment should continue to be included in balance of payments statistics and introduced into the revised SNA. These were the conclusions of the External Sector Group and the BOP Group, although there was no unanimity of view.

III. Method of Calculation

Three issues arise here. How should reinvested earnings of direct-investment enterprises be calculated? How should reinvested earnings be apportioned between direct investment and nondirect investment? How should reinvested earnings of direct-investment enterprises that are financial enterprises be treated?

Calculation of Direct-Investment Enterprises' Reinvested Earnings

As outlined in Section I, the BPM provides guidelines on the calculation of reinvested earnings. Although all the relevant principles are enunciated in the BPM, the statement is somewhat imprecise from a national compiler's viewpoint. The OECD Benchmark Definition provides a more comprehensive statement on the calculation of reinvested earnings on direct investment; paragraph 49 provides a very useful summary of its recommendations:

As a result the Group recommends that direct-investment earnings should be defined as the operational earnings of the direct-investment enterprise after deducting provisions for depreciation and for income and corporation tax charged on these earnings. Direct-investment earnings should not include any realized or unrealized capital gains or losses made by either the direct-investment enterprise or the direct investor. However, it is recommended that supplementary information be collected on these various capital gains and losses incurred by the enterprise and the direct investor in order to reconcile, or to estimate, movements in the net asset value of the stock of direct investment between the beginning and end of the period.

The measure of earnings thus defined is consistent with the SNA's measure of operating surplus adjusted for the receipt of property income and current transfers and the payment of interest, taxes, and current transfers. Although agreeing in concept, the OECD Benchmark Definition does not explain how depreciation and transfers should be valued. The BPM (paragraph 302) notes, however, that “although depreciation should, in principle, be calculated at current replacement cost, data will often be available only on an historical cost basis.” Obviously in both the revised SNA and BPM the definition should be consistent.

Calculation of the Direct Investors' Share

As mentioned above, reinvested earnings of direct-investment enterprises are attributable to direct investors in proportion to their equity share. To explain, the following examples are provided.

Assume that enterprise A in an economy records operational earnings of US$100 million, depreciation (measured on a basis consistent with SNA principles and not merely for taxation purposes) of $40 million, corporate taxes of $20 million, and remitted profits of $25 million, leaving reinvested earnings of $15 million.

If enterprise A were a branch of a nonresident corporation or a wholly owned subsidiary of a nonresident corporation, then the entire $15 million would be attributed to reinvested earnings on direct investment.

If enterprise A were less than wholly owned by a direct investor, then only the direct investor's portion would be attributed to reinvested earnings on direct investment. If enterprise A were 51 percent owned by a direct investor, then $7.65 million would be attributed to reinvested earnings on direct investment; if it were 12 percent owned by a direct investor, then $1.8 million would be attributed to reinvested earnings on direct investment. Note that under the OECD Benchmark Definition the threshold for determining a direct-investment relationship is generally a 10 percent equity ownership.

If enterprise A had an equity interest in enterprise B, then a portion of the reinvested earnings of enterprise B should also be attributed to the direct investor if a direct-investment relationship can be established between the direct investor and enterprise B. Under the OECD Benchmark Definition, in order to determine the equity portion, the direct investor's equity share in enterprise A is multiplied by enterprise A's equity share in enterprise B. If the direct investor owns 45 percent of enterprise A, which in turn owns 25 percent of enterprise B, the direct investor's share in enterprise B is calculated as 11.25 percent. If enterprise B has reinvested earnings of $12 million, then the reinvested earnings attributed to the direct investor would be $6.75 million with respect to enterprise A plus $1.35 million with respect to enterprise B.

Treatment of Financial Enterprises

Various financial enterprises raise some additional issues for consideration. These are briefly dealt with in the following paragraphs.

Treatment of the service charges of banks and other financial intermediaries is undergoing reconsideration as part of the SNA review. Whatever the treatment that is adopted, it is proposed that the measurement of property income received and paid by banks and similar intermediaries should in the revised SNA include reinvested earnings on direct investment, receivable and payable, respectively.

Life insurance enterprises may be direct-investment enterprises. Any calculation of reinvested earnings would obviously take place after deducting the net change in the equity of households during the period. If the life insurance enterprise is a corporation owned by shareholders, calculation of reinvested earnings on direct investment takes place in the normal way after deducting the net change in the equity of policy holders (households). If the enterprise is a branch of a foreign mutual life insurance fund, all the changes in assets of the branch would be attributed to policy holders in the domestic economy; hence there is no reinvested earnings attributed to direct investors.

IV. Presentation of Reinvested Earnings on Direct Investment in the Revised SNA

This section illustrates how entries on reinvested earnings on direct investment would be presented in the consolidated accounts of the nation. Space considerations prevent the presentation of the actual accounts; the reader who wishes to follow the entries described below more closely should consult the “Consolidated accounts for the nation,” which appear on pages 152-54 in the current SNA. To illustrate, it is assumed that in a country direct investors decide to reinvest $500 million in their direct-investment enterprises abroad, while direct investors abroad decide to reinvest $300 million in the country in a given period.

Under the proposed treatment, in the account for National Disposable Income and Its Appropriation, the entries 3.4.10 (“Property and entrepreneurial income from the rest of the world, net”) and 3.7.1 (“Saving”) would each increase by $200 million, as would the totals “Appropriation of disposable income” and “Disposable income.”

Similarly in the Capital Finance account, the entries 5.7.8 and 5.7.9 (“Net lending to the rest of the world”) and 5.7.1 (“Saving”) would increase by $200 million. In addition, entry 5.8.0 (“Net acquisition of financial assets”) would increase, or entry 5.9.0 (“Net incurrence of liabilities”) would decrease, by $200 million, as would the corresponding totals.

Finally, in the External Transactions account, entry 6.4.9 (“Property and entrepreneurial income from the rest of the world”) would increase by $500 million, while entry 6.4.8 (“Property and entrepreneurial income to the rest of the world”) would increase by $300 million. The entries 6.7.3 and 6.7.2 (“Surplus of the nation on current transactions”) would increase by $200 million, while entry 6.8.0 (“Net acquisition of foreign financial assets”) would increase, or entry 6.9.0 (“Net incurrence of foreign liabilities”) would decrease, by $200 million. Correspondingly, the totals of this account would also change.

In supplementary tables, separate details should be provided on reinvested earnings on direct investment and other income items. It would also be useful to show the derivation of reinvested earnings on direct investment. This could be done by presenting a supplementary table on direct-investment enterprises that showed their operating profits; their depreciation; their corporate taxes; their distribution of earnings to direct investors, foreign portfolio shareholders, and domestic investors, separately; and their retained earnings attributable to their direct and other investors, separately. Data in this table when compared with data on nondirect-investment enterprises would provide a useful starting point for analyzing behavioral differences between direct-investment and other enterprises. In addition, it should also be possible to disaggregate data on direct-investment enterprises by industry of investee in the domestic economy and by country of investor. This would provide further information on the behavior of direct investors.

V. Compilation of Estimates of Reinvested Earnings on Direct Investment: Practical Issues

As mentioned earlier, not all countries currently produce estimates of reinvested earnings on direct investment for inclusion in their balance of payments accounts. This is particularly true where countries rely on administrative records of foreign exchange transactions (which are not a good source of data on direct investment) rather than on direct surveys of enterprises. More and more countries, however, are recognizing the desirability of obtaining good data on direct investment, including reinvested earnings transactions, and have been investigating or introducing surveys to collect such data. The experience of countries that have introduced surveys is that direct-investment enterprises, which often wish to be “good corporate citizens,” readily cooperate with the statistical authority if data being collected are kept confidential and are used for statistical purposes only. Another potentially useful, but underrated source, is taxation data on corporate profits, which may complement survey data and allow the national statistical compiler to obtain reasonably accurate data.

From the national accounts side, many countries have seen the need to improve data on corporate profits. The link between operating surplus and reinvested earnings has been shown above; there is an obvious advantage in coordinating surveys of company profits and direct investment. By ensuring consistency between the two data sets, current balance of payments estimates of reinvested earnings on direct investment may be improved.

Because company accounts may not meet all the economic statistician's requirements, it may be necessary for certain adjustments to be carried out to ensure consistency between balance of payments and national accounts data, particularly with reference to the measurement of operating profit and depreciation.

The Fund's Bureau of Statistics has an interest in seeing improvements in the quality of national accounts and balance of payments data and intends, as part of its future work, to develop practical guidelines for balance of payments reporting, including sample questionnaires, collection forms, and the like that could be of considerable assistance to countries initiating or improving collections of data from direct-investment enterprises.

Therefore, although the data on reinvested earnings are not available in all countries, countries have been looking at ways to improve their data collections. In addition, there are links between the collection of corporate profits and direct-investment transaction data that may be exploited to improve the coordination of these data. As noted above, the Fund's Bureau of Statistics also plans an active program of assistance to help countries establish or improve appropriate balance of payments collection methodology.

VI. Conclusions

Although there may be misgivings by some experts about the introduction of reinvested earnings on direct investment into the national accounts, from an analytical standpoint it would be desirable to incorporate reinvested earnings in the transaction accounts of the SNA as outlined in Section IV. Such a revision of current practice would provide for an alignment of the SNA with the UN Provisional Guidelines. There are some practical difficulties with implementation of the proposal, but these difficulties are being addressed at the national level and should soon be overcome. The IMF's Bureau of Statistics plans an active program of support to national compilers to facilitate this process.

United Nations, Provisional International Guidelines on the National and Sectoral Balance-Sheet and Reconciliation Accounts of the System of National Accounts, Statistical Papers, Series M, No. 60 (New York, 1977).

OECD, “Detailed Benchmark Definition of Foreign Direct Investment” General Distribution, BOP.B2 (Paris, February 1983).

International Monetary Fund, September 1987.

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