Transfer pricing and tax havens | Taxes | Finance & Capital Markets | Khan Academy

Summary

The transcript outlines how a U.S.-based company can significantly reduce its tax burden by establishing a subsidiary in a low-tax jurisdiction. Initially earning $1 million in pre-tax profits and facing a 35% tax rate, the company pays $350,000 in taxes. By transferring intellectual property to its subsidiary and paying $800,000 in licensing fees, its pre-tax profits drop to $200,000, leading to a reduced tax liability of $70,000. This strategy allows the company to pay a total of $110,000 in taxes, illustrating how corporations leverage transfer pricing to maximize profits while navigating complex tax regulations.

Takeaways

• 💼 A company based in the U.S. can save on taxes through strategic offshore arrangements.
• 💰 The initial pre-tax profit of the U.S. company is $1 million, with a corporate tax rate of 35%.
• 🧾 After taxes, the U.S. company retains $650,000 in profit from its pre-tax earnings.
• 🌴 Setting up an offshore subsidiary in a low-tax jurisdiction (5% tax rate) allows for significant tax savings.
• 📊 Transfer pricing is a key strategy, where the U.S. company pays its offshore subsidiary for licensing intellectual property.
• 📉 By paying $800,000 in royalties, the company's pre-tax profit decreases to $200,000.
• 🏦 The U.S. tax liability drops to $70,000 after the transfer pricing adjustment.
• 🌐 The offshore subsidiary pays only $40,000 in taxes, retaining $760,000 as post-tax profit.
• 📉 Overall, the company pays a total of $110,000 in taxes instead of $350,000, resulting in substantial savings.
• 🚫 Repatriation of offshore profits incurs taxes, which prevents companies from freely transferring profits back to the U.S.

Q & A

What is the initial pre-tax profit of the U.S.-based company in the scenario?

The initial pre-tax profit of the U.S.-based company is $1 million.

What is the corporate tax rate applied to the company's profits in the U.S.?

The corporate tax rate applied to the company's profits in the U.S. is 35%.

How much tax does the company pay on its initial pre-tax profit?

The company pays $350,000 in taxes on its initial pre-tax profit.

What strategy does the company use to reduce its tax burden?

The company sets up an offshore subsidiary in a low-tax jurisdiction with a 5% corporate tax rate and transfers intellectual property to it.

What amount does the company pay in royalties to its offshore subsidiary?

The company pays $800,000 in royalties to its offshore subsidiary.

What is the new pre-tax profit of the company after accounting for the royalty payment?

The new pre-tax profit of the company after accounting for the royalty payment is $200,000.

How much tax does the company pay after the royalty payment, based on the new pre-tax profit?

The company pays $70,000 in taxes after the royalty payment, which is 35% of $200,000.

What is the total tax paid by the company after establishing the offshore subsidiary?

The total tax paid by the company after establishing the offshore subsidiary is $110,000 ($70,000 in the U.S. and $40,000 to the offshore jurisdiction).

What is the net profit for the U.S.-based company after taxes?

The net profit for the U.S.-based company after taxes is $130,000.

Why is repatriation of funds from the offshore subsidiary subject to additional tax?

Repatriation of funds from the offshore subsidiary is subject to additional tax to prevent companies from avoiding taxes by transferring profits abroad and then bringing them back into the U.S. without incurring tax liabilities.