Mikco, a foreign corporation, owns 100% of Flagco, a U.S. corporation. Mikco manufactures a wide variety of flags for worldwide distribution. Flagco imports Mikco’s flags for resale in the United States. Flagco’s average financial results for the last three years are as follows: Sales.................................................... $20 million Cost of goods sold............................. (15 million) Operating expenses.............................. (4 million) Operating profit................................... $ 1 million Flagco’s CFO has decided to use the comparable profits method to assess Flagco’s exposure to an IRS transfer pricing adjustment by testing the reasonableness of Flagco’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 Flagco 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 Flagco’s reported profits. In addition, if an adjustment to Flagco’s reported profits is required, compute the amount of that adjustment.
Mikco, a foreign corporation, owns 100% of Flagco, a U.S. corporation. Mikco manufactures a wide variety of flags for worldwide distribution. Flagco imports Mikco’s flags for resale in the United States. Flagco’s average financial results for the last three years are as follows:
Sales.................................................... $20 million
Cost of goods sold............................. (15 million)
Operating expenses.............................. (4 million)
Operating profit................................... $ 1 million
Flagco’s CFO has decided to use the comparable profits method to assess Flagco’s exposure to an IRS transfer pricing adjustment by testing the reasonableness of Flagco’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 Flagco 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 Flagco’s reported profits. In addition, if an adjustment to Flagco’s reported profits is required, compute the amount of that adjustment.
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