performanceevaluation.doc

Model answer P1: international transfer pricing
Velocity publishes regular model answers to practice questions to help you revise.

This question and answer is for P1. To answer it, you first need to read the article ‘Management accounting - performance evaluation’ (PDF 83KB) from the November 2008 Financial Management magazine. This article was written by Grahame Steven, lecturer in the School of Accounting, Economics and Statistics at Napier University, Edinburgh.
Question
A multinational has a subsidiary that manufactures a key component for its subsidiaries located around the world. The multinational and the subsidiary that manufactures the key component are resident for tax in France.
The multinational’s subsidiary in Malaysia was recently approached by a local company interested in manufacturing the key component.
After a series of meetings, the local manufacturer offered a price equivalent to $48 per component. The Malaysian subsidiary subsequently contacted head office for permission to source supply with the local company since its price is $2 less than the price charged by the subsidiary in France.
The following information was obtained by head office for this proposal:
· Number of components used by Malaysian subsidiary: 50,000 a year 
· Price charged by French subsidiary: $50 per component
· Variable costs incurred by French subsidiary: $40 per component
· French corporation tax rate: 30%
· Malaysian corporation tax rate: 20%.
The French subsidiary informed head office that if the components were sourced in Malaysia the surplus capacity would be used to make products for a non-group company.
Sales to the non-group company are expected to be 40,000 components a year and contribution from these sales would be same as its Malaysian business. The subsidiary’s fixed costs would remain at the same level.
Required
(a) Prepare a financial appraisal for the proposal by the Malaysian company to source its components with the local company.
(b) Identify other issues that would be considered by the multinational in relation to this proposal.

Solution
Part (a)
While the French subsidiary would lose sales of 50,000 components to Malaysia, it would be able to sell 40,000 components to the other company.
The loss to the French company, before tax, would be $100,000 (10,000 x $10) since the contribution is the same if the French company sells to either company.
The net loss after tax to the French company would be $70,000 since it would no longer pay tax of $30,000 ($100,000 x 30%) on the higher level of sales previously made to the Malaysian subsidiary.
The Malaysian subsidiary’s costs would reduce by $100,000 (50,000 x $2 per component) if it sourced the components locally. However, this figure would be reduced by $20,000 ($100,000 x 20%) to $80,000 since the subsidiary would have to pay tax on its higher profits.
The multinational’s after tax profits would be increased by $10,000 if it gave permission to the Malaysian subsidiary to source its components locally. This increase arises due to the differing levels of corporation taxation in France and Malaysia since the before tax gain/loss to each subsidiary is $100,000.
Part (b)
The multinational would need to consider a number of issues before it reached a final decision about allowing the Malaysian subsidiary to source its components locally, including:
· What rate of corporation tax will be charged by Malaysia and France in the future?
· Can dividends be readily remitted from the Malaysian subsidiary to its foreign shareholders?
· Are the components manufactured by the Malaysian subsidiary of an equivalent quality to those produced by the French subsidiary?
· How secure is the local source of supply?
· Will the French subsidiary (which will have obtained replacement business) be able to supply sufficient components to the Malaysian subsidiary at short notice if the local supplier decides to stop supply?
· Is the local company offering a low price in order to gain business in the expectation of raising the price in the future?
· Is it possible to enter into a long-term contract with the local supplier?