Question

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 $34 million, excluding services performed for Cargo Division aircraft. Cargo Division revenues last year were $111 million.

Operating costs of Maintenance Division were $24 million last year and operating costs for the Cargo Division, before considering maintenance costs, totaled $55 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 $30 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 $51 million. In its latest tax filing, Badger assigned the $51 million as the appropriate transfer price Cargo paid for the services from Maintenance. The U.S. tax authorities denied that expense and instead applied $30 million dollars as the appropriate transfer price.

Required:

1. Calculate the revenues, costs, income taxes and total taxes for both Cargo Division and the Maintenance Division using the Philippines basis. (Do not round intermediate calculations. Enter your answers in millions rounded to 2 decimal places.)

Cargo Division MaintenanceDivision
Total revenue
Total costs
Income taxes

Total taxes

2. Calculate the revenues, costs, income taxes and total taxes for both Cargo Division and the Maintenance Division using the U.S. basis. (Do not round intermediate calculations. Enter your answers in millions rounded to 2 decimal places.)

Cargo Division MaintenanceDivision
Total revenue
Total costs
Income taxes

Total taxes

3. 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 $30 million and $51 million? (Do not round intermediate calculations. Enter your answer in millions rounded to 2 decimal places.)

Answer 1

Answer :-

1. Calculate the revenues, costs, income taxes and total taxes for both Cargo Division and the Maintenance Division using the Philippines basis:-

Particulars	Cargo Division	Maintenance Division
Revenue	$111 millions	= 34 millions + 30 millions = $64 millions
Cost	= 55 millions + 30 millions = $85 millions	$24 millions
PBT	= 111 millions - 85 millions = $26 millions	= $64 millions - $24 millions = $40 millions
Income tax	= 26 millions * 40% = $10,400,000	= $40 millions * 25% = $10,000,000
Total tax	= 10,400,000 + 10,000,000 = $20,400,000.00

2. Calculate the revenues, costs, income taxes and total taxes for both Cargo Division and the Maintenance Division using the U.S. basis:-

Particulars	Cargo Division	Maintenance Division
Revenue	$111 millions	= 24 millions + 34 millions = $58 millions
Cost	= 55 millions + 51 millions = $106 millions	= $24 millions
PBT	= $111 millions +  $106 millions = $217 millions	= $58 millions - $24 millions = $34 millions
Income tax	=  $217 millions * 40% = $86,800,000	= $34 millions * 25% = $8,500,000
Total tax	= $86,800,000 +  $8,500,000 = $95,300,000.00

3. 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 $30 million and $51 million?

Tax calculated under 1	$20,400,000.00
Tax calculated under 2	$95,300,000.00
Difference	= $20,400,000 - $95,300,000 = $74,900,000.00