Transfer Pricing/ Tax Treaties
First, please complete the homework problems found below. These will help you to apply the concepts you have learned from the readings. They require you to think critically about hypothetical situations to determine how to handle the given problem for tax purposes.
Assignment 1: Problems
- Maxco, a foreign corporation, owns 100% of Sheetco, a domestic corporation. Maxco manufactures a wide variety of sheets for worldwide distribution. Sheetco imports Maxco’s finished goods for resale in the United States. Sheetco’s average financial results for the last 3 years are as follows:
Sales……………………………………………… $20 million
Cost of goods sold……………………………. (15 million)
Operating expenses…………………………… (4 million)
Operating profit…………………………………. $ 1 million
Sheetco’s CFO has decided to use the comparable profits method to assess Sheetco’s exposure to an IRS transfer pricing adjustment by testing the reasonableness of Sheetco’s reported operating profit of $1 million. An analysis of five comparable uncontrolled U.S. distributors indicates that the ratio of operating profits to sales is the most appropriate profitability measure. After adjustments have been made to account for material differences between Sheetco and the uncontrolled distributors, the average ratio of operating profit to sales for each uncontrolled distributor is as follows: 6%, 8%, 10%, 10%, and 14%.
Using this information regarding comparable uncontrolled U.S. distributors, apply the comparable profits method to assess the reasonableness of Sheetco’s reported profits. In addition, if an adjustment to Sheetco’s reported profits is required, compute the amount of that adjustment.
- FORco, a foreign corporation incorporated in foreign country F, manufactures and sells figure skates. FORco owns a U.S. C corporation (“USSub”) that distributes only FORco’s figure skates. USSub uses the comparable profits method to show the arm’s length nature of its transfer pricing. USSub can choose comparable companies from the following list of potentially comparable companies.
All Berry Ratios are an average of gross profit over operating expense for the last 3 years.
- Shelter Inc.: A distributor of camping tents. Berry Ratio = 2.00.
- Cash Cow Inc.: A distributor of electronic knives. The company’s sales are split 50-50 between the United States and India. Berry Ratio = 1.50.
- Disk Inc.: A distributor of computer equipment manufactured by its Hong Kong affiliate. Berry Ratio = 1.20.
- Floss Inc.: A distributor of dental care products. Floss has a contractor use Floss’s proprietary manufacturing process to manufacture all the products Floss distributes. The contractor affixes the valuable Floss tradename to all the products it manufactures. Floss retains the right to all intellectual property. Berry Ratio = 1.10.
- Acme Inc.: A sporting goods distributor. Berry Ratio = 1.05.
- Mountain Top Inc.: A distributor of hiking gear. Berry Ratio = 1.15.
- Juice Inc.: A distributor of juicers. Berry Ratio = 1.20.
- Canine Inc.: A distributor of pet toys. Berry Ratio = 1.00.
What is the arm’s length range? Why?
- Chairco, a domestic corporation, produces a line of low-cost bar stools at its facilities in Missouri for sale throughout the United States. During the current year, Chairco’s management has decided to begin selling its bar stools overseas and has begun exploring the idea of establishing branch sales offices in some key countries in Europe and Asia. If possible, Chairco’s management would like to avoid establishing a taxable presence in these countries.
Chairco’s management has asked you to advise them on the types of marketing activities they can conduct within these countries without creating a taxable nexus. For purposes of this analysis, assume that the United States has entered into an income tax treaty with the countries in question that is identical to the United States Model Income Tax Convention of 2016.
- US-Cco is a United States C Corporation that is wholly owned by FRGNco, a company incorporated in country F, which has a tax treaty with the United States similar to the United States Model Treaty. FRGNco is privately owned by six unrelated residents of Canada. FRGNco manufactures widgets and earns $500,000 of income, all from the sale of those widgets to US-Cco. US-Cco owns valuable marketing intangibles, which make its resale of the widgets extremely profitable. During the current year, US-Cco earns income of $10 million that US-Cco distributes as a dividend to FRGNco. After receiving the dividend, FRGNco pays $6 million of compensation (which is reasonable, ordinary, and necessary) to one of the Canadian individuals, who acts as FRGNco’s CEO and is the brains behind the operations. What is the rate of the withholding tax on the dividend? Why?
- SafeCo, a country Z corporation, has sales subsidiaries throughout Europe and Asia. SafeCo sells in the United States through its employee, Tom Johnson, who works out of his home but meets with sales prospects daily. Pre-tax income attributable to Tom’s sales constitute $1 million.
- Does SafeCo have a U.S. trade or business? Why or why not?
- If country Z has a treaty with the United States similar to the Model Treaty, would SafeCo have a permanent establishment in the United States? Why or why not?
Misey, J., & Schadewald, M. S. (2018). Practical guide to U.S. taxation of international transactions (11th ed.). CCH.