A firm has affiliates in both Japan, whose corporate income tax rate is 40 perce

Question

A firm has affiliates in both Japan, whose corporate income tax rate is 40 percent, and Ireland, whose corporate income tax rate is 15 percent. The major activity of the Irish affiliate is to produce a special component that it sells to the Japanese affiliate, initially at a price of $18 per unit. The cost of producing the component in Ireland has just risen from $12 per unit to $14 per unit. The controller of the MNE is considering three possible changes in the price of the component (for the sales between the Irish and the Japanese affiliate):

• Ignore the cost increase, and leave the price at $18 (no price change).

• Increase the price to $20, to reflect exactly the increase in cost.

• Increase the price to $22, and, if necessary, explain the price increase by making general reference to unavoidable cost increases at the Irish affiliate.

a) If the goal of the MNE is to maximize its global after-tax profit, which of these three should the controller choose? Why?

b) What does each national government think of this use of transfer pricing?

Explanation / Answer

Ans 1 Option 1 Option 2 Option 3 Sale price 18 20 22 Cost 14 14 14 Profit In Ireland 4 6 8 Tax @ 15% 0.6 0.9 1.2 Tax saved in Japan ,based on a price of 22 Option 1 Option 2 Option 3 Differential Price 0 2 4 Differential Tax rate 25% 0 0.5 1 Option 3 , Transfer price of 22 would be most beneficial for the firm , since it will optimize its global tax. Ans 2 Ireland would prefer a transfer price of 22 , where as Japan would prefer 18.

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