IX. Direct Investment (2024)

The Concept of Direct Investment

509. Direct investment is a category of international investment in which a resident entity in one economy (the direct investor) acquires a lasting interest in an enterprise resident in another economy (the direct investment enterprise). Direct investment implies a long-term relationship between the direct investor and the direct investment enterprise and a significant degree of influence by the direct investor on the management of the direct investment enterprise. Direct investment comprises the initial transaction between the two entities—that is, the transaction that establishes the direct investment relationship—and all subsequent transactions between the entities and among affiliated enterprises, both incorporated and unincorporated.

510. The Organisation for Economic Cooperation and Development (OECD) presents the same concept of direct investment in the Detailed Benchmark Definition of Foreign Direct Investment (BMD). The BMD is complementary to the Balance of Payments Manual. The purpose of the BMD is to provide a detailed operational definition of direct investment to serve as a reference, or standard, against which each country can compare its statistical system by using the concept and definition of direct investment contained in the Balance of Payments Manual. The BMD supplements the information provided in the Balance of Payments Manual.

511. The concept of direct investment differs from the concept of control. To be classified as a direct investor, an investor need not have the controlling share, or even the largest share, of ownership in an enterprise.

Motivation for Direct Investment

512. Direct investors expect to derive benefits from having a voice in the management of an enterprise. Portfolio investors, who do not exercise significant influence over the enterprises in which they invest, expect to obtain different benefits. From a direct investment perspective, enterprises often represent units in a multinational operation, the overall profitability of which depends on advantages gained by deploying resources available to each unit in a way that best enhances the synergy of the group. For example, the direct investor may be able to obtain resources or access to markets that might otherwise be unavailable to the enterprise. Direct investors may also be able to increase enterprise profitability and value through management skills and other expertise. Direct investment may also allow the direct investor to diversify and manage risk more effectively.

513. Therefore, direct investors may receive benefits in addition to income that would otherwise accrue on invested capital. In contrast, portfolio investors are primarily concerned about return on investment and the likelihood of appreciation in value. Portfolio investors generally evaluate prospective investment units separately and often shift their investments according to changes in prospects.

Defining the Direct Investment Relationship

514. The direct investor may be an individual, an incorporated or unincorporated private or public enterprise, an associated group of individuals or enterprises, or a government or government agency that owns a direct investment enterprise (as described subsequently) in an economy other than that in which the direct investor resides. A direct investment enterprise is an incorporated or unincorporated enterprise in which a direct investor owns 10 percent or more of the ordinary shares or voting power (for an incorporated enterprise) or the equivalent (for an unincorporated enterprise). The direct investment relationship extends to direct investment enterprise subsidiaries, direct investment enterprise associates, and branches directly or indirectly owned by the direct investor.

515. Enterprise X is a subsidiary of enterprise N only if:

(1) enterprise N owns more than half of the shareholders’ or members’ voting power in X

or

(2) enterprise X is a subsidiary of any other enterprise that is a subsidiary of N.

Enterprise K is an associate of enterprise N only if:

(1) enterprise N and its subsidiaries own 10 percent or more of the shareholders’ voting power in enterprise K and enterprise K is not a subsidiary of N

or

(2) enterprise K is a subsidiary of any other enterprise that is an associate of N.

Therefore, an investor need not control or be the largest shareholder in an enterprise for a direct investment relationship to exist between them. The concept of direct investment is fundamentally different from the concept of foreign-controlled enterprises. While all foreign-controlled enterprises are direct investment enterprises, enterprises not considered foreign controlled may also be in direct investment relationships with nonresident direct investors.

516. The rule of 10 percent is used to ensure consistent classification of investor/investee relationships for all countries’ statistics. In many countries, regulatory and other authorities consider 10 percent ownership to constitute a relationship implying a degree of influence by the investor. Sometimes, investors who own 10 percent or more of an enterprise have little or no influence on enterprise management (e.g., pension funds not involved in the management of enterprises in which the funds have substantial investments). On the other hand, investors who own less than 10 percent may have an effective voice in enterprise management (for example, by being able to appoint managing directors). In the interest of comparability, however, use of the 10 percent rule is preferable to subjective judgment. Furthermore, as most direct investment enterprises are branches or subsidiaries that are wholly or majority owned by nonresidents, borderline cases are relatively insignificant.

517. Illustrated below are subsidiary and associate relationships. Enterprise N has these investments:

According to the definition of direct investment:

A is a subsidiary of N.

B is a subsidiary of A and therefore a subsidiary of N, even though only 33 percent of B is indirectly attributable to N.

C is an associate of B and therefore an associate of N through N’s subsidiary B, even though only 4 percent of C’s capital is indirectly attributable to N.

D is an associate of N.

E is a subsidiary of D and therefore an associate of N, even though only 6 percent of E is indirectly attributable to N.

F is an associate of N.

G is an associate of F but not of N as F is only an associate of N.

H is neither a subsidiary nor an associate of N.

J is a subsidiary of H but neither a subsidiary nor an associate of N.

K is a subsidiary of N.

L is a branch of K and thus a branch of N.

Therefore, enterprises A, B, C, D, E, F, K, and L are involved in a direct investment relationship with N and in direct investment relationships with each other. Transactions between company E and company K, for example, represent direct investment transactions.

518. For purposes of the balance of payments and the national accounts, enterprises that have significant long-term (that is, more than one year) operations in more than one economy are divided into separate entities in each economy. These entities are always in a direct investment relationship; the head office constitutes the direct investor and the branches constitute the direct investment enterprises. Land and structures directly owned by nonresidents (other than foreign governments) are, in the balance of payments and the national accounts, considered to be owned by notional resident units that are in direct investment relationships with the legal owners of the land. Also considered to be owned by enterprises that are resident in the host country and in direct investment relationships with the actual operators of equipment (such as ships, aircraft, gas and oil drilling rigs) is mobile equipment that operates in an economy for at least one year, is accounted for separately by the operator, and is recognized by taxation and similar authorities of the host country as part of the country’s capital stock.

Direct Investment Capital

519. Direct investment capital is (1) capital provided by the direct investor—either directly or through other enterprises related to that investor—to the direct investment enterprise or (2) capital received by the direct investor from the direct investment enterprise. Direct investment capital includes equity capital, reinvested earnings, and other capital involved in various intercompany debt transactions. Direct investment capital includes only actual amounts provided; for example, funds for which the direct investor merely makes the arrangements or guarantees repayment are not considered direct investment capital.

520. Equity capital covers equity in branches, all shares (whether voting or nonvoting) in subsidiaries and associates, and other capital contributions (for example, the provision of machinery—which constitutes part of the capital of the direct investment enterprise—by a direct investor to a direct investment enterprise). Equity capital also covers the acquisition by a direct investment enterprise of shares in its direct investor. Reinvested earnings are the direct investors’ shares (in proportion to equity held) of the undistributed earnings of the direct investment enterprise. These reinvested earnings are recorded as income with an offsetting capital transaction. The rationale for including reinvested earnings in the balance of payments is discussed in chapter 6.

521. Other capital (or intercompany debt transactions) covers the borrowing and lending of funds, including debt securities and trade credits, between direct investors and direct investment enterprises and between two direct investment enterprises that share the same direct investor. Debt claims on the direct investor by the direct investment enterprise are also recorded as direct investment capital.

522. However, in regards to investments between affiliated banks and other financial intermediaries, only those investments associated with equity and permanent debt (that is, loan capital) are considered to be direct investment. Other debt investment (such as deposits and other claims and liabilities related to normal banking activity) between affiliated banks and other financial intermediaries is considered to be portfolio investment or other investment.

523. In practice, it is sometimes difficult to distinguish between the equity capital and the other capital of direct investment enterprises. Differentiation is particularly difficult when an enterprise is 100 percent owned by a direct investor. In these situations, the classification of capital for the balance of payments could be the same as that used in the direct investor’s (or direct investment enterprise’s) accounting records. That is, when a claim of the direct investor on the direct investment enterprise is considered—in the accounting records of the direct investor or the enterprise—to be equity capital or shareholder funds, this claim is also considered equity capital in the balance of payments.

524. Capital provided to a direct investment enterprise by economic units other than the direct investor and enterprises related to the direct investor is not direct investment capital. For example, if a direct investment enterprise borrows money from an enterprise that is not affiliated with the direct investor, this borrowing is classified in the balance of payments as other investment.

525. The following example illustrates the concept of direct investment capital. Enterprise X in Namdarb is 50 percent owned by enterprise Z in Coonawarra. Forty-five percent of enterprise X’s shares are owned by residents of Namdarb, and 5 percent are owned by a resident in Cromania. In a particular year, enterprise X undertakes the following transactions:

(1) One hundred shares of new equity are issued, and these are purchased by shareholders of enterprise X in proportions equal to their existing shareholdings.

(2) Enterprise Z provides enterprise X with 20 units’ worth of machinery, which is entered in the accounting records of enterprise X as non-voting equity.

(3) Enterprise Z sells goods worth 40 units to enterprise X. Enterprise X pays 20 units, and the remaining 20 units are entered, in the accounting records of enterprise X, as a trade credit payable.

(4) Acting as a guarantor for the loan, enterprise Z arranges for an unrelated bank in Dromesia to lend enterprise X 75 units.

(5) Enterprise X’s operating profit, after tax and interest expenses, for the year is 10 units. Enterprise X does not pay any dividends during the year.

526. These entries would be made in Namdarb’s balance of payments:

A direct investment relationship is created when an investor (or group of related investors) obtains 10 percent or more of the shares in an enterprise. If an investor does not own any shares in an enterprise prior to becoming a direct investor, the entire acquisition of shares is recorded as a direct investment transaction. Conversely, if an investor has enterprise shareholdings of less than 10 percent prior to becoming the direct investor, only the shares acquired in the transaction that makes the investor a direct investor are classified as a direct investment transaction. In other words, the reclassification of shares previously classified as portfolio investment to direct investment is not recorded in the balance of payments but is reflected instead in the international investment position.

527. For example, enterprise P in Pokolbin purchases, for 8,000 units, 8 percent of the shares in enterprise M in Madornia. One month later, enterprise P acquires, for 6,000 units, another 5 percent of the shares of enterprise M. The following transactions would be shown in Madornia’s balance of payments:

528. If enterprise P’s investment in Madornia is valued at 15,000 units at the end of the period, the following entries would be shown in Madornia’s IIP statement:

Direction of Investment

529. Unlike other financial investments, direct investment is not recorded in the balance of payments on a strict asset/liability basis. Instead, direct investment is recorded on a directional basis—resident direct investment abroad and nonresident direct investment in the reporting economy. Capital invested by the direct investment enterprise in its direct investor (reverse investment) is regarded as an offset to capital invested in the direct investment enterprises by a direct investor and its related enterprises. That is, such capital is regarded as disinvestment by the direct investor rather than as an asset of the direct investment enterprise. For purposes of analysis, these investments are recorded separately in the BOP standard components. When a direct investment enterprise invests in an enterprise related to its direct investor, this investment is recorded, by the economy providing the investment, as resident direct investment-abroad and, by the economy of the enterprise receiving the investment, as direct investment-reporting economy.

530. In some instances, two enterprises or groups of related enterprises hold 10 percent or more of each other’s voting shares. Thus, two direct investment relationships are established, and investments between the two enterprises or groups of enterprises are recorded on a full asset and liability basis—that is, as direct investment- reporting economy and as direct investment- abroad.

531. The following two examples illustrate the directional basis for recording direct investment transactions. In the first example, enterprise A in Algornia is 100 percent owned by enterprise N in Nostaw. Enterprise N owns 100 percent of enterprise E in Essendonia. In a particular period, enterprise A is involved in the following transactions:

Enterprise N provides machinery worth 50 units to enterprise A. The machinery is recorded as an equity investment in the accounting records of enterprise A.

Enterprise A lends enterprise E 100 units. The loan is repayable in five years. Enterprise E pays interest of 5 units on the loan during the year.

Enterprise E sells to enterprise A goods worth 50 units. Enterprise A provides payment in the form of trade credit, which remains outstanding at the end of the year. Enterprise A pays interest of 4 units on the trade credit.

Enterprise A purchases 80 units of bonds issued by enterprise N and receives 8 units in interest income.

Enterprise A’s operating profit, after taxes and interest, is 25 units; dividends equal to this amount are paid.

The following entries would be recorded in Algornia’s balance of payments:

532. In the second example, enterprise H operating in Hughesavia is 50 percent owned by enterprise L in Longa. In a particular year, these transactions occur in the order of presentation:

Enterprise H lends enterprise L 45 units.

Enterprise H purchases 20 percent of the shares of enterprise L for 1,200 units.

Enterprise H lends another 15 units to enterprise L.

Enterprise H receives interest of 6 units on funds lent to enterprise L.

Enterprise H’s operating profit, after taxes and interest, is 50 units. No dividends are paid.

Enterprise L’s operating profit, after taxes and interest, is 80 units. Dividends of 40 units are paid to shareholders.

533. The following entries would be made in Hughesavia’s balance of payments:

Enterprise H’s first loan to enterprise L is shown as reverse investment because, at the time the loan is made, enterprise H does not have a direct investment interest in enterprise L. The second loan, which is made after enterprise H becomes a direct investor in enterprise L, is treated as direct investment-abroad. As all of the interest is paid after enterprise H becomes a direct investor in enterprise L, this amount is shown as a direct investment credit rather than as a negative direct investment income debit. The value of enterprise H’s stock of direct investment abroad would be shown in Hughesavia’s statement of international investment position at the end of the period as the entire amount that enterprise H has lent to enterprise L. The reclassification of the first loan would be shown as a non-transaction change in levels.

Valuation

534. The recommendation of the BPM is that market values be used to value direct investment financial flows, income transactions, and stock positions. Use of market values is consistent with valuation principles recommended for recording other entries in the balance of payments and the international investment position. The recommendation to use market values for the valuation of direct investment is made for two primary reasons. First, comparisons of direct investment and other financial investment recorded in the balance of payments and international investment position would be invalid if inconsistent valuation bases were used. Second, market valuation provides the most meaningful measure of the economic value of resources available to, or transferred between, economies.

535. Unfortunately, because of the nature of the direct investment relationship, the criterion used for establishing market values is generally not satisfied as a key aspect of this criterion is that the parties to transactions must be independent. With regard to transactions, values shown in the accounting records of the direct investor and direct investment enterprise often serve as acceptable proxies for market valuations. However, in some instances, transactions occur between enterprises in a direct investment relationship, and the values shown in the accounting records of the transactors are significantly distorted from market values. For example, an enterprise may use prices that are unrelated to costs of production or acquisition in selling goods to a related enterprise. Such pricing might be employed as a means of transferring profits from one country to another for tax reasons or because the country of the direct investment enterprise imposes restrictions on repatriation of income by more straightforward means. In other instances, transfer prices may be used as a means by which a direct investor makes a capital investment in a direct investment enterprise.

536. The recommendation of the BPM is that, when the actual transaction price of a transfer of real resources between enterprises in a direct investment relationship differs from the value that could have been expected if the enterprises had been independent, the BOP compiler should make an adjustment to these values as shown in the balance of payments. The BPM also contains the caution that such adjustments should be made only when significant distortions are encountered.

537. When adjustments are made to one side of a BOP transaction, similar adjustments must be made to the other side of the exchange to preserve equality between credit and debit entries. Offsetting adjustments are always made to investment income or to direct investment financial transactions.

538. The following two examples illustrate the adjustment process. In the first example, direct investment enterprise U in Urangastan produces copper. Were this copper sold to an unrelated enterprise, direct investment enterprise U could expect, on the basis of the production cost of the copper, to earn 50 units per ton. However, the government of Urangastan has imposed restrictions on the repatriation of income to nonresidents. Therefore, enterprise U sells—to direct investor C in Clintonstan—1,000 tons of copper at only 10 units per ton. In this case, direct investment enterprise U and direct investor C are using transfer pricing to achieve a repatriation, which would otherwise not be permitted, of income to Clintonstan. These entries would be made:

539. In the second example, direct investor D in Daniherland wishes to increase his investment in wholly owned subsidiary B in Bushland. However, Bushland’s foreign investment policy restricts further explicit financial investment. To circumvent this policy, direct investor D sells machinery to subsidiary B for 2,000 units. Direct investor D could have sold this machinery to an unrelated enterprise for 5,000 units. The following entries would be shown in Daniherland’s balance of payments:

540. The concept of market valuation can also be difficult to apply to direct investment relationships for valuations of equity positions in the IIP statement. Stock positions for equities and other securities are generally valued by using prices prevailing in an independent market on the date for which the IIP statement is prepared. As an independent market often does not exist for equity investment in direct investment enterprises, the BPM recommendation is that market value proxies be used. In the absence of regular market trading, the value of equity investment could be calculated as the net worth of an enterprise; one would apply current market values to the assets (including intangibles) and liabilities of the enterprise and determine the difference. See chapter 13 for valuation of direct investment equity stocks.

Special Cases

541. Four types of direct investment require elaboration: (1) special purpose entities, (2) construction enterprises, (3) investment in land, and (4) mobile equipment stationed in an economy for more than one year.