Taxes and Entry Mode Decision in Multinationals: Export and FDI with and without Decentralization

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1 Taxes and Entry Mode Decision in Multinationals: Export and FDI with and without Decentralization Yoshimasa Komoriya y Chuo University Søren Bo Nielsen z Copenhagen Business School Pascalis Raimondos x Queensland University of Technology November, 206 Abstract We use a duopoly model to simultaneously consider both foreign direct investment (FDI) and decentralization decisions, featuring transfer pricing. To investigate the relationship between corporate taxes and the optimal entry mode for the foreign market, we examine and compare rms pro t in each of three entry modes: export, FDI with decentralization, and FDI with centralization. We nd that, even when a host country does not have any advantage, FDI can be undertaken because of a strategic incentive. We also nd that trade liberalization promotes decentralization of multinationals and that a tougher regulation of transfer pricing may expand the region of no centralization. Keywords: decentralization; foreign direct investment; transfer pricing JEL Classi cation: F2, F23, H25 Very preliminary! This is one of our ongoing research projects undertaken while Komoriya was visiting the Department of Economics in the Copenhagen Business School as a visiting scholar. Komoriya would like to thank the department for its hospitality. y Faculty of Economics, Chuo University, Hachioji, Tokyo , Japan; komoriya@tamacc.chuou.ac.jp z Department of Economics, Copenhagen Business School, Frederiksberg 2000, Denmark; sbn.eco@cbs.dk x Economics and Finance, QUT Business School, Brisbane QLD 4000, Australia; pascalis.raimondos@qut.edu.au

2 Introduction Transfer pricing is one of the pro t-shifting instruments for multinationals. In addition to the pro t-shifting role, transfer pricing may have other roles. In oligopoly settings, multinationals have an incentive to manipulate their intra- rm prices for a ecting competition that their subsidiaries are facing. This manipulation of intra- rm price is denoted the strategic role of transfer pricing. The strategic role of transfer pricing is widely known after Schjelderup and Sørgard (997). The motivation of their research is as follows: In the IO-literature on MNE behaviour both delegation of authority to local a liates and strategic interaction are discussed. [t]he focal point in the IO literature on MNEs, however, is on foreign direct investments, not on pro t shifting through transfer pricing (Schjelderup and Sørgard, 997, pp.278) 2. With this motivation, Schjelderup and Sørgard (997) nd this new role of transfer pricing. However, foreign direct investments (FDI) is taken as a given in their analysis. Therefore, in this paper, we consider both of FDI decision and pro t shifting, focusing on the strategic motive of transfer pricing. Decentralization is the key of the strategic role of transfer pricing. In the model of Schjelderup and Sørgard (997), in addition to FDI, decentralization is also taken as a given. Although Nielsen et al. (2008) examine decentralization decisions, that is, they investigate whether multinationals decentralize or not, FDI is taken as a given even in their analysis. Therefore, in this paper, we simultaneously consider both FDI and decentralization decisions of multinationals, featuring transfer pricing. In the literature, Porter (202) analyzes e ects of a corporate tax on choices between FDI and export. In a duopoly setting, taking rms choices between export and FDI into account, Porter (202) shows the possibility that an increase in the host country s corporate tax can create its desirable situation where the more e cient rm undertakes FDI and the less e cient rm does not. Although, as far as we know, Porter (202) is one of the rare papers that focus on e ects of corporate tax on choices between export and FDI, she does not consider pro t shifting and transfer pricing. Amerighi and Peralta (200) investigate choices of modes for serving two countries. A rm has two alternatives in their model. One is to have a plant in one country and to serve both the local and foreign markets from the plant. The other alternative is to have two plants and to serve markets from the local plants. They combine the proximity-consentration trade-o with a tax-saving incentive. Although, as far as we know, Amerighi and Peralta (200) is the rst paper that shows the relationship between the pro t shifting and FDI incentive, they do not focus on strategic incentives for undertaking FDI because they use a monopoly model. In our paper, we rst examine multinationals pro t in each of three entry modes into a foreign market: export, FDI with decentralization, and FDI with centralization (without decentralization). Second, to investigate FDI incentives in decentralization and centralization cases and a See for, example, Göx and Schiller (2007). 2 See, for example, Horstmann and Markusen (992) and Motta (992). 2

3 decentralization incentive, we compare after-tax pro t between entry modes. Finally, we show the relationship between corporate tax rates and the optimal entry mode for the foreign market by simultaneously considering FDI and decentralization decisions. First, we nd that, even when a host country does not have any advantage, that is, even when there is no di erence in marginal production cost between the home and host countries, there is no tax di erence, and trade costs are not incurred on export, FDI can be undertaken due to a strategic incentive. Second, we also show that centralized multinationals do not appear in free trade at least in our current setting and that trade liberalization promotes decentralization of multinationals. And nally, we nd that a tougher regulation of transfer pricing may expand the region of no centralization. Section 2 introduces our model and shows pro ts and welfare in each of the three modes and Section 3 investigates FDI incentives in decentralization and centralization cases and a decentralization incentive. Section 4 shows the relationship between corporate tax rates and the optimal entry mode for the foreign market. Section 5 discusses e ects of trade cost and Section 7 discusses that of transfer pricing cost. Section 7 o ers conclusions. 2 The Model In this section, we introduce our model. There are two countries (home and foreign) and two rms ( rm and rm 2). Only rm serves the home market and both rms serve the foreign market. The two rms compete in Cournot fashion. The output levels of rm in the home and foreign markets are, respectively, q and Q, and the output level of rm 2 in the foreign market is Q 2. We use linear demand functions, p = a bq in the home market and P = A BQ in the foreign market, where q q and Q Q + Q 2. p and P are, respectively, the market prices in the home and foreign markets. Marginal costs for production of the two rms are c and c 2. We assume c = c 2 = 0 for simpli cation. Firm has three entry modes for serving the foreign market: Export, FDI with decentralization, and FDI with centralization. The following subsections show each of the three modes. 2. Export Case In this mode, rm is an exporting rm and it competes with the rival ( rm 2) in the foreign market. Governments in the home and foreign countries tax locally earned pro t at t h and t f, respectively. After-tax pro ts of rm and rm 2 are, respectively, where is a trade cost. We nd = ( t h ) [(a bq )q + (A BQ BQ 2 )Q Q ] ; 2 = ( t f ) [(A BQ BQ 2 )Q 2 ] ; q = a 2b ; Q = A 2 3B 3 ; Q 2 = A + 3B

4 in the equilibrium. The after-tax pro ts are By assuming = 0, we have = ( t h ) 2 = ( t f ) and de ne (2) as EX in the following part FDI with decentralization " a 2 4b # (A 2)2 + ; () (A + )2 : a 2 = ( t h ) 4b + A2 ; (2) In this mode, rm is a decentralized MNE 4. Before-tax pro ts from production and sales on the part of rm in the home and foreign countries and rm 2 are, respectively, h = (a bq )q + mq ; f = (A BQ BQ 2 )Q mq ; f2 = (A BQ BQ 2 )Q 2 ; where, m is a intra- rm price (transfer price). The transfer price m can deviate from the marginal production cost (of zero). If it is set di erent from zero, the company is assumed to incur transfer pricing cost. After-tax pro ts of rm and rm 2 are, respectively, = ( t h ) h + ( t f ) f u 2 m2 F; 2 = ( t f ) f2 : The third and fourth terms of are the transfer pricing cost and the FDI xed cost. parameter u governs the change in transfer pricing cost, if the deviation from zero is enlarged. In this case, the headquarters of rm sets the transfer price before its subsidiary and rm 2 choose their output levels. We solve this model using backward induction. In the second stage, we have In the rst stage, d dm d dm q = a 2b ; Q = A 2m 3B ; Q 2 = A + m 3B : d dm = A (4t f 3t h ) 4m 2t f 3t h Bu ; 4 = 2t f 3t h Bu < 0: 3 We relax this assumption in section 5. 4 In this subsection, we assume 4t f 5t h + + 3Bu > 0 for obtaining non-negative output levels of both rms. If Bu > 4, we can obtain non-negative output levels. 3 The 4

5 The second order condition holds with the assumption of 4t f the level of the transfer price is m = A (4t f 3t h ) 4 2t f 3t h Bu: 5t h ++3Bu > 0. In equilibrium, Given corporate tax rates, the absolute value of the transfer price jmj decreases in u. If tax rates are not vastly di erent (t f is not much greater than t h ), m will lie below marginal cost of zero, in that case, the transfer price increases in u. Generally, the more pronounced are transfer pricing costs, the closer m is to zero. If t h = t f = t, m = A 4 + 9ABu 6 t Bu > A 4 : Although this equation shows the existence of the strategic motive of transfer pricing, the strategic motive is muted because of the transfer pricing cost 5. And the transfer pricing costs are present, even though there is no tax rate di erence. Equilibrium outputs are and the after-tax pro ts are If t h = t f = t, A [2 ( t h ) + 3Bu] Q = 4B 2t f 3t h Bu = A A [8 (t f t h ) + 3Bu] 2B 8B 2t f 3t h Bu; Q 2 = A (4t f 5t h + + 3Bu) 4B 2t f 3t h Bu = A 4B + A [8 (t f t h ) + 3Bu] 6B 2t f 3t h Bu = ( t h) a 2 4b + i A h( 2 t h ) 2 + 2Bu ( t f ) 8B 2t f 3t h F; (3) 4Bu 2 = ( t f ) A 2 (4t f 5t h + + 3Bu) 2 6B 2t f 3t h Bu 2 > 0: = ( t) We de ne (3) as DC in the following part. 2.3 FDI with centralization " a 2 4b + A2 ( 8B # t + 2Bu) t Bu F: (4) In this mode, rm is a centralized MNE 6. Before-tax pro ts of rm in the home and foreign countries and rm 2 and after-tax pro ts of the two rms are the same as those in the decentralization case. Unlike in the previous case, the headquarter of rm chooses both its transfer price and output level, and rm 2 chooses its output level simultaneously. 5 When m = A 4, Q is equal to the output level of the Stackelberg leader. 6 In this subsection, we assume t f t h 2 + Bu tf > 0, for non-negative output levels of both rms. 5

6 = (t f t h ) = ( t f ) (A 2BQ BQ 2 ) + m (t f t h ) 2 = ( t f ) (A BQ 2BQ 2 ) = 2B ( t f ) < 2 2 = (t f t h ) 2 + 2Bu ( t f ) = 2B ( t f ) < 2 (t f t h ) 2 + 2Bu ( t f ) > 0 holds with the assumption of (t f t h ) 2 + Bu ( t f ) > 0. From F.O.C., we have m = (t f t h ) Q ; u Q = ( t f ) (A BQ 2 ) + m (t f t h ) ; 2B ( t f ) Q 2 = A BQ : 2B Thus, in the equilibrium, transfer price and outputs are, respectively, m = Q = A (t f t h ) ( t f ) 2 (t f t h ) 2 + 3Bu ( t f ) ; Au ( t f ) 2 (t f t h ) 2 + 3Bu ( t f ) = A 3B + 2A (t f t h ) 2 h i; 3B 2 (t f t h ) 2 + 3Bu ( t f ) h i A (t f t h ) 2 + Bu ( t f ) Q 2 = h i B 2 (t f t h ) 2 + 3Bu ( t f ) = A 3B h 3B A (t f t h ) 2 i: 2 (t f t h ) 2 + 3Bu ( t f ) As already mentioned in Nielsen (204), the output of rm is consist of two parts. If t h = t f = t, because m = 0, the output of each rm equals a Cournot output level. And we also have q = a 2b. 6

7 The after-tax pro ts are = ( t h) a 2 4b 2 = + h i A 2 u ( t f ) 2 (t f t h ) 2 + 2Bu ( t f ) h i 2 F; (5) 2 2 (t f t h ) 2 + 3Bu ( t f ) h i 2 ( t f ) A 2 (t f t h ) 2 + Bu ( t f ) h i 2 > 0; B 2 (t f t h ) 2 + 3Bu ( t f ) If t h = t f = t, We de ne (5) as C in the following part. a 2 = ( t) 4b + A2 F: (6) 3 Comparison of three modes In this section, we investigate FDI incentives in each of the two FDI modes and decentralization incentives of multinationals. 3. Export and FDI with decentralization In this subsection, we compare EX and DC for investigating the FDI incentive for decentralization case. The condition for FDI is DC > EX, [ ( t h) (6t f 5t h ) 8Bu (t f t h )] 72 2t f 3t h Bu > F (A 2 =B) : ( t If ( t h ) (6t f 5t h ) 8Bu (t f t h ) < 0, that is, t f t h > h ) 2 2[8( t h )+u], rm chooses Export. This means that rm chooses Export when t f is su ciently high relative to t h. If t f t h < ( t h ) 2 2[8( t h )+u] = t h 6 t h t h Bu not depends on the relative size of the xed cost, F A 2 =B < t h 6, whether rm chooses FDI or. When F is low enough, when A is high enough, and/or when B is low enough, a rm chooses to be a decentralized multinational rm 7. Otherwise, rm chooses Export. If t h = t f = t, from (2) and (4), DC > EX ", A2 8B, # ( t + 2Bu) 8 t Bu > F 9 A 2 ( t) 72B t + 9 > F: 4Bu This means that rm chooses FDI when F is low enough and in particular when F = 0. 7 Because we use P = A BX for the demand function in the foreign market, A (A=B) governs pro t opportunities in that market. 7

8 When A = B =, F = 0, u =, and t h = 0:3, the condition for FDI ( DC > EX ) is t f 72 ( t f ) > 0: Below, Figures has been drawn using these values for A, B, F, u, and t h. FDI premium t_f Figure. Additional pro t of FDI with decentralization (t h = 0:3) In Figure, rm chooses FDI when t f < et f ' 0:3678. Because we assume t h = 0:3, we can nd that, even when t f > t h, can rm chooses FDI. Proposition Even in a case without the foreign country s production cost and tax advantages and trade cost, FDI may take place. Even when the tax rate in the foreign country is higher than that in the home country, FDI can be superior to export because of a (purely) strategic incentive, if the tax di erence is small. Whent f > t h, there is no FDI incentive coming from tax-saving incentive. However, in the above gures, rm chooses FDI if the tax di erence is small. Although Amerighi and Pelarta (200) shows a tax-saving FDI incentive, they do not consider this strategic incentive for FDI. 3.2 Export and FDI with centralization In this subsection, we compare EX and C to investigate the FDI incentive for the centralization case. The condition for FDI is C > EX n A 2 (t f t h ), o 8 ( t h ) (t f t h ) 3 + 3Bu ( t f ) [(3t f 8t h + 5) (t f t h ) 6Bu ( t f )] h i 2 > F: 8B 2 (t f t h ) 2 + 3Bu ( t f ) 8

9 If t h = t f and F > 0, from (2) and (6), rm does not prefer FDI with centralization to Export because C = EX F. When A = B =, F = 0, u =, and t h = 0:3, the condition for FDI ( C > EX ) is (0t f 3) 5240t f + 325t 2 f t3 f > 0: 90 90t f + 00t 2 f 4 Figure 2 has been drawn using these values. Because, with our parameters, t f 2 [0; 0:77468) meets the assumption of (t f t h ) 2 + Bu ( t f ) > 0, we cut o the rage above t f = 0:7 from the gure. FDI premium t_f Figure 2. Additional pro t of FDI with centralization (t h = 0:3) In Figure 2, when t h = t f, C = DC because of F = 0. And FDI with centralization is better than Export only in the case where the tax rate in the host country is lower than that in the home country (t f < t h ). 3.3 FDI with decentralization and FDI with centralization In this subsection, we compare DC and C for investigating the decentralization incentive 8. The condition for decentralization is DC > C, i A h4 2 ( t h ) 2 (t f t h ) 4 Bu ( t f ) h i 2 > 0; 8B 2t f 3t h Bu 2 (t f t h ) 2 + 3Bu ( t f ) 8 This subsection is based on Nielsen et al. (2008). 9

10 where 4 ( t h ) ( t f t h + 2) (t f t h ) 2 Bu ( t f ) 8t f + 6t h + t 2 f 6t 2 h + 6t f t h +. As Nielsen (2008) showed, decentralization is preferable to centralization when the two countries have the same tax level. If t h = t f = t, from (4) and (6), DC C = A2 8B = " ( t + 2Bu) t Bu 8 9 A 2 ( t) 72B t + 9 > 0: 4Bu Thus, FDI with decentralization is preferred to FDI with centralization when the two countries have the same tax level. is When A = B =, F = 0, u =, and t h = 0:3, the condition for decentralization ( DC > C ) 84880t f t 2 f 32800t 3 f t4 f > 0: 40 (40t f + 47) 90t f + 00t 2 f 4 Figure 3 illustrate the additional pro t from decentralization, using the parameter values above. # Dec. premium t_f Figure 3. Additional pro t of decentralization (t h = 0:3) In Figure 3, rm chooses FDI with decentralization when t f < t f ' 0:3863 0

11 4 Optimal entry mode for the foreign market In this section we explore the optimal entry mode of rm. We directly compare the following three pro ts, EX = ( t h) a 2 4b + ( t h) A 2 ; DC = ( t h) a 2 A h( 2 t h ) 2 + 2Bu ( t f ) + 4b 8B 2t f 3t h F; 4Bu C = ( t h) a 2 4b h i A 2 u ( t f ) 2 (t f t h ) 2 + 2Bu ( t f ) + h i 2 F; 2 2 (t f t h ) 2 + 3Bu ( t f ) when a = 2, b =, A = B =, F = 0, u =, and t h = 0:3 in this section. We have EX = 0:77778; DC = 84t f (40t f + 47) ; C = 48582t f 8865t 2 f t3 f + 500t4 f : 2 90t f + 00t 2 f 4 Figure 4 shows these pro ts ( EX is black thin straight line, DC is red thin line, and C is blue bold line). i Profit Figure 4. Comparison of pro t in the three modes (t h = 0:3) t_f

12 Firm prefers decentralized FDI to centralized FDI when t f < t f ' 0:3863, prefers decentralized FDI to Export when t f < et f = ' 0:36 78, and prefers centralized FDI to Export when t f < bt h = 0:3. The order of the three pro ts are EX > C > DC for t f > 0:3863, EX > DC > C for < t f < 0:3863, DC > EX > C for 0:3 < t f < , and DC > C > EX for t f < 0:3. Thus, we have the following proposition. Proposition 2 Given the parameter values, in the case of no foreign country s advantage and no trade cost, when the rm chooses FDI, the rm also implements decentralization. This proposition implies no centralized multinationals appear in free trade. Because the FDI xed cost decreases DC and C (shifts the red thin line and blue bold line downward) and it does not a ect the decentralization incentive, this proposition would remain valid even when F 6= 0. 5 Trade cost In this section, we relax the assumption, = 0: For checking and enforcing robustness, we investigate how and to what extent trade costs a ect the result in the previous section 9. When 6= 0, from (), the after-tax pro t of rm is EX = ( t h ) " a 2 4b # (A 2)2 + : With our parameters, EX = : 45 When = 0:05, we have EX = 0:763. In Figure 4, the green bold straight dotted line shows this pro t. Although, in this case, the trade cost does not a ect the decentralization decision, the cost a ects FDI decisions. Firm prefers decentralized FDI to Export when t f < et f = ' 0:43404 and prefers centralized FDI to Export when t f < bt f ' 0: The order of the three pro ts are EX > C > DC for t f > 0:45327, C > EX > DC for < t f < 0:45327, C > DC > EX for 0:3863 < t f < , and DC > C > EX for t f < 0:3863. Thus, as the corporate tax in the foreign country increases, rm s entry mode to the foreign market shifts from FDI with decentralization to FDI with centralization, to Export. This implies FDI with centralization is feasible when the trade cost is su ciently high. By comparing the results in the previous and current sections, we can nd that trade liberalization accelerates decentralization 0. At t f ' 0:3863, DC t = C f t ' 0: We call the trade cost, at which f " # a 2 ( t h ) 4b + (A 2 ) 2 = DC t = C f t : f 9 In this section, we consider a case where the trade cost is speci c. We will show an ad valorem case in our future research. We will also consider the case where rm incurs trade costs even in FDI cases. 0 In our future research, we will discuss a relationship between trade costs and decision lights with anecdotal evidence. 2

13 And we obtain ' 0: When <, the relationship between the optimal entry mode and the foreign country s tax rate is the same as the case of = 0 (in the previous section). When >, the relationship is the same as the case of = 0:05. We can consider the possibility that rm has a domestic subsidiary and delegates an output decision to the subsidiary and the subsidiary competes with the local rival. If F = 0, the net pro t of rm with this domestic decentralization overcomes the pro t in Export case. However, even when we replace the normal Export pro t by this decentralized export pro t, the replacement only makes the critical trade cost rate higher ( 0 ' 0: > ' 0:027934) and our results do not change. 6 Transfer pricing cost We examine the e ect of u on the optimal entry mode. It could be considered that the higher u is related to the tougher transfer pricing regulation. Before that, we consider how u a ect the transfer price. We nd that an increase in u a ects the transfer prices in both cases as follows, dm dc du dm c du = = 4 2t f 3t h Bumdc ; 3B ( t f ) 2 (t f t h ) 2 + 3Bu ( t f ) mc : This means dmdc du Q 0 when mdc R 0 and dmc du Q 0 when mc R 0. Figure 5 shows the transfer prices of decentralized MNEs and centralized MNEs using our parameters. The solid lines show the case of u = and the dotted lines the case of u = :2. The red thin lines show the decentralized cases and the blue bold the centralized case. A change of u has no e ect on the transfer price of decentralized MNEs when t f = 0:475, that is, when m dc = 0 and no e ect on that of centralized MNEs when t f = 0:3, that is, when m c = 0. We do not use any transfer pricing cost in the domestic decentralization case. 3

14 TP t_f Figure 5. E ect of u on transfer price We nd that an increase in u decreases DC and C as follows, d DC du d C du = = (4t f 3t h ) 2 A 2 2 (8t f 2t h + u + 4) 2 0; 2 A2 (t f t h ) 2 ( t f ) 2 2 (t f t h ) 2 + 5Bu ( t f ) 3 0: 2 (t f t h ) 2 + 3Bu ( t f ) Although a tougher regulation (an increase in u) reduces the FDI pro t in both cases, when t f = +3t h 4, because decentralized MNEs always set m = 0, a change of u has no e ect on the pro t of the rm and when t f = t h, because centralized MNEs always set m = 0, a change of u has no e ect on the pro t of the rm. 4

15 Profit Figure 6. E ect of u on pro t When a = 2, b =, A = B =, F = 0, u = :2, t h = 0:3, at t f ' 0:38267, DC t = f C t ' 0:7692. The critical trade cost rate is ' 0: >. This implies that a f tougher regulation (an increase in u) may expand the region of no centralization. t_f 7 Conclusion We investigated FDI incentives, taking into account the strategic role of transfer pricing and decentralization. It has been found that, even when a host country has neither production cost advantage nor tax advantage, FDI can be undertaken by a (purely) strategic incentive. We also found that trade liberalization and a tougher transfer pricing regulation boost decentralization of multinationals. For checking and enforcing robustness, we should examine how and to what extent an ad valorem trade cost a ect our ndings and also consider the case where rm incurs trade costs even in FDI cases. We leave those investigations to future work. In the model, we assume a quadratic form of transfer pricing cost. This cost implicitly re ects transfer pricing regulation implemented by governments. Investigating more speci cally the e ects of transfer pricing regulation on FDI incentives is also left to future work. 5

16 References [] Amerighi, Oscar, Susana Peralta, 200, The Proximity-concentration Trade-o with Pro t Shifting?, Journal of Urban Economics 68, [2] Göx, Robert F., Ulf Schiller, 2007, An Economics Perspective on Transfer Pricing, In: Chapman, Christopher S., Anthony G. Hopwood, and Michael D. Shields (Eds), Handbook of Management Accounting Research, , Elsevier. [3] Horstmann, Ignatius J. and James R. Markusen, 992, Endogenous Market Structures in International Trade (natura facit saltum), Journal of International Economics 32, [4] Motta, Massimo, 992, Multinational Firms and the Tari -jumping Argument, European Economics Review 36, [5] Nielsen, Søren Bo, 204, Transfer Pricing: Roles and Regimes, CESifo Working Paper Series No [6] Nielsen, Søren Bo, Pascalis Raimondos-Møller and Guttorm Schjelderup, 2008, Taxes and Decision Rights in Multinationals, Journal of Public Economic Theory 0, [7] Porter, Lynda A, 202, Asymmetric Oligopoly and Foreign Direct Investment: Implications for Host-Country Tax-Setiting, International Economic Journal 26, [8] Schejelderup, Guttorms and Lars Sørgard, 997, Transfer Pricing as a Strategic Device for Decentralized Multinationals, International Tax and Public Finance 4,

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