Fundamentals of Cost Accounting 3rd Edition by William N. Lanen, Shannon W. Anderson, Michael Maher

Exercise 33

Transfer Prices and Tax Regulations: Ethical Issues

Gage Corporation has two operating divisions in a semiautonomous organizational structure. Adams Division, located in the United States, produces a specialized electrical component that is an input to Bute Division, located in the south of England. Adams uses idle capacity to produce the component, which has a domestic market price of $36. Its variable costs are $15 per unit. Gage’s U.S. tax rate is 40 percent of income.

In addition to the transfer price for each component received from Adams, Bute pays a $9 per unit shipping fee. The component becomes a part of its assembled product, which costs an additional $6 to produce and sells for an equivalent of $69. Bute could purchase the component from a Manchester (England) supplier for $30 per unit. Gage’s English tax rate is 70 percent of income. Assume that English tax laws permit transferring at either variable cost or market price.

Required

a. What transfer price is economically optimal for Gage Corporation? Show computations.

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b. Is it ethical to choose a transfer price for tax purposes that is different from the transfer price used to evaluate a business unit’s performance?

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c. Suppose Gage had a third operating division, Case, in Singapore, where the tax rate is below that of the United States. Would it be ethical for Gage to use different transfer prices for transactions between Adams and Bute and between Adams and Case?

Step 1 of 3

Transfer Prices and Tax Regulations—Ethical Issues: Gage Corporation.

a. The transfer price economically optimal for Gage Corporation is $36 per unit. As illustrated below this is due to the difference in tax rates between the U.S. and England. It would thus be advantageous to Gage to charge as high a transfer price as possible so as to generate income in the U.S. and avoid the higher tax rate of 70% in England.

Profit after tax at the transfer price of $15 per unit

Adams Division, U.S.			Bute Division, England
			Selling Price			$69.00
Transfer Price	$15		Transfers from U.S	$15.00
Variable Cost	15		Shipping costs	9.00
?Profit	$0		Additional processing costs	6.00		??30.00
			Profit before tax			?$39.00
			Tax @ 70%			??27.30
			?Profit after tax			$?11.70

Total Profit after tax for Gage = $11.70 per unit

Profit after tax at the transfer price of $36 per unit

Adams Division, U.S.			Bute Division, England
Transfer Price	$36.00		Selling Price			$69.00
Variable Cost	15.00		Transfers from U.S	$36.00
?Profit	$21.00		Shipping costs	9.00
Tax @ 40%	8.40		Additional processing costs	6.00		51.00
Profit after tax	$12.60		Profit before tax			$  18.00
			Tax @ 70%			12.60
			?Profit after tax			$?5.40

Total profit after tax for Gage Corporation = $12.60 + $5.40 = $18 per unit