Transfer Pricing at Parson Foods Company

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Transfer Pricing at Parson Foods Company: When the Lure of Cheaper Foreign Production Does Not Deliver

INTRODUCTION

William F. Parson established Parson Foods Company (“PFC”) in the late 1800’s in Green Lake, Wisconsin, as one of the first processors of canned vegetables in the United States. PFC primarily sourced and canned peas, green beans, carrots and corn grown in the Midwest. In 1926, the company introduced “Mixall”, a mixture of vegetables in a can. In the mid 1950’s PFC began freezing vegetables. Through a series of acquisitions of frozen vegetable processors in the late 1990’s, PFC became the largest processor of frozen vegetables in the United States with domestic operations coast-to-coast.

One vegetable processing company acquired by PFC was Eagle Foods (“EF”), with an acquisition value of $140 million. The acquisition included purchasing EF’s wholly owned Mexican subsidiary, Eagle Foods Sociedad Anonima (“EFSA”), marking PFC’s first international exposure in processing and importing frozen vegetables. EFSA annually exports all 50 million pounds of broccoli it processes and freezes to EF in the United States. Prior to the acquisition, EF managed its subsidiary with a decentralized management philosophy, allowing the EFSA management to operate autonomously with very little oversight from the corporate office.

MEXICO’S MAQUILADORA PROGRAM

EFSA is a maquiladora, a Mexican company that provides manufacturing or assembling services to a U.S. partner. While a maquiladora is a legal entity in Mexico, the formation of a maquiladora requires the sponsorship of a U.S. company. In 1965, the government of Mexico established Maquiladora program (now legally known as IMMEX: Maquiladora, Manufacturing and Export Services Industry) to stimulate the economy, attract foreign investment, and create jobs along the U.S.-Mexico border. The Mexican government provided maquiladora companies with special provisions and preferential customs treatment that were not available to local Mexican companies. Particularly, the Mexican government allowed maquiladoras to import raw materials, parts, and components, on a duty-free basis, into Mexico for manufacturing, processing, or assembly, with the understanding that the finished products will be exported out of Mexico.[footnoteRef:1] [1: “Maquiladora”, derived from the Spanish word “maquilar”, is a term used to describe assembly services without necessarily taking ownership of products being assembled. Hence, maquiladoras are often referred to as “in bond” or “twin” plants. ]

At the same time, the maquiladora industry was greatly assisted by a U.S. customs program that provides favorable duty treatment to “American goods returned” after undergoing processing abroad. That is, as long as the original components come from the U.S., the finished goods assembled outside the U.S. can enter the country without paying U.S. import duties on the value of the U.S. components. The import duties are imposed only on the value of the operations performed abroad. The complementary benefits provided by the Mexican and the U.S. governments enabled maquiladora companies to import U.S. raw materials or commodities for processing in Mexico and re-export the finished products to the United States virtually duty-free. The importing U.S. company pays an import duty to the United States Customs and Border Protection on the conversion costs incurred in Mexico. Specifically, the import duty is imposed on the sum of manufacturing conversion costs: direct labor, manufacturing overhead, administrative costs, and any markup.

The maquiladora program appeals to the U.S. manufacturers that seek to enhance their international competitiveness by tapping into lower wages in Mexico. The removal of restrictions on non-Mexican ownership of maquiladoras in 1972 resulted in an exponential increase of U.S. investment in the maquiladora program, leading maquiladoras to play an important role in U.S. production. Top 100 maquiladora employers include such major U.S. companies as Ford Motor Company, General Electric, and Johnson & Johnson. Furthermore, thousands of U.S. suppliers are connected to maquiladoras by providing raw materials and components. Mexico, in turn, greatly benefits from the large flow of trade created by maquiladoras. Maquiladoras represent the second largest industrial segment in Mexico, after oil production. Roughly 80 percent of goods produced in Mexico are shipped to the United States, with maquiladoras responsible for an estimated 65 percent of Mexico’s exports.[footnoteRef:2] [2:

Originally, maquiladoras typically operated as cost centers for the U.S. parent or client companies. Maquiladoras would bill the U.S. partners for the value added (labor and overhead costs) incurred in Mexico plus a small percentage of markup, traditionally between 1% and 5% (cite). Therefore, the profit was guaranteed to the maquiladora, albeit minimal. Such low profit margins allowed the U.S. parent companies to minimize the tax liabilities of their maquiladora subsidiaries. Because Mexico imposes a corporate tax rate as high as 35%, unlike other developing countries that offer lower tax rates to attract foreign investors, operating as cost centers enabled maquiladoras to stay competitive for foreign parent companies pursuing a low-cost strategy. Maquiladoras typically incur operating expenses in pesos, the local currency in Mexico, and bill their U.S. clients or parents in U.S. dollars.

In late 2000, the government of Mexico introduced new regulations that were intended to raise tax revenues but, simultaneously, would hurt maquiladoras’ competitiveness. Under the new regulations, maquiladoras can no longer operate as cost centers. Instead, maquiladoras must operate as profit centers and are required to bill their foreign partners in “arm’s length” transactions. However, in lieu of meeting the arm’s length requirements, the Mexican government offers two “Safe Harbor” options to maquiladoras. Specifically, the Mexican government requires that maquiladoras report as a minimum pre-tax income the largest of two computations: (a) 6.5 percent of total operating expenses, or (b) 6.9 percent of operating assets.[footnoteRef:3] [3:

These Safe Harbor provisions ensure that a portion of taxable income of maquiladoras is retained, and taxed, in Mexico. On one hand, the Safe Harbor provisions potentially reduce the administration costs and procedures for maquiladoras because documenting compliance with Safe Harbor provisions may be easier than demonstrating that an arm’s length transaction has occurred. On the other hand, choosing to use the Safe Harbor is likely to substantially increase maquiladoras’ income tax liability. Clearly, one outcome of these new transfer pricing requirements is that maquiladoras have seen their competitiveness erode. For instance, the impact of all tax changes brought by the new regulations could represent an increase anywhere between 100 percent to 800 percent of the amount of income taxes that maquiladoras had previously paid. Mexico is now experiencing a decline in the maquiladora industry, a crucial part of the Mexican economy, by losing out to less expensive manufacturing opportunities in other countries.

THE EFSA (Eagle Foods Sociedad Anonima) DILEMMA

The role of EFSA as a maquiladora is unusual because most maquiladoras deal with non-perishable products; hence, those maquiladoras typically import from the U.S. parts and components related to manufacturing and assembly processes. In contrast, the only raw materials imported by EFSA from the United States are broccoli seeds and packaging materials. In Mexico the seeds are grown into broccoli that is harvested, processed, frozen, packaged and then exported back to the United States.

PFC management considers the maquiladora program to be an opportunity to reduce total overall frozen broccoli costs and improve company profits in an industry with slim profit margins, often measured in pennies per pound. During acquisition due diligence, the controller of EF indicated that EFSA was in compliance with the first option of the Safe Harbor provision. Specifically, EFSA’s transfer price to EF was at least 6.5 percent of manufacturing conversion costs, an amount that was internally referred to as “total cost to the border”.

When PFC acquired EF, PFC expected that EFSA broccoli processing costs would be considerably lower than domestic broccoli processing costs. After the acquisition, the management of PFC instructed its financial analyst to generate comparative profit and loss statements by vegetable group (e.g. cauliflower, carrots, broccoli, etc.) and quantify the impact of the acquisition of EFSA on the overall profit of PFC. PFC management was surprised and disappointed to learn that, instead of seeing an increase in the overall gross profit margin, the combined gross profit declined by $0.0137 per pound, a decrease from $0.1200 per pound to $0.1063 per pound. Exhibit 1 compares the net income of PFC for broccoli production based on domestic operation (produced by PFC) and the net income of PFC based on combined operations (broccoli production by both PFC and EFSA).

[Insert Exhibit 1 Here]

This result was puzzling. Exhibit 2 shows that EFSA’s broccoli manufacturing conversion costs (i.e. direct labor and manufacturing overhead) per pound ($0.0600 and $0.0900 per pound, respectively) are indeed much cheaper than the comparable PFC domestic costs ($0.1500 and $0.2500 per pound, respectively). Clearly, factors other than manufacturing costs appear to be adversely influencing broccoli costs from EFSA.

[Insert Exhibit 2 Here]

In addition to the analysis presented in Exhibits 1 and 2, the financial analyst generated an EFSA income statement as presented in Exhibit 3.

[Insert Exhibit 3 Here]

OTHER FACTORS THAT AFFECT EFSA AND PFC PROFITABILITY

The financial analyst noticed several factors that complicate the analysis of the profitability for EFSA and PFC. First, while the federal income tax rates of EFSA (located in Mexico) and PFC (located in the U.S.) are both 35 percent, EFSA’s pre-tax income is subject to another financial burden. Specifically, the Mexican government mandates that all Mexican companies, including maquiladoras, distribute to their employees 10 percent of their pre-tax income in the form of employee profit-sharing. In essence, the effective tax rate of EFSA is 45 percent (35 percent federal income tax and 10 percent mandatory employee profit sharing), resulting in a 10 percent difference in effective tax rates between EFSA (45 percent) and PFC (35 percent).

Second, PFC pays an import duty rate of 16 percent. That is, PFC pays $0.1600 for every dollar of pre-tax profit earned by EFSA in Mexico. These duties are paid to the U.S. Customs and Border Protection when the broccoli is re-exported to the United States. Third, the financial analyst learned that the exchange rates of the Mexican peso to the U.S. Dollar had been volatile; that is, the value of the peso had been depreciating and appreciating sharply for the past five years.

Using the current transfer price between EFSA and PFC, the financial analyst summarizes the overall impact of federal income taxes, mandatory profit sharing, and import duties (see Exhibit 4). The analyst also summarizes the total pre-tax income of PFC based on the current transfer price (see Exhibit 5).

[Insert Exhibit 4 Here] [Insert Exhibit 5 Here]

REQUIRED

  1. What markup is EFSA currently charging? Is EFSA in compliance with the maquiladoraSafe Harbor provisions for transfer pricing?
  2. What conditions might exist that encourage EFSA management not to charge the minimum allowable transfer price under the Safe Harbor provisions?
  3. Calculate the minimum allowable maquiladora transfer price per pound under the Safe Harbor provisions. Using this new transfer price, calculate PFC’s revised (a) total broccoli costs from EFSA (including import duties) and (b) combined weighted average broccoli cost.
  4. If EFSA charges the minimum allowable maquiladoratransfer price, calculate the effect on EFSA’s pre-tax income and PFC’s pre-tax income.
  5. What challenges do you envision when communicating the revised transfer price to EFSA management?

Bonus Question

  1. Suppose that PFC instructs EFSA to charge the minimum allowable transfer price. (a) What will be the overall after-tax income (and after import duties) effect for EFSA and PFC? (b) Will overall PFC profitability be higher or lower? (c) After performing this analysis, do you think that PFC should instruct EFSA to charge the minimum allowable transfer price? Explain.

Last Updated on December 1, 2020 by Essay Pro