Problem 15-38 International Transfer Prices (LO 15-4) Badger Air is an all-cargo
ID: 2520871 • Letter: P
Question
Problem 15-38 International Transfer Prices (LO 15-4) Badger Air is an all-cargo airline that operates on four continents. Its headquarters are in the United States. It has two divisions, Cargo and Maintenance. Cargo Division flies cargo to and from international locations, but does not operate services between two points outside the United States. That is, the planes fly to and from the United States only. Badger Air also has a maintenance facility located in Hong Kong and schedules its planes in such a way that most maintenance can be done there. In addition to Badger aircraft, Maintenance Division also provides services to Asian passenger and cargo air companies All of the Cargo Division income is deemed to be earned in the United States. Income from the Maintenance Division is deemed to be earned in Hong Kong. Badger's income deemed attributable to the United States is taxed at a 40 percent rate. Its income attributable to Hong Kong is taxed at a 25 percent rate. Last year, Maintenance Division had operating revenues of $45 million, excluding services performed for Cargo Division aircraft. Cargo Division revenues last year were $133 million Operating costs of Maintenance Division were $35 million last year and operating costs for the Cargo Division, before considering maintenance costs, totaled $53 million. No similar maintenance facilities in Hong Kong are available to Badger Recently, a maintenance facility opened in the Philippines. That facility proposed to Cargo Division that it could conduct the maintenance in the Philippines. The facility proposed a price of $41 million for the services that Maintenance Division in Hong Kong provided to Cargo Division. Badger management estimated that had the services been provided in United States, the costs for the year would have totaled $72 million. In its latest tax filing, Badger assigned the $72 million as the appropriate transfer price Cargo paid for the services from Maintenance. The U.S. tax authorities denied that expense and instead applied $41 million dollars as the appropriate transfer priceExplanation / Answer
Part A: Using Phillipines Basis
Cargo Division
Amount in Millions $
Maintenance Division
Total Revenue
133
45
(A)
Operating Cost
53
35
Maintenance Cost
41
0
Total Costs
94
35
(B)
Net Income
39
10
(A-B)
Tax Rate
40%
25%
(C )
Income Tax
15.6
2.50
(A-B)*(C )
Total Taxes
18.10
Part B: Using US Basis
Cargo Division
Amount in Millions $
Maintenance Division
Total Revenue
133
45
(A)
Operating Cost
53
35
Maintenance Cost
72
0
Total Costs
125
35
(B)
Net Income
8
10
(A-B)
Tax Rate
40%
25%
(C )
Income Tax
3.2
2.50
(A-B)*(C )
Total Taxes
5.70
Part B: Difference in Tax Cost
Tax expenses as per philipines
72
(A)
Tax expenses as per US
41
(B)
Additional Tax expense due to transfer price
31
(A-B)
Tax Rate
40%
(C )
Tax Expense
12.40
(A-B)*(C )
Difference in Tax Cost
12.40
Part A: Using Phillipines Basis
Cargo Division
Amount in Millions $
Maintenance Division
Total Revenue
133
45
(A)
Operating Cost
53
35
Maintenance Cost
41
0
Total Costs
94
35
(B)
Net Income
39
10
(A-B)
Tax Rate
40%
25%
(C )
Income Tax
15.6
2.50
(A-B)*(C )
Total Taxes
18.10
Part B: Using US Basis
Cargo Division
Amount in Millions $
Maintenance Division
Total Revenue
133
45
(A)
Operating Cost
53
35
Maintenance Cost
72
0
Total Costs
125
35
(B)
Net Income
8
10
(A-B)
Tax Rate
40%
25%
(C )
Income Tax
3.2
2.50
(A-B)*(C )
Total Taxes
5.70
Part B: Difference in Tax Cost
Tax expenses as per philipines
72
(A)
Tax expenses as per US
41
(B)
Additional Tax expense due to transfer price
31
(A-B)
Tax Rate
40%
(C )
Tax Expense
12.40
(A-B)*(C )
Difference in Tax Cost
12.40