Question

Galactic Empire Ltd. has two divisions. Division A is located in Canada where the income tax rate is 40%. Division B is located in India where the income tax rate is 30%. Division A produces an intermediate product at a variable cost of $100 per unit and transfers the product to Division B where it is finished and sold for $500 per unit. Variable costs in Division B are $80 per unit. Fixed costs are $75,000 per year in Division A and $90,000 per year in Division B. Assume 1,000 units are produced and transferred annually and the minimum transfer price allowed by the Canadian tax authorities is the variable cost. Also assume operating income in each country is equal to taxable income.
Required:
1) What transfer price should be set for the Galactic Empire to minimize its total income taxes? Show your calculations.
2) If Galactic Empire desires to minimize its total income taxes, calculate the amount of tax liability in each country.

Answer 1

Solution 1:

It is assumed that tax savings (refund) will be available for reported taxable losses in the country.

As income tax rate in canada is higher than income tax rate in india, therefore in order to reduce total income taxes, transfer price from canada to india will be set as minimum as possible. As minimum transfer price allowed by Canadian tax authorities is the variable cost, therefore Division A should transfer intermidiate product to division B at $100

Solution 2:

Computation of Tax Liability for each country
Particulars	Canada	India
Sales Revenue	$100,000.00	$500,000.00
Variable Cost:
Divison A	$100,000.00
Transferred in Cost from Division A to Division B		$100,000.00
Division B		$80,000.00
Fixed Cost	$75,000.00	$90,000.00
Operating Income	-$75,000.00	$230,000.00
Income Tax (40%, 30%)	-$30,000.00	$69,000.00

Total income tax liability = $69,000 - $30000 = $39,000