Cristina’s Crafts has two operating divisions: one in the U.S. and one in Mexico. The Mexican Division produces product X, which is a component used in the production process of the U.S. Division. If the U.S. Division purchases product X from the Mexican Division, a transfer price of $650,000 is charged. However, if the U.S. Division were to purchase product X from an outside supplier, the cost would be $750,000. The operating expenses for the Mexican and U.S. Divisions are, respectively, $200,000 and $350,000 (not including the cost of goods transferred from the Mexican Division). The U.S. Division has revenue amounting to $1,500,000. Cristina, the CEO of the company, is trying to decide which amount should be used for the transfer price ($650,000 or $750,000).
a. Assume that the marginal tax rates for Mexico and the U.S. are 30 percent and 40 percent, respectively. What is the tax liability of each division for each of the transfer pricing alternatives?
b. Which transfer pricing alternative will produce the lowest tax liability for the company as a whole? Show your computations.