Chapter 15, Problem 38P

International Transfer Prices

Badger Air is an all-cargo airline that operates on four continents. Its headquarters are in the United States. It has two divisions, Cargo and Maintenance. Cargo Division flies cargo to and from international locations, but does not operate services between two points outside the United States. That is, the planes fly to and from the United States only. Badger Air also has a maintenance facility located in Hong Kong and schedules its planes in such a way that most maintenance can be done there. In addition to Badger aircraft, Maintenance Division also provides services to Asian passenger and cargo air companies.

All of the Cargo Division income is deemed to be earned in the United States. Income from the Maintenance Division is deemed to be earned in Hong Kong. Badger’s income deemed attributable to the United States is taxed at a 40 percent rate. Its income attributable to Hong Kong is taxed at a 25 percent rate. Last year, Maintenance Division had operating revenues of $26 million, excluding services performed for Cargo Division aircraft. Cargo Division revenues last year were $95 million.

Operating costs of Maintenance Division were $16 million last year and operating costs for the Cargo Division, before considering maintenance costs, totaled $47 million. No similar maintenance facilities in Hong Kong are available to Badger.

Recently, a maintenance facility opened in the Philippines. That facility proposed to Cargo Division that it could conduct the maintenance in the Philippines. The facility proposed a price of $22 million for the services that Maintenance Division in Hong Kong provided to Cargo Division. Badger management estimated that had the services been provided in United States, the costs for the year would have totaled $35 million. In its latest tax filing, Badger assigned the $35 million as the appropriate transfer price Cargo paid for the services from Maintenance. The U.S. tax authorities denied that expense and instead applied $22 million dollars as the appropriate transfer price.

Required

What is the difference in tax costs to Badger between the alternate transfer prices for maintenance services, that is, the difference between a transfer price of $22 million and $35 million?