A firm has affiliates in both Japan and Ireland. The corporate tax rate is 40% (

Question

A firm has affiliates in both Japan and Ireland. The corporate tax rate is 40% (of profits) in Japan and 15% (of profits) in Ireland. The Irish affiliate produces a special component that it sells to the Japanese affiliate at a price of $18/unit (=transfer price). The cost of producing the component has just risen from $12/unit to $14/unit. The multinational enterprise is considering 3 possible changes in the transfer price of the component:

-Ignore the cost increase and leave the transfer price at $18
-Increase the price to $20, reflecting the increase in costs
-Increase the price to $22, and, if necessary, explain the price increase by making general references to unavoidable cost increases at the Irish affiliate.

You may assume that the cost of the finished product that the Japanese producer makes is $40, and the Japanese affiliate’s cost of production (excluding the transfer price) is $5/unit.
If the goal of the MNE is to maximize its global after-tax profit, which of the three options should the controller choose?

Explanation / Answer

The enterprise sholud increase the price to $22, and, if necessary, explain the price increase by making general references to unavoidable cost increases at the Irish affiliate. As the tax rate in Ireland is only 15%, it will save taxes for the company in global after-tax profit.

Tax in Ireland for additional $4 = $4 x 15% = $0.6
Tax in Japan for additional profit of $4 = $4 x 40% = $1.60

So, it will save $1 per unit in taxes, if third option is selected.

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