Question

PART A

Multinational transfer pricing, global tax minimisation

Derwent Ltd manufactures telecommunications equipment at its plant in Geelong. The
company has marketing divisions throughout the world. A Derwent Ltd marketing division in
Dallas, USA, imports 10 000 units of product B12 from Australia. The following information is
available:

Australian income tax rate on the Australian division’s operating profit	35%
US income tax rate on the US division’s operating profit	40%
US import duty	15%
Variable manufacturing cost per unit of product B12	$550
Full manufacturing cost per unit of product B12	$800
Selling price (net of marketing and distribution costs) in the United States	$1150

Suppose that the Australian and US tax authorities only allow transfer prices that are between
the full manufacturing cost per unit of $800 and a market price of $950, based on comparable
imports into the USA. The US import duty is charged on the price at which the product is
transferred into the USA. Any import duty paid to the US authorities is a deductible expense
for calculating US income taxes due.

Required

1. Calculate the after-tax operating profit earned by the Australian and US divisions from
transferring 10 000 units of product B12: (a) at full manufacturing cost per unit and
(b) at market price of comparable imports. (Income taxes are not included in the
calculation of the cost-based transfer prices.)

2. Which transfer price should Derwent Ltd select to minimise the total of company
import duties and income taxes? Remember that the transfer price must be between
the full manufacturing cost per unit of $800 and the market price of $950 of
comparable imports into the USA. Explain your reasoning.

PART B

Multinational transfer pricing, goal congruence (continuation of PART A)

Suppose that the Australian division could sell as many units of product B12 as it makes at

$900 per unit in the US market, net of all marketing and distribution costs.

Required

1. From the viewpoint of Derwent Ltd as a whole, would after-tax operating profit be maximised if it sold the 10 000 units of productB12 in Australia or in the USA? Show your calculations.

2. Suppose that division managers act autonomously to maximise their division’s aftertax operating profit. Will the transfer price calculated in requirement 2 of Scenario 1a) result in the Australian division manager taking the actions determined to be optimal in requirement 1 of this exercise? Explain

3. What is the minimum transfer price that the Australian division manager would agree to? Does this transfer price result in Derwent Ltd as a whole paying more import duty and taxes than in the answer to requirement 2 of Scenario 1a)? If so, by how much?

Answer 1

PART A

1)

2) Basic thumb rule: where A TRANSFERS TO B, t_A, t_B : marginal tax rates respectively

If t_A > t_B set as low transfer price as possible

If t_A < t_B set as high tranfer prices as possible.

THEREFORE USA TAX RATE:40% PLUS AN IMPORT DUTY OF 15% AUSTRALIAN TAX RATE:35% BEST KEEP TRANSFER PRICE AS LOW AS POSSIBLE THAT WILL BE $800

or another way of thinking is

Consider what happens every time the transfer price is increased by $1 over, say, the full manufacturing cost of $800. This results in the following change for each unit:
a.an increase in AUSTRALIAN taxes of 35% × $1............. $0.35
b. an increase in import duties paid in USA,15%×$1..........................................0.15
c. a decrease in USA taxes of 40% × $1.15 ......................................................(0.46) (the $1 increase in transfer price + $0.15 paid by wayof import duty)

Net effect is an increase in import duty and tax payments of: $0.04
To verify this solution, note that if the transfer price changes from $800 to $950, the net effect is an increase in import duty and tax payments of ($950-$800) × $0.04 = $6 per unit. Across 10,000 units, this implies a decrease in total profits of (10,000) × $6 = $60,000 , which corresponds exactly to the $60,000 difference in total after-tax operating incomes documented in Solution 1.
Hence, Derwent Ltd will minimize import duties and income taxes by setting the transfer price at its minimum level of $800, the full manufacturing cost

PART B

1)BEST FOR DERWENT LTD. TO TRANSFER UNITS TO USA AS PROFIT IS MORE THAN WHAT IT WOULD HAD MADE IF AUSTRALIAN DIVISION HAD SOLD LOCALLY , EXPLANATION

2)TRANSFERRING PRODUCT AT FULL MANUFACTURING COST OF THE AUSTRALIAN DEPARTMENT MINIMIZES IMPORT DUTIES AND TAXES AS WE HAVE SEEN IN PART A REQUIRMENT 1 BUT CREATES A ZERO OPERATING PROFIT FOR THE AUSTRALIAN DIVISION.ACTING AUTONOMOUSLY AUSTRALIAN DIVISION WOULD LIKE TO MAXIMIZE ITS PROFIT BY SELLING THE PRODUCT IN AUSTRALIA WHICH RESULTS IN A PROFIT OF $650,000 RATHER THAN TRANSFERRING PRODUCT TO USA DIVISION AT FULL MANUFACTURING COST.THUS THE TRNAFER PRICE CALACULATED IN requirement 2 of PART A will not result in actions that a re optimal for derwent company as a whole

3)the minimum transfer price at which australian division manager acting autnomoously would agree to is $900 per unit any price less than $900 per unit will leave the australian department performance worse than selling in USA market.

the supporting calculations are as follows:

the minimum transfer price that australian division manager would agree to would result derwent Ltd. Paying extra $40,000 in import duties and taxes