# (Answered): . Determine transfer prices under three different methods….

Case 11-2 Global Electronics Company

1. Determine transfer prices under three different methods.

a.   Comparable uncontrolled price method

LG-Malay sells the same product to a related party (Electronic Superstores) and an unrelated party (Wal-Mart). The sale to Wal-Mart is a comparable uncontrolled transaction. The comparable uncontrolled price method results in a transfer price of \$180.

b.   Resale price method

The transfer price under the resale price method can be determined by reviewing the calculation used by Wal-Mart to determine its retail price of \$324 per laser guitar:

Invoice price                                                              \$180

plus: import duty (20% x invoice price)                        36

Total cost                                                                  \$216

plus: Markup (50% x total cost)                                  108

Retail price                                                                \$324

The relationship between invoice price and retail price can be modeled as:

(x + .2x) x 1.50 = y, where x = invoice price and y = retail price.

This can be further reduced as: 1.8x = y or x = y/1.8

Electronic Superstores’ retail price is \$333. Substituting \$333 for y in the formula results in an invoice price of \$185 (\$333/1.8).   This is the transfer price under the resale price method.

c.   Cost plus method

The transfer price under the cost plus method is determined as follows:

Production cost                                                         \$120

plus: Transportation cost                                              15

Total cost                                                                  \$135

plus: Markup (40% x total cost)                                    54

Transfer price                                                            \$189

Case 11-2 Global Electronics Company (continued)

2. Given this set of facts, the highest price (\$189 cost plus method price) results in the greatest amount of consolidated after-tax net income.

 Malaysia U.S. Consolidated Comparable Uncontrolled Price Method – \$180 Sales \$180.00 \$333.00 \$333.00 Less: Cost of sales 120.00 180.00 120.00 Less: Transportation cost 15.00 -0- 15.00 Gross profit 45.00 153.00 198.00 Less: Import duty (20%) -0- 36.00 36.00 Taxable income 45.00 117.00 162.00 Less: Income tax 6.75 15% 40.95 35% 47.70 Net income \$38.25 \$76.05 \$114.30 Resale Price Method – \$185 Sales \$185.00 \$333.00 \$333.00 Less: Cost of sales 120.00 185.00 120.00 Less: Transportation cost 15.00 15.00 Gross profit 50.00 148.00 198.00 Less: Import duty (20%) 37.00 37.00 Taxable income 50.00 111.00 161.00 Less: Income tax 7.50 15% 38.85 35% 46.35 Net income \$42.50 \$72.15 \$114.65 Cost Plus Method – \$189 Sales \$189.00 \$333.00 \$333.00 Less: Cost of sales 120.00 189.00 120.00 Less: Transportation cost 15.00 15.00 Gross profit 54.00 144.00 198.00 Less: Import duty (20%) 37.80 37.80 Taxable income 54.00 106.20 160.20 Less: Income tax 8.10 15% 37.17 35% 45.27 Net income \$45.90 \$69.03 \$114.93 highest

Case 11-2 Global Electronics Company (continued)

3. When Malaysian profits are repatriated to the United States, the addition of Malaysian withholding taxes causes the lowest price (\$180 comparable uncontrolled price method) to yield the greatest amount of after-tax cash flow for GEC. In this case, the analysis must consider the fact that the repatriated dividend is subject to U.S. income taxation (refer back to Chapter 10). However, given that the effective tax rate (income tax plus withholding tax) paid to the Malaysian government exceeds the U.S. income tax rate, no additional U.S. taxes are due on the dividend paid by LG-Malay. The Malaysian effective tax rate is 40.5% [15% + 30% (1 – .15)].

Transfer Price

 \$180 \$185 \$189 Malaysian net income \$38.25 \$42.50 \$45.90 Less: Withholding tax (30%) 11.48 12.75 13.77 Dividend to GEC \$26.78 \$29.75 \$32.13 Plus: U.S. net income 76.05 72.15 69.03 Net cash flow \$102.83 \$101.90 \$101.16 highest Additional U.S. tax on dividend: Dividend to GEC \$26.78 \$29.75 \$32.13 Plus: Withholding tax 11.48 12.75 13.77 Grossed-up for w/h tax 38.25 42.50 45.90 Plus: Income tax 6.75 7.50 8.10 Grossed up for income tax \$45.00 \$50.00 \$54.00 x   U.S. tax rate = U.S. tax before FTC \$15.75 \$17.50 \$18.90 –   FTC allowed** 15.75 17.50 18.90 = Additional U.S. tax \$0.00 \$0.00 \$0.00 ** FTC allowed is lesser of: a. foreign taxes deemed paid \$18.23 \$20.25 \$21.87 b. overall FTC limitation \$15.75 \$17.50 \$18.90

Case 11-2 Global Electronics Company (continued)

4.   Even with the Malaysian withholding tax rate reduced to 10%, the lowest transfer price still results in the greatest amount of after-tax cash flow for GEC.   Note that in this case, additional U.S. income tax must be paid on the dividend received from LG-Malay because the effective Malaysian tax rate 23.5% [15% + 10%(1 – .15)] is less than the U.S. income tax rate of 35%.

Transfer Price

 \$180 \$185 \$189 Malaysian net income \$38.25 \$42.50 \$45.90 Less: Withholding tax (10%) 3.83 4.25 4.59 Dividend to GEC 34.43 38.25 41.31 Plus: U.S. net income 76.05 72.15 69.03 Subtotal 110.48 110.40 110.34 Less: Additional U.S. tax * 5.17 5.75 6.21 Net cash flow \$105.31 \$104.65 \$104.13 highest *Calculation of Additional U.S. Tax: Dividend to GEC \$34.43 \$38.25 \$41.31 Plus: Withholding tax 3.83 4.25 4.59 Grossed-up for w/h tax 38.25 42.50 45.90 Plus: Income tax 6.75 7.50 8.10 Grossed up for income tax \$45.00 \$50.00 \$54.00 x   U.S. tax rate = U.S. tax before FTC \$15.75 \$17.50 \$18.90 –   FTC allowed** 10.58 11.75 12.69 = Additional U.S. tax \$5.17 \$5.75 \$6.21 ** FTC allowed is lesser of: a. foreign taxes deemed paid \$10.58 \$11.75 \$12.69 b. overall FTC limitation \$15.75 \$17.50 Can I please get the References for this paper \$18.90

Pricing Reference – International Transfer Pricing

Transfer price under CUP method

Price of Sale to unrelated party                                                        \$180

Resale price method

Invoice price                                                                                         \$180

Add – mark up and import duty                                                       \$108

Retail price                                                                                      \$324

Retail transfer price                                                                             185

Cost plus method

Production cost                                                                                    120

Add -transport and mark up                                                             69

Cost plus transfer price                                                                       189

Ref:

The basic rule is that intercompany transactions should be made at an “arm’s length price.”

The “best method rule” requires taxpayers to use the method that under the facts and circumstances provides the most reliable measure of an arm’s length price. The two primary factors to be considered in determining the best method are

(a) the degree of comparability between the intercompany transaction and any comparable uncontrolled transactions

(b) the quality of the data and assumptions used in the analysis.

One of five specific methods must be used to determine the arm’s length price in a sale of tangible property.

(1) comparable uncontrolled price method,

(2) resale price method,

(3) cost plus method,

(4) comparable profits method

(5) profit split method.

The comparable uncontrolled price method is generally considered to provide the most reliable measure of an arm’s length price when a comparable uncontrolled transaction exists.

Cost minimization objectives that companies might wish to achieve through transfer pricing include:

• minimization of income taxes, withholding taxes and/or import duties
• protecting foreign cash flows from currency devaluation
• avoidance of repatriation restrictions
• improve competitive position of foreign operation

Application of a particular transfer pricing method can result in an “arm’s length range” of acceptable prices. Companies can try to achieve cost minimization objectives by selecting prices at the extremes of the relevant range.

X.      Enforcement of transfer pricing regulations varies from country to country. Transfer pricing is the most important international tax issue faced by many U.S. MNCs. The United States is especially concerned with foreign MNCs not paying their fair share of taxes in the U.S.

Withholding taxes are paid to a foreign government by a foreign subsidiary when it pays dividends (or interest or royalties) to its parent located in another country. In contrast, payments made to the parent for the purchase of goods and/or services are not subject to withholding tax.   A parent company can avoid receiving cash payments from its foreign subsidiary in the form of dividends (or interest or royalties) by transferring goods and services to its foreign subsidiary at inflated prices. The higher the price charged to the foreign subsidiary, the more cash can be extracted from the foreign country without incurring withholding tax.

a.   Comparable uncontrolled price method

LG-Malay sells the same product to a related party (Electronic Superstores) and an unrelated party (Wal-Mart). The sale to Wal-Mart is a comparable uncontrolled transaction. The comparable uncontrolled price method results in a transfer price of \$180.

b.   Resale price method

The transfer price under the resale price method can be determined by reviewing the calculation used by Wal-Mart to determine its retail price of \$324 per laser guitar:

Invoice price                                                             \$180

plus: import duty (20% x invoice price)                        36

Total cost                                                                  \$216

plus: Markup (50% x total cost)                                  108

Retail price                                                                \$324

The relationship between invoice price and retail price can be modeled as:

(x + .2x) x 1.50 = y, where x = invoice price and y = retail price.

This can be further reduced as:    1.8x = y or x = y/1.8

Electronic Superstores’ retail price is \$333. Substituting \$333 for y in the formula results in an invoice price of \$185 (\$333/1.8).   This is the transfer price under the resale price method.

c.   Cost plus method

The transfer price under the cost plus method is determined as follows:

Production cost                                                         \$120

plus: Transportation cost                                               15

Total cost                                                                  \$135

plus: Markup (40% x total cost)                                    54

Transfer price                                                           \$189

2. Given this set of facts, the highest price (\$189 cost plus method price) results in the greatest amount of consolidated after-tax net income.

 Malaysia U.S. Consolidated Comparable Uncontrolled Price Method – \$180 Sales \$180.00 \$333.00 \$333.00 Less: Cost of sales 120.00 180.00 120.00 Less: Transportation cost 15.00 -0- 15.00 Gross profit 45.00 153.00 198.00 Less: Import duty (20%) -0- 36.00 36.00 Taxable income 45.00 117.00 162.00 Less: Income tax 6.75 15% 40.95 35% 47.70 Net income \$38.25 \$76.05 \$114.30 Resale Price Method – \$185 Sales \$185.00 \$333.00 \$333.00 Less: Cost of sales 120.00 185.00 120.00 Less: Transportation cost 15.00 15.00 Gross profit 50.00 148.00 198.00 Less: Import duty (20%) 37.00 37.00 Taxable income 50.00 111.00 161.00 Less: Income tax 7.50 15% 38.85 35% 46.35 Net income \$42.50 \$72.15 \$114.65 Cost Plus Method – \$189 Sales \$189.00 \$333.00 \$333.00 Less: Cost of sales 120.00 189.00 120.00 Less: Transportation cost 15.00 15.00 Gross profit 54.00 144.00 198.00 Less: Import duty (20%) 37.80 37.80 Taxable income 54.00 106.20 160.20 Less: Income tax 8.10 15% 37.17 35% 45.27 Net income \$45.90 \$69.03 \$114.93 highest

3. When Malaysian profits are repatriated to the United States, the addition of Malaysian withholding taxes causes the lowest price (\$180 comparable uncontrolled price method) to yield the greatest amount of after-tax cash flow for GEC. In this case, the analysis must consider the fact that the repatriated dividend is subject to U.S. income taxation (refer back to Chapter 10). However, given that the effective tax rate (income tax plus withholding tax) paid to the Malaysian government exceeds the U.S. income tax rate, no additional U.S. taxes are due on the dividend paid by LG-Malay. The Malaysian effective tax rate is 40.5% [15% + 30% (1 – .15)].

Transfer Price

 \$180 \$185 \$189 Malaysian net income \$38.25 \$42.50 \$45.90 Less: Withholding tax (30%) 11.48 12.75 13.77 Dividend to GEC \$26.78 \$29.75 \$32.13 Plus: U.S. net income 76.05 72.15 69.03 Net cash flow \$102.83 \$101.90 \$101.16 highest Additional U.S. tax on dividend: Dividend to GEC \$26.78 \$29.75 \$32.13 Plus: Withholding tax 11.48 12.75 13.77 Grossed-up for w/h tax 38.25 42.50 45.90 Plus: Income tax 6.75 7.50 8.10 Grossed up for income tax \$45.00 \$50.00 \$54.00 x   U.S. tax rate = U.S. tax before FTC \$15.75 \$17.50 \$18.90 –   FTC allowed** 15.75 17.50 18.90 = Additional U.S. tax \$0.00 \$0.00 \$0.00 ** FTC allowed is lesser of: a. foreign taxes deemed paid \$18.23 \$20.25 \$21.87 b. overall FTC limitation \$15.75 \$17.50 \$18.90

4.   Even with the Malaysian withholding tax rate reduced to 10%, the lowest transfer price still results in the greatest amount of after-tax cash flow for GEC.   Note that in this case, additional U.S. income tax must be paid on the dividend received from LG-Malay because the effective Malaysian tax rate 23.5% [15% + 10%(1 – .15)] is less than the U.S. income tax rate of 35%.

Transfer Price

 \$180 \$185 \$189 Malaysian net income \$38.25 \$42.50 \$45.90 Less: Withholding tax (10%) 3.83 4.25 4.59 Dividend to GEC 34.43 38.25 41.31 Plus: U.S. net income 76.05 72.15 69.03 Subtotal 110.48 110.40 110.34 Less: Additional U.S. tax * 5.17 5.75 6.21 Net cash flow \$105.31 \$104.65 \$104.13 highest *Calculation of Additional U.S. Tax: Dividend to GEC \$34.43 \$38.25 \$41.31 Plus: Withholding tax 3.83 4.25 4.59 Grossed-up for w/h tax 38.25 42.50 45.90 Plus: Income tax 6.75 7.50 8.10 Grossed up for income tax \$45.00 \$50.00 \$54.00 x   U.S. tax rate = U.S. tax before FTC \$15.75 \$17.50 \$18.90 –   FTC allowed** 10.58 11.75 12.69 = Additional U.S. tax \$5.17 \$5.75 \$6.21 ** FTC allowed is lesser of: a. foreign taxes deemed paid \$10.58 \$11.75 \$12.69 b. overall FTC limitation \$15.75 \$17.50 \$18.90
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