In Farrah Tech's current setup, it will generate $2,000,000 in sales next year and $1,100,000 in cost of goods sold (its only expense, besides taxes, in this example). The firm's tax rate is 40 percent. Farrah's CFO is considering a subsidiary in the Cayman Islands (where there are no corporate taxes). If Farrah sold the same goods to the Cayman Island subsidiary at $1,400,000, how much would Farrah save in taxes?

Question

Quizplus · Accepted Answer

First, calculate the profit before taxes in the current setup: $2,000,000 (sales) - $1,100,000 (cost of goods sold) = $900,000. The tax on this profit is 40%, so the tax amount is $900,000 * 40% = $360,000. If Farrah sells the same goods to the Cayman subsidiary for $1,400,000, the cost of goods sold increases to $1,400,000, reducing the profit before taxes to $600,000 ($2,000,000 - $1,400,000). The tax on this new profit is $600,000 * 40% = $240,000. The tax saving is the difference between the original tax amount and the new tax amount: $360,000 - $240,000 = $120,000. However, this calculation does not account for the profit shifted to the Cayman Islands, which is taxed at 0%. The profit shifted is $1,400,000 - $1,100,000 = $300,000. Since this profit would have been taxed at 40%, the tax saving on this amount is $300,000 * 40% = $120,000. Therefore, the total tax saving is $120,000 (from the reduced profit taxed in the original country) + $120,000 (from the profit now taxed at 0% in the Cayman Islands) = $240,000.

In Farrah Tech's Current Setup, It Will Generate $2,000,000 in Sales