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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
our thinking about the international tax environment: tax neutrality and tax equity.
Tax equity is the principle that all similarly situated taxpayers should participate in the cost
of operating the government according to the same rules. This means that regardless in which
country an affiliate of a MNC earns taxable income, the same tax rate and tax due date apply.
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
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent
of McGraw-Hill Education.
directly by the taxpayer on whom it is levied. The tax is levied on active income, that is, income
that results from production by the firm or individual or from services that have been provided.
A withholding tax is a tax levied on passive income earned by an individual or corporation of one
country within the tax jurisdiction of another country. Passive income includes dividends and
interest income, and income from royalties, patents or copyrights paid to the taxpayer. A
withholding tax is an indirect tax, that is, a tax borne by a taxpayer that did not directly generate
the income that serves as the source of the passive income. The tax is withheld from
payments the corporation makes to the taxpayer and turned over to the local tax authority. A
value-added tax (VAT) is an indirect national tax charged on the sales price of a service or
consumption good as it moves through the various stages of production and/or service. As
such, a VAT is a sales tax borne by the final consumer.
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
country on their worldwide income no matter in which country it is earned. The territorial
method of declaring a tax jurisdiction is to tax all income earned within the country by any
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
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
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
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
pricing strategies, a large change in the transfer price is likely not to go unquestioned by the
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:
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
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent
of McGraw-Hill Education.
whether the Docket Company establishes a branch operation or a wholly owned subsidiary
under current tax law in New Zealand.
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
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
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
If Eastern Trading is successful in increasing the transfer price, more of the taxable
income per unit will be taxed at the current time in Singapore at 20%. A 25% increase in the
transfer price would raise it from S$300 to S$375 per unit. At S$375, the split would be as
follows:
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
Operating expenses
50
50
100
Taxable income
125
75
200
Income taxes (20%/17.5%)
25
13
38
Net income
100
62
162
The higher transfer price would result in only S$64 left to be repatriated from Hong Kong
instead of S$124.
