Question

GB Pharmaceuticals produces and sells a single drug, XY-5. The company is organized into three divisions: Manufacturing, Packaging, and Distribution. Manufacturing, located in country A, manufactures the drug producing a single-dose capsule. The variable cost of a capsule is $26. The fixed costs of Manufacturing is $10 million and Manufacturing produces 1 million capsules annually.

Packaging is located in country B. Packaging takes the pills that are sent by Manufacturing in bulk and packages them in bottles containing 10 capsules each. The variable costs of packaging are $56 per bottle. The pills from Manufacturing are transferred at average (variable plus fixed) costs. Fixed costs in packaging are $4 million annually.

Distribution, like Manufacturing, is located in country A. Distribution takes the bottles prepared by Packaging and sells them to distributors in country A. The variable costs of Distribution are $66 per bottle. Fixed costs in Distribution are $3 million annually.

The pill produced by GB Pharmaceuticals is a generic drug with many competitors. The market value before distribution costs is determined to be $560. Distribution Division sells bottles to its customers for $690 per bottle. The tax rate in country A is 40 percent and 15 percent in country B.

Required:

a. The company decides that for tax purposes, it will use the market value of the pills (before distribution costs) for the transfer price between Packaging and Distribution. What is the total tax GB Pharmaceuticals will pay in income tax to the two countries?

b. The tax authorities in country A object and argue that this drug is not that similar. Therefore, the transfer price should be the total cost (variable plus fixed) of Packaging. If that transfer price is used, what is the total tax GB Pharmaceuticals will pay in income tax to

Answer 1

Amount (in Million) 26 Manufacturing Division Variable cost of manufacturing Fixed cost of manufacturing Total cost of manufacturing 10 36 56x0.10 = 5.60 million 36 Packaging Division Cost of Materials Transferred from Manufacturing Variable cost of Packing Fixed cost of Packing Total Value of drug after packing 5.6 4 45.6 45.6 66x0.10 = 6.60 million Distribution Division Cost of Materials Transferred from Packaging Variable cost of Distribution Fixed cost of Distribution Total value of drug at the time of sale 6.6 3 55.2 1 million Notes No of Capsules No of Capsules in a bottle No of bottle 10 0.10 million a) If company decides that for tax purposes, it will use the market value of the pills (before distribution costs) for the transfer price between Packaging and Distribution. 560*.10 = 56 milliom 56 Tax to be paid in Country A Market value of the pills (before distribution costs) Variable cost of Distribution Fixed cost of Distribution Total cost of drug at the time of sale 6.6 3 65.6

690*.10 = 69 million 69 65.6 Selling Price of bottle Total value of drug at the time of sale Gain on Sale Tax rate Tax Amount 3.4 30% 1.02 56 45.6 Tax to be paid in Country B Market value of the pills (before distribution costs) Less: Total cost of drug after packing Gain on transfer Tax rate Tax Amount 10.4 15% 1.56 b) If company decides that for tax purposes, it will use total cost (variable plus fixed) of Packaging for the transfer price Tax to be paid Country A Total Value of drug after packing Variable cost of Distribution Fixed cost of Distribution Total cost of drug at the time of sale 45.6 6.6 3 55.2 69 Selling Price of botle Total cost of drug at the time of sale Gain on Sale Tax rate 55.2 13.8 30% 4.14 Tax Amount 45.6 45.6 Tax to be paid in Country B Transfer Value of drug after packing Less: Total cost of drug after packing Gain on transfer Tax rate Tax Amount 0 15% 0