Step 4. Calculate the option price (for a call option)
2.2 MNCs: transfer pricing and tax rules
Transfer prices are prices charged internally within a group, and have no effect on the total pre-tax profit of the group. Transfer prices are simply a way of sharing the profit between the two companies concerned.
Transfer prices between a company and a foreign subsidiary have implications for taxation, and the aim of a group of companies should be to minimise total tax payable on the group profits. Issues to consider are:
the rate of taxation on profits in the two countries
the existence of a double taxation agreement
the existence of any withholding tax in the country of the foreign subsidiary
tax rules on transfer pricing.
Tax rates
The rate of taxation on profits will vary between the two countries and two companies concerned. As a general principle, the aim of a group should be to set a transfer price that shares the profits in a way that reduces the profits of the company in the higher-tax country.
For example, suppose that a parent company in country A sells goods to its 100%- owned subsidiary in country B, and the rate of tax is 20% in country A and 30% in country B. The transfer price should be set as high as the tax rules permit, because this will increase profits of the parent company in lower-tax country A and reduce the profits of the subsidiary in higher-tax country B.
Double taxation agreement
There should usually be a double taxation agreement between the two countries.
From the point of view of the parent company, this means that:
If the rate of tax on profits is higher in the country of the foreign subsidiary than in the parent company’s country, the subsidiary pays tax in its own country on its profits at the rate applicable in that country. No further tax is payable in the parent company’s country on the profits of the foreign subsidiary.
If the rate of tax on profits is lower in the country of the foreign subsidiary than in the parent company’s country, the subsidiary pays tax in its own country on its profits at the rate applicable in that country. However, tax is also payable by the parent company in its own country. The tax payable is the difference between tax on profits at the rate in the parent company and the tax payable by the subsidiary in its own country.
Withholding tax
Withholding tax is additional tax that is ‘withheld’ when a company pays interest or dividends to a foreign investor. It affects international groups where foreign subsidiaries are located in a country where withholding tax is charged. Payments of interest or dividends by a subsidiary to the parent company will be subject to the withholding tax.
Tax rules on transfer prices
The tax rules in a country are likely to make it difficult for an international group to charge inter-company transfer prices that are significantly different from market prices (where these exist). This is because the tax authorities recognise that transfer prices might be set artificially so as to minimise the total tax burden for the group.
These various tax aspects of transfer pricing are illustrated by the following example.
Example
A UK company has recently acquired a foreign subsidiary in another country, Outland. A part of the operating arrangements of the new group is that the parent company will export a component to the subsidiary, and the subsidiary will use this component to make a product that it will sell in Outland. The management of the parent company have to decide what the transfer price for the component should be.
The following information is available:
UK (annual) Outland (annual) Components transferred to
Outland
100,000 units Units of product sold 100,000 units Sales price per unit $150
Variable cost per unit £15 Local variable cost per unit $40 Fixed costs £900,000 Local fixed costs $600,000
Tax rate 30% Tax rate 25%
The exchange rate is £1 = $4.
Withholding tax of 10% is charged on all remittances of interest and dividends from Outland. The UK parent company intends to remit all available profits from Outland to the UK.
There is a double taxation agreement between the UK and Outland. Tax on income and distributions in one country may be credited against a tax liability on the same income in the other country.
Required
Calculate the group profits if the transfer price for the component is set at (a) its market price, which is £26 per unit
(b) total UK cost per unit plus 25%.
Answer
Tax on profits in Outland will be 25%, but there will be an additional withholding tax of 10% since all available profits will be remitted to the UK. The total tax payable on income in Outland is therefore 35% which is higher than the rate of UK tax. This means that profits earned in Outland will not be taxed at all in the UK.
(a) Transfer price = market price
Parent company, UK £ £
Component sales (£26 per unit) 2,600,000 Variable costs (£15 per unit) 1,500,000
Fixed costs 900,000
2,400,000
Profit before tax 200,000
Tax at 30% (60,000)
Profit after tax 140,000
The transfer price in Outland dollars is £26 × $4 = $104.
Subsidiary company, Outland $ $
Product sales ($150 per unit) 15,000,000 Transfer costs ($104 per unit) 10,400,000
Local variable costs ($40 per unit) 1,500,000 Local fixed costs 600,000
12,500,000
Profit before tax 2,500,000
Tax at 25% (625,000)
Profit after tax 1,875,000
Withholding tax at 10% (187,500)
Profit in the UK after tax 1,687,500 = £421,875
The total group profit will be £140,000 + £421,875= £561,875.
(b) Transfer price = cost plus 25%
Total UK costs are £2,400,000 or £24 per unit. Cost plus 25% = £30 per unit.
The transfer price will therefore be £30, which is $120 per unit.
Parent company, UK £ Component sales (£30 per unit) 3,000,000 Total costs (as above) 2,400,000 Profit before tax 600,000
Tax at 30% (180,000)
Profit after tax 420,000
Subsidiary company, Outland $ $
Product sales ($150 per unit) 15,000,000 Transfer costs ($120 per unit) 12,000,000
Local variable costs ($40 per unit) 1,500,000 Local fixed costs 600,000
14,100,000
Profit before tax 900,000
Tax at 25% (225,000)
Profit after tax 675,000
Withholding tax at 10% (67,500)
Profit in the UK after tax 607,500 = £151,875 The total group profit will be £420,000 + £151,875 = £571,875.
The higher transfer price will provide a bigger after-tax profit for the group.
However, the tax authorities in Outland might not agree to accept a transfer price of $20, because this is $4 per unit above the market price for the component.