1a. Determine the transfer price requested by Sergio i.e. price at which profit from sale is zero. Remember, in order to fill the entire order, Harmon will lose some of its existing customers.

b. Pick two individuals in the case who would be in favor of using the transfer price determined in the first question. Briefly discuss why each of these two individuals would support the price.

c. Pick two individuals in the case who would be opposed to using the transfer price determined in the first question. Briefly discuss why each of these two individuals would prefer a different price.

d. Assume the transfer price in the first question is used and tax professionals determine it does not meet the MLTN threshold when evaluating uncertain tax positions. Determine the amount of the unrecognized tax benefit (UTB), or reserve as it is generally referred to in the case, if the settlement of the transfer price upon audit is assumed to be $800. Ignore any impact on the liability that would result from interest and penalties.

To increase cash flow flexibility, the companies under the Lenzini operating umbrella either engage in or are considering four inter-company transactions (ICTs) related to: (1) product sales, (2) working capital loans, (3) royalty payments for licensed intellectual property, and (4) management fees for machine acquisition/refitting. Appendix A provides a summary of the ICTs. Also, Figure 2 illustrates how the ICTs impact the three divisions.

ICT 1: Product Sales

To provide AVI with a reliable supplier and to take further advantage of the premium AVI is able to charge its Brazilian customers, AVI is negotiating with Harmon Mills to provide long steel for resale in Brazil. Figure 3 provides variable costing income statements for the two divisions. Typically, product sales between divisions represent the most traditional ICT and the most common use of transfer pricing. Management accounting professionals become highly involved in the determination of the appropriate transfer pricing range. The range, however, can be established based on either the companys own internal analysis, a third-party service provider, or a combination of both. Harmon Mills looks to develop an internally determined transfer pricing range without input from an external consultant for a benchmark price.

Discussion of ICT 1 (Product Sales)

With respect to product sales (ICT 1), AVI needs 60,000 tons of steel from Harmon, but Harmons available capacity is only 40,000 tons. Harmon can provide 40,000 tons without any change to normal operations, but to provide 60,000, they would need to cut contracts with several existing customers. Diego Guerra (AVIs CFO) said, We need 60,000 tons. Any less doesnt fulfill our needs. That will cause us problems, William said. To provide you with 60,000 tons, well need to buy 20,000 on the market or shift production away from an existing customer. Finally, William looks at you and says, Thats your job. When the meeting is over, determine how we can fulfill Diegos request. Examine whether we should make or buy the 20,000 of production that we need. Also, determine the price that we need to charge our Brazilian friends for the entire 60,000 tons. Diego chimed in, Be competitive, William, because we expect a good deal. We are brothers, after all, and we deserve to be treated as such. I can get all I want from my Brazilian suppliers for $800 a ton. I fully expect you to come in well below that amount. Well below, my friend.

Everyone started to laugh, except Pearsons two partners. Ashleigh Moore (tax partner) expressed her concern. She told the group that as related parties, the deal between AVI and Harmon is sure to arouse IRS concerns unless it is similar to an external, third-party benchmark price. She told the group that the selected price needs to represent a price that is More Likely Than Not (MLTN) to be accepted by the IRS, which means that it needs to be a price that has a greater than 50 percent chance of being sustained under an IRS audit. Nicholas Webb (audit partner) stated that a reserve account would need to go on the books for any unreasonable transfer price. He provided the group with two documents (1) Transfer Pricing and Uncertain Tax Positions: A Primer (see Appendix B), and (2) An Example ASC-740-10 Reserve Calculation (see Appendix C). As indicated in the documents, aggressive transfer prices that minimize a companys tax liability too much require reserve accounts and disclosures to the IRS. Ashleigh suggested that the transfer price defensibility would benefit from an external pricing study that established a transfer pricing range based on benchmark arms-length transactions. William Chipman (Harmon CFO) interrupted bluntly, Were not paying for one of those. Catherine Simmons (in-house counsel) agreed as William smiled. Ashleigh then stated that after researching the existing tax regulations, tax cases, and private letter rulings she could see the IRS establishing a transfer pricing range with a Ceiling$1,000, Floor$650. She believes that the IRS will establish an $850 per ton transfer price for any steel sales from Harmon Mills to AVI. She acknowledges that her expected transfer price is above the ceiling price determined based on Harmon Mills internal benchmark study. However, she provides three reasons to support her conclusion:

--The IRS is not required to abide by any internal benchmark or pricing study. It can choose any reasonable price based on a variety of factors, with local fair market values being just one of those factors. Internal cost is not relevant.

--In lieu of its own study, the IRS will consider an external benchmark study provided by an independent third party (e.g., international public accounting firm). The object is to determine the sale price of a comparable arms-length transaction.

--The IRS is increasingly aggressive when it comes to transfer pricing audits. The head of the IRSs transfer pricing division was once referred to in a popular press article by his nickname Howling Mad, and his immediate supervisor has the moniker Hannibal.9 Companies attempting to shift taxable income with the primary goal of tax avoidance can quickly come under IRS scrutiny (and audit).

--Well, when the lawyers and auditors of this firm are happy, were bound to be losing money, Sergio Vanoni (Global CFO) mumbled to Diego. Sergio then rose from his chair, You only worry about the taxes you have to pay. I worry about the survival of this company. Taxes are killing the cash flow of this firm. He then looked at you and said, Calculate the minimum amount that Harmon needs to charge AVI for 60,000 tons of production. No profit. Just cover your costs. Thats the price that AVI will pay. Pearsons tax and audit partners looked at Sergio and asked if he understood the implications of this demand. Ashleigh informed Sergio that she has little or no confidence that a price that minimized U.S. tax liability will be sustained under IRS audit. Sergio was silent for a long time. He then said, I pay you to fix my problems, not to create them. I seem to be the only one in this room worried about the overall health of Lenzini. William Chipman quickly spoke: Im worried about this problem, too. And, everyone here knows that I hate paying taxes as much as the next guy. He turned to you and said, When this meeting is done, please compute the transfer price that brings Harmons U.S. tax liability to zero. Then, if it is acceptable to Sergio, lets see if we can think of a price that makes sense without running afoul of the IRS. Glancing back at Sergio, William asked, Is that OK with you, Sergio? Fine, Sergio said. But any other price you come up with had better improve our financial position.

FICITRF. ? IcoVit Currenty, Harmon aoes not sell any stee to A v 1 . State taxes are included for completeness but do not include the benefit of federal tax benefits. We believe such an inclusion introduces a level of mplexity beyond its foreseen benefit