5.1 As introduced in Chapter 2, the BPM5 defines direct investment as a category of international investment that reflects the objective of a resident in one economy (the direct investor) obtaining a lasting interest in an enterprise resident in another economy (the direct investment enterprise). The lasting interest implies the existence of a long-term relationship between the direct investor and the direct investment enterprise and a significant degree of influence by the investor on the management of the enterprise.
5.2 The concept of direct investment does not necessarily imply control of the direct investment enterprise because, according to BPM5, an ownership criterion of only 10 percent of the ordinary or voting shares of the direct investment enterprise is used to define or establish a direct investment relationship. In practice, however, a large proportion of FDI capital involves majority-owned subsidiaries and branches. For example, Statistics Canada reported that majority-owned subsidiaries and branches accounted for 93 percent of Canada's stock of inward FDI and 94 percent of the stock of outward FDI in 2001. The Godeaux Report found similar ratios for several industrial countries-94-96 percent of inward FDI and 83-97 percent of outward FDI was accounted for by majority-owned subsidiaries and branches. The Godeaux Report also noted that "equity holdings in the range of 10 to 20 or 25 percent accounted for only 1 or 2 percent of the stock of direct investment."
5.3 The lasting interest in a direct investment enterprise typically involves the establishment of manufacturing facilities, bank premises, warehouses, and other permanent or long-term organizations abroad, but it may also involve the operation of mobile equipment such as drilling rigs and construction activities, and expenditure on exploration for natural resources. This may involve the creation of a new establishment abroad ("greenfield investments"), joint ventures, or the acquisition of an existing enterprise abroad (M&A). The direct investment enterprises can be incorporated or unincorporated and can include ownership of land and buildings by nonresident enterprises, as well as by nonresident individuals.
5.4 Once a direct investment relationship has been established, all subsequent capital transactions between the direct investor and the direct investment enterprise and among affiliated enterprises resident in different economies are considered to be direct investment. The direct investment relationship extends to certain other enterprises indirectly owned by the direct investor. Thus, direct investment enterprises comprise nonresident subsidiaries, associates, and branches either directly or indirectly owned by the direct investor. The inclusion of transactions with and between indirectly owned entities can greatly extend the number of entities involved in the direct investment relationship, and adds to the complexity of compiling the data.
5.5 Once established, increases in FDI can take the form of injections of additional equity capital, the reinvestment of earnings not distributed as dividends by subsidiaries and affiliated enterprises and earnings of branches not distributed, and intercompany debt, both long- and short-term, such as the extension of suppliers' credits or loans, all of which represent FDI capital.
5.6 FDI capital flows are recorded on a net basis, in the same manner as other cross-border financial flows (that is, investments during the reporting period are netted against disinvestments, separately for claims and liabilities). FDI is recorded on a directional basis-broadly, as an asset for the economy of the direct investor and as a liability for the economy of the direct investment enterprise.
5.7 Two recording features-that of recording transactions with indirectly owned direct investment enterprises (for example, transactions between two foreign subsidiaries of the direct investor located in different economies) and the netting of certain transactions between the direct investor and the direct investment enterprise (reverse investment)-appear to pose special difficulties for compilation and contribute to asymmetries in the recording of FDI. 1 These two items are discussed in Box 5.1. Other selected recording features of FDI transactions, stocks, and investment income are described in the following paragraphs. Some of these features-such as the valuation of direct investment stocks and applying the Current Operating Performance Concept to measure direct investment earnings-also pose difficulties for compilation.
5.8 Equity capital covers equity in branches; voting or nonvoting shares in subsidiaries (greater than 50 percent ownership) and associates (10-50 percent ownership); and other capital contributions, which can include the provision of machinery or other capital equipment, raw materials, and technical know-how.
5.9 A direct investor can also increase its direct investment equity through the reinvestment of earnings of the direct investment enterprise, which consist of the direct investors' share (in proportion to equity held) of earnings not distributed as dividends by subsidiaries or associates and earnings of branches not remitted to the direct investor during the reporting period. In conformity with the double- entry system for constructing the balance of payments, the BPM5 recommends, for the economy of the direct investor, the recording of a credit in rein- vested earnings under FDI investment income for the amount of the reinvested or undistributed earnings of the direct investment enterprise abroad, together with an offsetting debit entry under FDI abroad to reflect the net increase in investment arising from the undistributed earnings. 2 The rationale for this "imputation" is that the direct investor has consciously chosen to forgo a distribution of income and elected to increase its investment in the direct investment enterprise.
5.10 Like other financial transactions, undistributed earnings are recorded on a net basis-earnings from operations are netted against any operational losses incurred during the reporting period. Earnings should be measured net of host-country income and corporation taxes and depreciation, and exclude realized and unrealized capital gains and losses, write- offs, and realized and unrealized exchange rate gains and losses: that is, conform with the Current Operating Performance Concept of recording direct investment earnings. If operating losses exceed profits, the recommended recording remains the same as above, except that a net debit would be recorded in reinvested earnings under direct investment income in the current account, and a credit would be recorded under FDI abroad to reflect the net decrease in investment arising from the losses. At times, this recording practice can give rise to peculiar results in the current account, such as negative investment income receivable, whenever unusually large losses are incurred by direct investment enterprises abroad. (Conversely, the economy of the direct investment enterprise would record a credit under investment income payable.)
5.11 The international statistical methodology also recommends that the reinvested earnings of indirectly owned direct investment enterprises (see Box 5.1) be included in proportion to the indirect ownership of the equity of those enterprises, which may be difficult to measure when they extend down through a chain of affiliates. The ability of compilers to gather the necessary data may also be constrained by accounting conventions regarding the preparation of consolidated company accounts.
5.12 The third component of FDI capital-other capital-covers intercompany debt-that is, the extension of trade credits, loans, and other advances to the direct investment enterprise. The BPM5 makes two important exceptions. Intercompany debt transactions between affiliated banks (depository institutions) and between affiliated financial intermediaries, including auxiliaries (for example, security dealers) recorded under FDI are limited to those transactions associated with permanent debt (loan capital representing a permanent interest) and equity (share capital) investment or, in the case of branches, fixed assets. 3 Second, intercompany transactions in financial derivatives are not considered to be FDI. 4
Box 5.1. Treatment of Indirectly Owned Enterprises and Reverse Investment
Indirectly owned direct investment enterprises
Once a direct investment...