A firm has affiliates in both Japan, whose corporate income tax rate is 40 percent, and Ireland, whose corporate income tax rate is 15 percent. The major activity of the Irish affiliate is to produce a special component that it sells to the Japanese affiliate, initially at a price of $18 per unit. The cost of producing the component in Ireland has just risen from $12 per unit to $14 per unit.
The controller of the MNE is considering three possible changes in the price of the component (for the sales between the Irish and the Japanese affiliate): Ignore the cost increase, and leave the price at $18 (no price change). Increase the price to $20, to reflect exactly the increase in cost. Increase the price to $22, and, if necessary, explain the price increase by making general reference to unavoidable cost increases at the Irish affiliate.
a. If the goal of the MNE is to maximize its global after-tax profit, which of these three should the controller choose? Why?
b. What does each national government think of this use of transfer pricing?