Assume the U.S. corporate income tax rate is 40 percent and the Mexican corporate income tax rate is 30 percent. Jacques International Apparel Company has subsidiaries in both the U.S. and Mexico. Jacques is trying to decide what transfer price to use for its famous French frock, which is being transferred from the U.S. subsidiary to the Mexican subsidiary. It could ship the frock at the market price of $75 or at cost plus 20 percent. The cost of the frock is $40. Which transfer price would minimize Jacques's tax burden?

Question

Quizplus · Accepted Answer

If Jacques International Apparel Company chooses to transfer the French frock at market price, it would generate a profit of $35 in the U.S. subsidiary ($75 - $40), which would be taxed at 40 percent, resulting in a tax payment of $14 ($35 x 0.4). In the Mexican subsidiary, it would generate a profit of $35, which would be taxed at 30 percent, resulting in a tax payment of $10.50 ($35 x 0.3). Therefore, Jacques's total tax burden would be $24.50 ($14 + $10.50).
If Jacques International Apparel Company chooses to transfer the French frock at cost plus 20 percent, it would generate a profit of $48 in the U.S. subsidiary ($40 x 1.2), which would be taxed at 40 percent, resulting in a tax payment of $19.20 ($48 x 0.4). In the Mexican subsidiary, it would generate a profit of $48, which would be taxed at 30 percent, resulting in a tax payment of $14.40 ($48 x 0.3). Therefore, Jacques's total tax burden would be $33.60 ($19.20 + $14.40).
Using a transfer price of $48 would minimize Jacques's tax burden as it results in a lower total tax payment compared to using the market price of $75.