Paterson Company,* a U.S.-based company, manufactures and sells electronic components worldwide. Virtually all its manufacturing takes place in the United States. The company has marketing divisions throughout Europe, including France. Debbie Kishimoto, manager of this division, was hired from a competitor three years ago. Debbie, recently informed of a price increase in one of the major product lines, requested a meeting with Jeff Phillips, marketing vice president. Their conversation follows.
Debbie: Jeff, I simply don't understand why the price of our main product has increased from $5 to $5.50 per unit. We negotiated an agreement earlier in the year with our manufacturing division in Philadelphia for a price of $5 for the entire year. I called the manager of that division. He said that the original price was still acceptable-that the increase was a directive from headquarters. That's why I wanted to meet with you. I need some explanations. When I was hired, I was told that pricing decisions were made by the divisions. This directive interferes with this decentralized philosophy and will lower my division's profits. Given current market conditions, there is no way we can pass on the cost increase. Profits for my division will drop at least $600,000 if this price is maintained. I think a midyear increase of this magnitude is unfair to my division.
Jeff: Under normal operating conditions, headquarters would not interfere with divisional decisions. But as a company, we are having some problems. What you just told me is exactly why the price of your product has been increased. We want the profits of all our European marketing divisions to drop.
Debbie: What do you mean that you want the profits to drop? That doesn't make any sense. Aren't we in business to make money?
*This scenario is based on the experiences of an actual firm. Names have been changed to preserve confidentiality.
Jeff: Debbie, what you lack is corporate perspective. We are in business to make money, and that's why we want European profits to decrease. Our U.S. divisions are not doing well this year. Projections show significant losses. At the same time, projections for European operations show good profitability. By increasing the cost of key products transferred to Europe-to your division, for example-we increase rev- enues and profits in the United States. By decreasing your profits, we avoid paying taxes in France; with losses on other U.S. operations to offset the corresponding increase in domestic profits, we avoid paying taxes in the United States as well. The net effect is a much-needed increase in our cash flow. Besides, you know how hard it is in some of these European countries to transfer out capital. This is a clean way of doing it.
Debbie: I'm not so sure that it's clean. I can't imagine the tax laws permitting this type of scheme. There is another problem, too. You know that the company's bonus plans are tied to a division's profits. This plan could cost all of the European managers a lot of money.
Jeff: Debbie, you have no reason to worry about the effect on your bonus-or on our evaluation of your performance. Corporate management has already taken steps to ensure no loss of compensation. The plan is to compute what income would have been if the old price had prevailed and base bonuses on that figure. I'll meet with the other divisional managers and explain the situation to them as well.
Debbie: The bonus adjustment seems fair, although I wonder if the reasons for the drop in profits will be remembered in a couple of years when I'm being considered for promotion. Anyway, I still have some strong ethical concerns about this. How does this scheme relate to the tax laws?
Jeff: We will be in technical compliance with the tax laws. In the United States, Sec- tion 482 of the Internal Revenue Code governs this type of transaction. The key to this law, as well as most European laws, is evidence of an arm's-length price. Since you're a distributor, we can use the resale price method to determine such a price. Essentially, the arm's-length price for the transferred good is backed into by starting with the price at which you sell the product and then adjusting that price for the markup and other legitimate differences, such as tariffs and transportation.
Debbie: If I were a French tax auditor, I would wonder why the markup dropped from last year to this year. Are we being good citizens and meeting the fiscal responsibilities imposed on us by each country in which we operate?
Jeff: Well, a French tax auditor might wonder about the drop in markup. But, the markup is still within reason, and we can make a good argument for increased costs. In fact, we've already instructed the managers of our manufacturing divisions to legitimately reassign as many costs as they can to the European product lines. So far, they have been very successful. I think our records will support the increase that you are receiving. You really do not need to be concerned with the tax authorities. Our Tax Department assures me that this has been carefully researched-it's unlikely that a tax audit will create any difficulties. It'll all be legal and above board. We've done this several times in the past with total success.
Required
1. Do you think that the tax minimization scheme described to Debbie Kishimoto is in harmony with the ethical behavior that should be displayed by top corporate executives? Why or why not? What would you do if you were Debbie?
2. Apparently, the Tax Department of Paterson Company has been strongly involved in developing the tax-minimization scheme. Assume that the accountants responsible for the decision are CMAs and members of the IMA, subject to the IMA standards of ethical conduct. Review the IMA standards. Are any of these standards being violated by the accountants in Paterson's Tax Department? If so, identify them. What should these tax accountants do if requested to develop a questionable tax-minimization scheme?