Question

Mikco, a foreign corporation, owns 100% of Flagco, a domestic corporation. Mikco manufactures a wide variety of fl ags for worldwide distribution. Flagco imports Mikco’s finished goods for resale in the United States. Flagco’s average fi nancial results for the last three years are as follows:

Sales	$20 million
Cost of goods sold	($15 million)
Operating expenses	($4 million)
Operating profit	$1 million

Flagco’s CFO has decided to use the comparable profits method to assess Flagco’s exposure to an IRS transfer pricing adjustment by testing the reasonableness of Flagco’s reported operating profit of $1 million. An analysis of fi ve comparable uncontrolled U.S. distributors indicates that the ratio of operating profits to sales is the most appropriate profitability measure. After adjustments have been made to account for material differences between Flagco and the uncontrolled distributors, the average ratio of operating profit to sales for each uncontrolled distributor is as follows: 6%, 8%, 10%, 10%, and 14%.

Using this information regarding comparable uncontrolled U.S. distributors, apply the comparable profits method to assess the reasonableness of Flagco’s reported profits. In addition, if an adjustment to Flagco’s reported profits is required, compute the amount of that adjustment.

Answer 1

Answer -

We must first construct an arm’s length range of comparable operating profits by applying the selected profitability measure (that is the ratio of operating profits to sales) to Flagco's sales. If Flagco’s reported profit lies outside the arm’s length range, an adjustment is made equal to the difference between the Flagco’s reported profit of $1 million and the benchmark arm’s length profit, which is either the mean or the median of the arm’s length range of comparable operating profits.

Applying the return on sales percentages derived from the five comparable uncontrolled U.S. distributors to Flagco’s sales of $20 million yields the following arm’s length range of comparable operating profits: $1.2 ($20*6%) million, $1.6 ($20*8%) million, $2 ($20*10%) million, $2 ($20*10%) million, and $2.8 ($20*14%) million. Because Flagco’s reported operating profit of $1 million lies outside the arm’s length range, an adjustment is required.

The median of the range of comparable operating profits (that is $2 million) is determined to be the arm’s length profit for Flagco. Therefore, the transfer prices that Flagco pays Mikco for its inventory are reduced by $1 million, which equals the difference between Flagco’s reported profit of $1 million and the arm’s length profit of $2 million. This adjustment increases Flagco’s United States taxable income by $1 million per year.