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The Price Dial

One company sells to its subsidiary in another country. Set the price between them and watch profit and tax move from one country to the other.

6 minutes, five short steps

  1. Guess
  2. Play
  3. Explain
  4. Check
  5. Try it

First, a bet

The US Entrepreneur designs a product and makes it in its own US factory for $7.5m. It ships the goods to the Canada Distributor, its subsidiary, which handles distribution in Canada. Distribution is all it does: it does not make or design the product, and it owns none of the brand or patents. It resells the goods to Canadian customers for $10.0m and spends $1.5m of its own on sales and delivery. The price the Distributor pays the Entrepreneur is the Intercompany priceThe price one company in a group charges another company in the same group, for example for goods, services or the use of IP. It decides how much of the group's profit, and so its tax, lands in each country. Tax rules require it to be an arm's length price: the price unrelated companies would agree in the same situation.Open in the Glossary.

If the Distributor pays the Entrepreneur more, what happens to the group's total profit?

Turn the dial

US EntrepreneurUnited States, tax 21%Canada DistributorCanada, tax 26.5%Profit $700kTax $147kProfit $300kTax $79.5kIntercompany price$8.20mgoodscashTotal profit $1.0m
$8.20m

Distributor's operating margin: 3.0%

Show it as
US Entrepreneur$700ktax $147k
Canada Distributor$300kmargin 3.0%, tax $79.5k
Group tax$226.5kon $1.0m of profit

Try this

  1. Drag the dial. Total profit stays at $1.0m.
  2. Find the price with the lowest group tax.
  3. Push the price outside the blue band and let go.
  4. Switch from Coins to Bars, then to Formula.

The price moves profit, not the total

Whatever the price, the group earns $1.0m on the Canadian sales. The price only decides which country that profit lands in, and so which tax rate it pays. Each $10k on the dial moves $10k of profit and changes group tax by the gap between the two rates.

That gives the group a reason to bend the price. Canada (26.5%) taxes more than the US (21%), so a high price is cheapest: it pulls the profit out of Canada and into the US.

Rates used: Canada 26.5% is the 15% federal rate plus Ontario's 11.5%. The US 21% is the federal rate only; state tax would add a few points.

The Arm's length principleThe rule that related companies should price their dealings the way unrelated companies would in the same situation. It is the foundation of both Section 482 and the OECD Guidelines.Open in the Glossary stops this. The price must be one that independent companies would agree to. The Distributor is the simpler company, so it is the Tested partyThe company in a transaction whose results are compared with comparables. It is usually the simpler, less complex party, such as a routine distributor or manufacturer.Open in the Glossary. Its Operating marginOperating profit divided by sales. It is the most common profit level indicator for distributors.Open in the Glossary (operating profit divided by sales) is compared with independent distributors. A higher price leaves the Distributor a lower margin. Under US rules this is the Comparable profits method (CPM)A US method that tests a company's operating profit against the operating profit of comparable companies, using a profit level indicator such as operating margin (Treas. Reg. § 1.482-5). It is close to the OECD's TNMM.Open in the Glossary. The Interquartile range (IQR)The middle 50% of comparable results, from the 25th to the 75th percentile. The US rule (Treas. Reg. § 1.482-1(e)(2)(iii)(C)) picks actual comparable results or averages two of them, while Excel's PERCENTILE.INC interpolates between values, so the two can give slightly different ranges.Open in the Glossary of the distributors' margins, 2.0% to 4.0%, is the blue band: a price of $8.10m to $8.30m. A result outside it is ordinarily moved to the Median adjustmentIf a US taxpayer's result falls outside the interquartile range, the IRS will ordinarily adjust it to the median of the comparables (Treas. Reg. § 1.482-1(e)(3)).Open in the Glossary, 3.0% or a price of $8.20m.

If only one country adjusts, the same profit is taxed twice until the other country gives relief. So a pushed price is not just risky. It can cost more than it saves.

Source: Treas. Reg. § 1.482-1, the arm's length standard and range

Check yourself

Three quick questions. Each answer explains itself, right or wrong.

Question 1 of 3The Canada Distributor is taxed at 26.5% (federal plus Ontario). The US Entrepreneur is taxed at 21% (US federal rate). If nobody checked, which price would give the group the lowest total tax?
Question 2 of 3With Canada at 26.5% and the US at 21%, the price goes up by $100k. By how much does group tax go down?
Question 3 of 3The price is $8.5m, above the range, so the Distributor earns nothing. Canada moves the Distributor's result up to the median, as if the price were $8.2m. The US does not lower the Entrepreneur's profit. What happens?

0 of 3 answered.

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