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Multi-National Enterprises (MNE) operates in two countries, X and Y, with tax rates of 40% and 10%, respectively
Multi-National Enterprises (MNE) operates in two countries, X and Y, with tax rates of 40% and 10%, respectively. Production costs are exactly the same in each country. The following summarizes the operating data for the two subsidiaries. (All data have been converted to dollars to simplify the example.)
Subsidiary In Country X- Subsidiary In Count
Tax rate 40% 10%
Units sold 100 200
Unit cost $10 $10
Selling price per unit $20 $20
a. If each operating unit of MNE produces and sells only in its local country, is treated as a separate company, and pays taxes only in the country of its operations, what is MNE's total tax bill?
b. Suppose that MNE's subsidiary in country Y manufactures all the output sold in both countries. It ships the output to the subsidiary in country X that sells the product. The transfer price is set at $20. There are no costs of shipping the units from Y to X. If each country taxes only those profits that occur within its jurisdiction, recalculate MNE's total tax liability.
c. Now suppose that the subsidiary in country X manufactures all the output sold in both countries. It ships the output to the subsidiary in country Y that sells the product. Again, there are no costs of shipping the units from Y to X. If each country taxes only those profits that occur within its jurisdiction, what transfer price must be set to minimize MNE's total tax liability?
Expert Solution
I have assumed that sales in each country will not change. Only the cost structure has been modified, which then changes the income tax.
MNE - Scenario a. Country X Country Y Total
Gross Sales $2,000.00 $4,000.00
Cost of units $1,000.00 $2,000.00
Gross Margin $1,000.00 $2,000.00
Income tax $400.00 $200.00 $600.00
Net income $600.00 $1,800.00
MNE - Scenario b.
Gross Sales $2,000.00 $4,000.00
Costs of units $- $3,000.00
Transfer price $2,000.00 $(2,000.00)
Gross Margin $- $3,000.00
Income tax $- $300.00 $300.00
$- $2,700.00
MNE - Scenario c.
Gross Sales $2,000.00 $4,000.00
Cost of units $3,000.00 $-
Transfer price $(1,000.00) $1,000.00
Gross Margin $- $3,000.00
Income tax $- $300.00 $300.00
Net income $- $2,700.00
To minimize the income tax in total, it is preferable to 'zero out' the country with the highest
tax rate which is done in the example. However, it should be noted that only enough
was transferred to bring the profit to zero. A discussion about a net operating loss
to offset the gain in Country Y is assumed to be beyond the scope of the problem.
Please see the attached file.
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