Cross-Border Distribution

Many multinational companies manufacture products in one country and appoint subsidiaries in other countries to distribute and sell those products to local customers. The distributor buys products from the parent company and resells them in its local market. The price charged between the related companies should be consistent with what independent businesses would agree to. For example, suppose ABC Cosmetics Inc. is a U.S. subsidiary of a Singapore company that manufactures luxury cosmetics. The Singapore parent sells cosmetics to ABC Cosmetics in the United States. ABC Cosmetics imports the products and sells them to U.S. retailers. The price paid by the U.S. subsidiary to the Singapore parent is called the transfer price. The transfer price should generally reflect what an independent distributor would pay for the same or comparable products under similar circumstances. Suppose independent distributors would normally pay $50 per unit for the same product. ABC Cosmetics sells each unit to U.S. retailers for $90. Under the arm’s-length principle, the transfer price would generally be around $50 per unit. Now suppose the Singapore parent charges ABC Cosmetics $75 per unit instead. The U.S. subsidiary is paying $25 more than the assumed arm’s-length price. That extra $25 is an additional expense for the U.S. subsidiary. As a result, the U.S. subsidiary’s profit decreases by $25, while the Singapore parent earns an additional $25. In simple terms, $25 of profit has shifted from the U.S. to Singapore. Profit Comparison

	Arm’s-Length Price: $50	Actual Transfer Price: $75
Selling price to U.S. customer	$90	$90
Amount paid to Singapore parent	$50	$75
Profit remaining in U.S.	$40	$15
Additional profit earned by Singapore parent	$0	$25
Tax Amount (21% rate)	$8.40 ($40 x 21%)	$3.15 ($15 x 21%)

The calculation is simple: At the $50 arm’s-length transfer price: $90 − $50 = $40 U.S. profit At the $75 actual transfer price: $90 − $75 = $15 U.S. profit So, if the U.S. paid $75, the U.S. subsidiary has $25 less profit, while the Singapore parent has $25 more profit. Now let’s see how this affects taxes in both countries. Tax Impact For this simplified example, assume:

• S. corporate tax rate = 21%
• Singapore corporate tax rate = 17%

If the Transfer Price Is $50 The U.S. subsidiary earns $40 of profit. U.S. tax: $40 × 21% = $8.40 The Singapore parent does not receive the additional $25 in this example. So, the combined tax shown in this simplified example is $8.40 per unit. If the Transfer Price Is $75 The U.S. subsidiary earns only $15 of profit. U.S. tax: $15 × 21% = $3.15 The Singapore parent receives the additional $25 of profit. Singapore tax on that additional profit: $25 × 17% = $4.25 Therefore: $3.15 U.S. tax + $4.25 Singapore tax = $7.40 combined tax Simple Tax Comparison of Combined Tax The difference is: $8.40 − $7.40 = $1.00 Therefore, under these simplified assumptions, charging $75 instead of the $50 arm’s-length price results in $1.00 less combined tax per unit. The U.S. tax decreases by $5.25 ($8.40 – $3.15); see line number E in the table above. The Singapore tax on the additional $25 of profit is only $4.25 ($4.25 – $0); see line number H in the table above. This shows that the U.S. subsidiary tried to shift profits to Singapore to pay less U.S. tax. This illustrates why transfer pricing can be important when related companies operate in countries with different tax rates. If the IRS determines that the transfer price is not at arm’s length, it may adjust the transaction under IRC Section 482. The U.S. subsidiary could also face interest and potentially penalties, depending on the circumstances. Next, let’s understand how U.S. transfer pricing rules apply to businesses, including foreign companies doing business in the United States.