Reference no: EM131328021

Case: Transfer Pricing

Willowmill Clothing, a multinational clothing chain, has operations that span around the world. The jeans-making process starts in Bermuda, where they spin natural fibers into cloth that is used to make jeans. They purchase raw material for $22.00 per jean and incur a cost of $8.00 per jean to spin the cloth. As such, total cost of the spinning process equals $30.00 per jean. The second phase of the jeans-making process occurs at two manufacturing plants, one in China and one in Hong Kong. There, they manufacture the jeans for distribution. Generally, 75% of the jeans are manufactured in China and 25% are manufactured in Hong Kong. The cost incurred to make the jeans, not including the price paid to purchase the cloth made in Bermuda, is $40.00 at each location. The jeans are then sent to the distribution center in France, where they sell the jeans to retailers around the world for $99 per pair of jeans. An additional cost of $6.00 is incurred at the distribution center.

Willowmill has called you in as a transfer pricing tax consultant to help them minimize its tax burden on the production of jeans. You are aware of the following tax information about the countries in which Willowmill operates.

Bermuda	No Income Tax
Hong Kong	25% income tax
China	37% income tax
France	30% income tax

Additionally, you researched the clothing industry to determine the standard markup for each phase of production to ensure that transfer prices are not set at levels which would be not be considered arm's length.

Cloth Spinning	15-25%
Manufacturing	5-15%
Distribution	5-10%

In order for Willowmill to set transfer prices to its advantage without committing tax evasion, the prices need to be set so that the markup at each stage is between the standard values found in the industry. Additionally, the prices set to and from the two distribution centers need to be identical. The company must also continue to produce 75% in China and 25% in Hong Kong.

Questions

1. Create a diagram that illustrates Willowmill's operations around the world. Include the tax rates in each country and the cost to manufacture the products in each area.

2. Determine the transfer price that should be set at each stage in order to minimize the tax burden for Willowmill. Remember that at the end, the distribution center needs to be able to sell the product for $99.00. Round your answers to the nearest cent. Hint: to determine whether you should minimize or maximize income at the distribution centers, weight the tax rates by the number of jeans manufactured there and compare the effective manufacturing tax rate to the distribution tax rate.

3. Assume Willowmill produces 1,000 pairs of jeans. Calculate the income recognized under your transfer pricing structure and the overall tax burden. The income recognized should be the same under any scenario, but the tax burden should differ according to your transfer pricing structure.

4. Compare your answer to what the income tax would have been if you used a 15% markup at the cloth spinning stage, a 15% markup at the manufacturing stage, and a 7.99% markup at the distribution stage. Note the difference between the two tax burdens.

5. Write a memo to advice the Corporate Financial Officer for the following issues:

a. How to develop the best transfer pricing systems to help them to achieve the corporate external objectives.

b. What are the limitations or drawbacks of using transfer pricing internationally in each of Bermuda, Hong Kong, China and France?

c. Will the suggested transfer pricing policy open the door for the government interventions of the tax authorities of the countries included?