Litchfield Corporation is a U.S.-based manufacturer of fashion accessories that produces umbrellas in its plant in Roanoke, Virginia, and sells directly to retailers in the United States. As chief financial officer, you are responsible for all of the company’s finance, accounting, and tax-related issues.
Sarah Litchfield, chief executive officer and majority shareholder, has informed you of her plan to begin exporting to the United Kingdom, where she believes there is a substantial market for Litchfield umbrellas. Rather than selling directly to British umbrella retailers, she plans to establish a wholly owned UK sales subsidiary that would purchase umbrellas from its U.S. parent and then distribute them in the United Kingdom. Yesterday, you received the following memo from Sarah Litchfield:
SUBJECT: Export Sales Prices
It has come to my attention that the corporate income tax rate in Great Britain is only 28 percent, as compared tothe 35 percent rate we pay here in the United States. Since our average production cost is $15.00 per unit and the price we expect to sell to UK retailers is $25.00 per unit, why don’t we plan to sell to our UK subsidiary at $15.00 per unit? That way we make no profit here in the United States and $10.00 of profit in the United Kingdom, where we pay a lower tax rate. We have plans to invest in a factory in Scotland in the next few years anyway, so we cankeep the profit we earn over there for that purpose. What do you think?
Draft a 1-2 page essay responding to Sarah Litchfield’s question by explaining U.S. income tax regulations related to the export sales described in her memo. Include a discussion of any significant risks associated with her proposal. Make a recommendation with respect to how the price for these sales might be determined.