Transfer Pricing and Corporate Taxation Research Paper

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Table of Contents

Projections
Lowest possible overall tax
Scenarios that will result in favorable tax position
Scenarios that less likely result in an IRS audit
Audit Defense
Audit tools and plan
References

Projections

Consider a scenario where a company is based in the US and it manufactures and sells cars. It has two fully owned subsidiaries that are based in Cayman Island and Japan. The corporation tax rate in the US is 35%, 0% in Cayman Island, and 38.01% in Japan. The table presented below shows the projections of revenue, costs, profits, and taxes for the company and subsidiaries for these three regions.

		Host country (Japan)		Host country (Cayman Island)		Home country USA	Total
Sales	$30,000 * 200	6,000,000	$20,000 * 100	2,000,000	$40,000 * 300	12,000,000	20,000,000
Costs	$20,000 * 200	4,000,000	$8,000 * 100	800,000	$30,000*200	6,000,000	10,800,000
					$20,000*100	2,000,000	2,000,000
Profit before tax		2,000,000		1,200,000		4,000,000	7,200,000
Tax rate		38.01%		0%		35%
Tax paid		760,200		0		1,400,000	2,160,200
Profit after tax		1,239,800		1,200,000		2,600,000	5,039,800

In these projections, Japan incurs a total cost of $20,000 to manufacture a single unit of a car. Japan then sells each unit to the plant in the US at $30,000. The total units manufactured in Japan are 200. Therefore, the plant in Japan makes a profit of $10,000 per unit. The plant in Cayman Island manufactures a unit of a car at $8,000. The plant sells a unit at $20,000 to the US plant. Therefore, the profit generated by the plant is $12,000 per unit.

The United States plant buys these units of cars from the fully owned subsidiaries and carries out painting and inspection on them. The cars are sold in the US at $40,000 per unit. Therefore, the profit made by the US plant is $4,000,000. The total profit before tax for these three plants is $7,200,000. The total tax paid is $2,160,000 while the profit after tax is $2,160,000.

Lowest possible overall tax

First scenario

		Host country (Japan)		Host country (Cayman Island)		Home country USA	Total
Sales	$30,000 * 150	4,500,000	$30,000 * 150	4,500,000	$40,000 * 300	12,000,000	21,000,000
Costs	$20,000 * 150	3,000,000	$8,000 * 150	1,200,000	$30,000*150	4,500,000	8,700,000
					$20,000*150	4,500,000	4,500,000
Profit before tax		1,500,000		3,300,000		3,000,000	7,800,000
Tax rate		0		0		0
Tax paid		570,150		0		1,050,000	1,620,150
Profit after tax		929,850		3,300,000		1,950,000	6,179,850

In this scenario, the number of cars produced in Japan will be reduced from 200 to 150 while the quantity produced in Cayman Island will be increased to 150. Further, the transfer price per car in Cayman Island will be increased from $20,000 to $30,000. This scenario will result in lower taxes for each country.

Second scenario

		Host country (Japan)		Host country (Cayman Island)		Home country USA	Total
Sales	$30,000 * 100	3,000,000	$30,000 * 200	6,000,000	$40,000 * 300	12,000,000	21,000,000
Costs	$20,000 * 100	2,000,000	$8,000 * 200	1,600,000	$30,000*200	3,000,000	6,600,000
					$30,000*100	6,000,000	6,000,000
Profit before tax		1,000,000		4,400,000		3,000,000	8,400,000
Tax rate		38.01%		0%		35%
Tax paid		380,100		0		1,050,000	1,430,100
Profit after tax		619,900		4,400,000		1,950,000	6,969,900

In this scenario, the quantity of cars produced in Japan will be reduced from 200 to 100 while the quantity produced in Cayman Island will be increased to 200. Further, the transfer price per car in Cayman Island will be increased from $20,000 to $30,000. This scenario will result in lower taxes for each country.

Scenarios that will result in favorable tax position

Scenario 1

		Host country (Japan)		Host country (Cayman Island)		Home country USA	Total
Sales	$30,000 * 0	0	$30,000 * 300	9000000	$40,000 * 300	12000000	21000000
Costs	$20,000 * 0	0	$8,000 * 300	2400000	$30,000*0	0	2400000
					$30,000 * 300	9000000	9000000
Profit before tax		0		6600000		3000000	9600000
Tax rate		0.3801		0		0.35
Tax paid		0		0		1050000	1,050,000
Profit after tax		0		6600000		1950000	8550000

This scenario will result in a favorable tax position because the tax paid will reduce from $2,160,200 to $1,050,000. All the units of cars will be produced in the plant located on Cayman Island.

Scenario 2

		Host country (Japan)		Host country (Cayman Island)		Home country USA	Total
Sales	$30,000 * 200	6000000	$40,000 * 100	4000000	$40,000 * 300	12000000	22000000
Costs	$20,000 * 200	4000000	$8,000 * 100	800000	$30,000*200	6000000	10800000
					$40,000 * 100	4000000	4000000
Profit before tax		2000000		3200000		2000000	7200000
Tax rate		0.3801		0		0.35
Tax paid		760200		0		700000	1,460,200
Profit after tax		1239800		3200000		1300000	5739800

This scenario will result in a favorable tax position because the tax paid will fall from $2,160,200 to $1,460,200. Production will take place in both in Japan plant and Cayman plant.

Scenario 3

		Host country (Japan)		Host country (Cayman Island)		Home country USA	Total
Sales	$30,000 * 200	6000000	$50,000 * 100	5000000	$40,000 * 300	12000000	23000000
Costs	$20,000 * 200	4000000	$8,000 * 100	800000	$30,000*200	6000000	10800000
					$50,000 * 100	5000000	5000000
Profit before tax		2000000		4200000		1000000	7200000
Tax rate		0.3801		0		0.35
Tax paid		760200		0		350000	1110200
Profit after tax		1239800		4200000		650000	6089800

This scenario will result in a favorable tax position because the tax paid will reduce from $2,160,200 to $1,110,200. Therefore, the company will gain from this arrangement.

Scenarios that less likely result in an IRS audit

Scenario 1

		Host country (Japan)		Host country (Cayman Island)		Home country USA	Total
Sales	$30,000 * 0	0	$40,000 * 300	12000000	$40,000 * 300	12000000	24000000
Costs	$20,000 * 0	0	$8,000 * 300	2400000	$30,000*0	0	2400000
					$40,000 * 300	12000000	12000000
Profit before tax		0		9600000		0	9600000
Tax rate		0.3801		0		0.35
Tax paid		0		0		0	0
Profit after tax		0		9600000		0	9600000

In this scenario, there will be no production in the Japan plant. All production will take place in the plant located on Cayman Island. The company will also increase the transfer price for Cayman Island to $40,000 from $20,000. This scenario will attract an IRS audit because the tax for the whole company is zero. It is a scenario of tax avoidance.

Scenario 2

		Host country (Japan)		Host country (Cayman Island)		Home country USA	Total
Sales	$30,000 * 0	0	$60,000 * 300	18000000	$40,000 * 300	12000000	30000000
Costs	$20,000 * 0	0	$8,000 * 300	2400000	$30,000*0	0	2400000
					$60,000 * 300	18000000	18000000
Profit before tax		0		15600000		-6000000	9600000
Tax rate		0.3801		0		0.35
Tax paid		0		0		-2100000	-2100000
Profit after tax		0		15600000		-3900000	11700000

In this case, all production will take place in the plant located on Cayman Island. Also, the transfer price within this Island will be increased from $20,000 to $60,000. This scenario will result in a negative tax of $2,100,000. This implies that the company will be seeking a repayment from the IRS and it will attract an audit.

Scenario 3

		Host country (Japan)		Host country (Cayman Island)		Home country USA	Total
Sales	$20,000 * 100	2,000,000	$45,000 * 200	9,000,000	$40,000 * 300	12,000,000	22,000,000
Costs	$20,000 * 100	2,000,000	$8,000 * 200	1,600,000	$20,000*200	2,000,000	6,600,000
					$40,000 * 200	9,000,000	8,000,000
Profit before tax		0		6,400,000		1,000,000	7,400,000
Tax rate		38.01%		0%		35%
Tax paid		0		0		350,000	350,000
Profit after tax		0		6,400,000		650,000	7,050,000

In this scenario, the company will produce 100 units in Japan. The the transfer price for cars manufactured in the US will be the same as the price in Cayman Island. Thus, the company will be avoiding the tax in Japan. Further, 200 units will be produced in Cayman Island. Besides, the transfer price in Cayman Island will be $45,000. The overall tax paid by the company will be significantly low (Sheppard, 2010).

Audit Defense

The pricing and allocations of revenue used by the company are arrived at after taking into consideration a number of dynamics in the market. The first dynamic is the increased cost of operation. As can be seen in the documentations provided, the cost of production in the two plants has risen significantly. Therefore, the methods used by the company ensure that there are no losses (Stuart, 2009). There is adequate documentation to support the cost of operation and revenue earned by the company.

Besides, the company uses of accredited team of experts who carries out the allocation of the revenue and costs. Thus, they carry out their duties while taking into account the laws and regulations. Thirdly, Japan and Cayman Island have different tax laws and other regulations. Therefore, the allocations take into account the tax laws of the companies. Finally, the allocations are in line with the company’s goal of profit maximization (King, 2008).

Audit tools and plan

Audit review of transfer pricing by the IRS is a common practice. Thus, multinationals should put in place effective control and review them on a period basis to ensure that the company complies with the requirements of the IRS.

Tools

There are a number of tools that can be used by an IRS auditor to carry out the activities. The first tool is the International Returns (IR). The tool is used for appraising the tax returns for controlled entries. The second tool is Tax Information Gateway (TIG). The report is used to review financial data for companies across the world. The third tool is Capital IQ. It will be used to relate results to industry results. The final tool that can be used is Compustat. It aids in understanding the business of a company (Styron, 2007).

Audit plan

The audit plan will be made up of three phases. A summary of the plan is presented in the table below.

Phase of auditing	Activities	Time frame in month
Planning	Pre-examination review Opening meeting Orientation of the taxpayer Construction of risk analysis	6
Implementation	Gathering of information and evidence Development of the issue being audited	14
Resolution	Presentation and determination of the issue Terminating the case	6

This strategy for conducting the audit is comprehensive because it takes into account all the basic stages of an audit, which are pre-audit, audit, and post audit. Besides, the time allocated is sufficient considering that the review will cut across various countries that have different laws (Gustafson, Peroni, & Pugh, 2011).

References

Gustafson, C., Peroni, R., & Pugh, R. (2011). Taxation of international transactions. St. Paul, MN: Thomson West Law Group.

King, E. (2008). Transfer pricing and corporate taxation: problems, practical implications and proposed solutions. USA: Springer Science & Business Media.

Sheppard, L. (2010). Transfer pricing as tax avoidance. Web.

Stuart, A. (2009). Transfer pricing: a world of pain. Web.

Styron, J. (2007). Transfer pricing and tax planning opportunities for U.S. corporations operating abroad. Web.

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