Motor Magic has two operating divisions: one in the UK and one in Mexico. The Mexican division produces a component part used in the production process of the UK division. If the UK division purchases the part from the Mexican division, a transfer price of £700,000 is charged.
However, if the UK division were to purchase the part from an outside supplier, the cost would be £800,000. The operating expenses for the Mexican and UK divisions are, respectively, £250,000 and £400,000 (not including the cost of goods transferred from the Mexican division). The UK division has revenue amounting to £1,600,000. The company's CEO of the company is trying to decide which amount should be used for the transfer price (£700,000 or £800,000).
a. Assume that the marginal tax rates for Mexico and the UK are 28 percent and 25 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.