CHAPTER 21 INTERNATIONAL TAX ENVIRONMENT AND TRANSFER PRICING
ANSWERS & SOLUTIONS TO END-OF-CHAPTER QUESTIONS AND PROBLEMS
QUESTIONS
1. Discuss the twin objectives of taxation. Be sure to define the key words.
Answer: There are two basic objectives of taxation that are necessary to discuss to help frame
Tax neutrality has its foundations in the principles of economic efficiency and equity. Tax
neutrality is determined by three criteria. Capital-export neutrality is the criterion that an ideal
tax should be effective in raising revenue for the government and not have any negative effects
on the economic decision making process of the taxpayer. That is, a good tax is one that is
efficient in raising tax revenue for the government and does not prevent economic resources
Tax equity is the principle that all similarly situated taxpayers should participate in the cost
2. Compare and contrast the three basic types of taxation that governments levy within their tax
jurisdiction.
Answer: There are three basic types of taxation that national governments throughout the world
use in generating tax revenue: income tax, withholding tax, and value-added tax. Many
countries in the world obtain a significant portion of their tax revenue from imposing an income
tax on personal and corporate income. An income tax is a direct tax, that is, one that is paid
directly by the taxpayer on whom it is levied. The tax is levied on active income, that is, income
3. Show how double taxation on a taxpayer may result if all countries were to tax the worldwide
income of their residents and the income earned within their territorial boundaries.
Answer: There are two fundamental types of tax jurisdiction: the worldwide and the territorial.
The worldwide method of declaring a national tax jurisdiction is to tax national residents of the
If a MNC was a resident of a country that taxed worldwide income, the foreign-source
income of its foreign affiliates would be taxed in the parent country. If the host country also
4. What methods do taxing authorities use to eliminate or mitigate the evil of double taxation?
Answer: The typical approach to avoiding double taxation is for a nation not to tax foreign-source
income of its national residents. An alternative method, and the one the U.S. follows, is to grant to
5. How might a MNC use transfer pricing strategies? How do import duties affect transfer
pricing policies?
Answer: A MNC might use transfer pricing strategies for two basic purposes: income tax
liability reduction or funds repositioning. If the tax rate in the country of the selling affiliate is
less than the tax rate in the buying affiliate country, a high markup policy on sales will leave little
taxable income in the buying affiliate country to be taxed at the higher rate. Even if the tax rate
6. What are the various means the taxing authority of a country might use to determine if a
transfer price is reasonable?
Answer: The U.S. and many other countries require the transfer price to be consistent with
arm’s length pricing, i.e., be a price that an unrelated party would pay for the same good or
service. The taxing authority can arbitrarily set the transfer price if it believes that transfer
pricing schemes are being used to evade taxes or that taxable income is not being clearly
reflected. There are three general methods to establish arm’s length pricing. One method is to
7. Discuss how a MNC might attempt to repatriate blocked funds from a host country.
Answer: There are several methods a parent firm might use to repatriate profits from an affiliate
in a host country that is blocking funds. Some of these measures should be enacted early on as
a guard against future funds blockage. One is to establish a regular dividend policy that the
host country becomes used to and expects. This assumes, however, the host country will let a
reasonable amount of funds be repatriated. If this is not the case, the parent firm might attempt
to use a high markup policy transfer pricing scheme. Since host countries are aware of transfer
PROBLEMS
1. There are three production stages required before a pair of skis produced by Fjord
Fabrication can be sold at retail for NOK2,300. Fill in the following table to show the value
added at each stage in the production process and the incremental and total VAT. The
Norwegian VAT rate is 25 percent.
_______________________________________________________________________
Production Selling Value Incremental
Stage Price Added VAT
_______________________________________________________________________
1 NOK 450
2 NOK1,900
3 NOK2,300
Total VAT
_______________________________________________________________________
Solution:
Production Selling Value Incremental
Stage Price Added VAT
_______________________________________________________________________
1 NOK 450 NOK 450 NOK112.50
_______________________________________________________________________
2. The Docket Company of Asheville, NC USA is considering establishing an affiliate operation
in the city of Wellington, on the south island of New Zealand. It is undecided whether to
establish the affiliate as a branch operation or a wholly-owned subsidiary. New Zealand taxes
income of both resident corporations and branch operations at a flat rate of 28 percent. New
Zealand withholds taxes at 5 percent on dividends for an investor who holds at least 10
percent of the shares in the subsidiary company that pays the dividend; 0 percent if the
investor holds 80 percent or more of the shares in the subsidiary company and meets other
criteria; 15 percent in all other cases. New Zealand does not withhold taxes on branch
income. The United States has an income tax rate of 35 percent on income earned worldwide,
but gives a tax credit for taxes paid to another country. Based on this information, is a branch or
subsidiary the recommended form for the affiliate?
Solution: If Docket establishes a branch operation in New Zealand, it will pay a total of 35
percent on its New Zealand source income. It will pay 28 percent in New Zealand and an
additional 7 percent in the United Sates after a receiving a tax credit for the New Zealand taxes.
If Docket sets up its New Zealand affiliate as a subsidiary, the subsidiary will pay taxes at 28
3. Affiliate X sells 10,000 units to Affiliate Y per year. The marginal tax rates for X and Y are 20
percent and 30 percent, respectively. The transfer price per unit is currently set at $1,000, but it
can be set as high as $1,250. Calculate the increase in annual after-tax profits if the higher
transfer price of $1,250 per unit is used.
4. Affiliate A sells 5,000 units to Affiliate B per year. The marginal income tax rate for Affiliate A
is 25 percent and the marginal income tax rate for Affiliate B is 40 percent. The transfer price
per unit is currently $2,000, but it can be set at any level between $2,000 and $2,400. Derive a
formula to determine how much annual after-tax profits can be increased by selecting the
optimal transfer price.
Note To Instructor: The solution to this problem is consistent with the example presented in the
text as Exhibit 21.6.
Solution: Let A and B be the marginal income tax rate for Affiliate A and B. Further let Q
denote quantity, and let P be the current transfer price per unit and P* be the optimal transfer
price per unit. The increase in annual after-tax profit (or the tax savings) can be stated as Q(P –
5. Affiliate A sells 5,000 units to Affiliate B per year. The marginal income tax rate for Affiliate A
is 25 percent and the marginal income tax rate for Affiliate B is 40 percent. Additionally, Affiliate
B pays a tax-deductible tariff of 5 percent on imported merchandise. The transfer price per unit
is currently $2,000, but it can be set at any level between $2,000 and $2,400. Derive (a) a
formula to determine the effective marginal tax rate for Affiliate B and, (b) a formula to determine
how much annual after-tax profits can be increased by selecting the optimal transfer price.
Solution: The solution to this problem is consistent with the example presented in the text as
Exhibit 21.7.This problem extends the work in problem 1, above. When the ad-valorem import
tariff is tax deductible, the effective marginal tax rate paid by Affiliate B is:
MINI CASE: SIGMA CORP.’S LOCATION DECISION
Sigma Corporation of Boston is contemplating establishing a wholly owned subsidiary
operation in the Mediterranean. Two countries under consideration are Spain and Cyprus.
Sigma intends to repatriate all after-tax foreign-source income to the United States. In the U.S.,
corporate income is taxed at 35 percent. In Cyprus, the marginal corporate tax rate is 10
percent. In Spain, corporate income is taxed at 30 percent. The withholding tax treaty rates
with the U.S. on dividend income paid is 5 percent from Cyprus and 10 percent from Spain.
The financial manager of Sigma has asked you to help him determine where to locate the
new subsidiary. The location decision of Cyprus or Spain will be based on which country has
the smallest total tax liability.
Suggested Solution for Sigma Corp.’s Location Decision
The total (income and withholding) tax liability in Cyprus will be: [.10 + .05 – (.10 x .05)]
= .145 or 14.5 percent. Additional taxes in the U.S. would be due, bringing the total tax liability
up to the U.S. income tax rate of 35 percent. The total (income and withholding) tax liability in
Spain will be: [.30 + .10 – (.30 x .10)] = .37, or 37 percent. Since this is greater than the U.S.
MINI CASE: EASTERN TRADING COMPANY’S OPTIMAL TRANSFER PRICING STRATEGY
The Eastern Trading Company of Singapore ships prepackaged spices to Hong Kong, the
United Kingdom, and the United States, where they are resold by sales affiliates. Eastern
Trading is concerned with what might happen in Hong Kong now that control has been turned
over to China. Eastern Trading has decided that it should reexamine its transfer pricing policy
with its Hong Kong affiliate as a means of repositioning funds from Hong Kong to Singapore.
The following table shows the present transfer pricing scheme, based on a carton of assorted,
prepackaged spices, which is the typical shipment to the Hong Kong sales affiliate. What do
you recommend that Eastern Trading should do?
Eastern Trading Company Current Transfer Pricing
Policy with Hong Kong Sales Affiliate
Singapore
Parent
Hong Kong
Affiliate
Consolidated
Company
Sales revenue S$300 S$500 S$500
Cost of goods sold 200 300 200
Gross profit 100 200 300
Operating expenses 50 50 100
Taxable income 50 150 200
Income taxes (20%/17.5%) 10 26 36
Net income 40 124 164
Suggested Solution to Mini Case 2: Eastern Trading Company’s Optimal Transfer Pricing
Strategy
Eastern Trading is currently in a good situation. Because the income tax rate in Hong Kong is
less than in Singapore, Eastern Trading’s present low markup transfer price strategy results in
larger pre-tax income in Hong Kong, which is taxed at only a 17.5% rate versus the 20% rate on
taxable income in Singapore. If Eastern Trading is free to repatriate profits from Hong Kong, it
If Eastern Trading is successful in increasing the transfer price, more of the taxable
Eastern Trading Company Current Transfer Pricing
Policy with Hong Kong Sales Affiliate
Singapore
Parent
Hong Kong
Affiliate
Consolidated
Company
Sales revenue S$375 S$500 S$500
Cost of goods sold 200 375 200
Gross profit 175 125 300
The higher transfer price would result in only S$64 left to be repatriated from Hong Kong
instead of S$124.