Question 1 The Omega group comprises two companies. A Ltd and B Ltd both of which are resident in a country where the corporate tax rate is at 30%. A Ltd A Ltd has two divisions: (i) Engineering division - provides engineering services to the oil & gas industry. Manufacturing division - assembles commercial refrigerators which it sells to supermarkets and convenience stores. The storage racks used in these commercial refrigerators are purchased from B Ltd. B Ltd B Ltd manufactures storage racks that are sold globally. Some of the storage racks are sold to A Ltd. Over the years, B Ltd had built up a strong presence in many countries and had emerged as the market leader in this industry. Given the way B Ltd currently operates, it is at its maximum capacity. Financial Results The financial results of the two companies for the year ended 31 December 2017 are as follows: ($'000) External sales Sales to A Ltd A Ltd B Ltd Engineering Manufacturing Division Division 700 1.270 400 350 750 230 900* 250 270 210 120** 200 160 380 800 2.000 4,000 Cost of sales General & Admin expenses Operating Profit Assets * Includes the costs of storage racks purchased from B Ltd. ** The general and admin expenses for B Ltd is fixed with respect to sales. Part A Required: (a) Evaluate and discuss the performance of the two divisions of A Ltd and B Ltd using the following three ratios (rounded to one decimal place of a percentage) and recommend areas of possible improvements: Return On Investment (ROI). (ii) Return On Sales. (111) Asset Turnover. (15 marks) Part B The current policy of the group is to allow managers to negotiate with each other directly on the transfer prices. The manager of B Ltd charges the same price internally, as he charges external customers, for B Ltd's storage racks. The manager argues that this is fair as he could have increased his external sales if the internal sales were not made. The manager of the Manufacturing division of A Ltd believes that the price being charged by B Ltd for the storage racks is too high and is restricting A Ltd's competitiveness in the market. Recently, A Ltd failed to win a potentially profitable order which it priced based on gross profit mark-up. The competitor who won the order set a price that was less than 10% lower than A Ltd's price. An analysis of the cost structure of B Ltd indicates that 40% of the cost of sales is fixed costs and the remaining costs vary with the value of sales. Required: Consider (b) (i) and (b)(ii) independently. (b) (1) Discuss how the current transfer pricing policy is affecting the overall performance of the group. Support your discussion with your computations from PART A where applicable. (10 marks) (ii) An analysis of the market demand shows that B Ltd currently satisfies only 80% of the external demand for its storage racks. Explain, with appropriate calculations, the minimum transfer price or prices at B Ltd at which it would be willing to supply the storage racks internally. State any necessary assumption(s) you have to make. (10 marks) (c) The group Managing Director is considering relocating B Ltd to a country that has a much lower rate of corporate taxation than that in its current location. Evaluate and explain the possible tax consequences for internal transfer pricing if B Ltd were to relocate
