Answers:
1. Explain the strategies PrimeCo considered in internationalizing its operations. What are the advantages and disadvantages of each method?

The strategies PrimeCo considered to enter the international market are the following along with the corresponding advantages and disadvantages of each strategy.

a. Exporting – defined as the marketing of goods produced in one country to another. It is considered to be the easiest way of entering foreign markets. Exporting can be either indirect or direct. In general, the advantages of exporting are: i) manufacturing is home based, hence it is less risky that overseas based, ii) gives an opportunity to “learn” overseas markets before investing in bricks and mortar, and iii) reduces potential risks of operating overseas (FAO, 1997). Some of the disadvantages are: i) limited profit potential, ii) company gains no market information, or experience in new markets, iii) plants may not be located in low cost locations, iv) high transport costs, v) tariffs tend to be highest on finished goods, and vi) loss of control as markets are distant form production (http://uwf.edu/rsjoland/12%20Market%20Entry%20Strategies%20as%20Used%2004%201.pdf). b. Licensing – method of foreign operation whereby a firm in one country agrees to permit a company in another country to use the manufacturing, processing, trademark, know-how or some other skill provided by the licensor. The following are the advantages and disadvantages of this strategy. Advantages | Disadvantages | 1. Provides opportunity to low risk manufacturing relationships | 1. Disclosure of accumulated competitive knowledge and experience | 2. Capital not tied up in foreign operation | 2. Creates possible future competitors | 3. Access to difficult markets | 3. Lack of control over license operations | 4. Improved delivery and service levels in local markets | 4. Potential returns from marketing and manufacturing may be lost | c. Contract Manufacturing – The firm’s product is produced in the foreign market by local producer under contract with the firm. The advantages are contract manufacturing avoids the need for plat investment, transportation costs, and custom tariffs. There is also the advantage of promoting product as locally made. This also enables firm to avoid labor and other issues due to lack of familiarity with local economy and culture. A drawback would be the loss of profit margin on production activities. There is the risk of transferring technological know-how to potential foreign competitor (http://www.palgrave.com/business/lambin/students/pdfs/Note%2013.pdf). d. Strategic Alliances – Allows firm to access assets not readily available in the market, access to technology and markets, and synergetic effects in the partner firms. e. Starting wholly-owned subsidiary – A wholly owned subsidiary is a company fully controlled or owned by another company. The advantages of this strategy are control over technological know-how and ability to coordinate international strategy. One disadvantage is the risks in withdrawal from the market that could entail huge expenses and affect company reputation.
2. What factors should James and Gold evaluate when setting a transfer price? How does each factor relate to PrimeCo and SubCo?

The factors to be considered are enumerated in the Treasury Regulations 1.482-1(d)(1). These factors are called comparability factors that aids in determining the proper transfer pricing method. The factors are: 1) Functions, 2) Contractual Terms, 3) Risks, 4) Economic Conditions, and 5) Property or Services. The Functional Analysis or Functions per Treasury Regulation 1.482-1(d)(3) requires that determining degree of comparability between uncontrolled and controlled transactions, the functions performed and associated resources employed by taxpayers are compared. Accordingly, functional analysis aims at identifying and comparing economically significant activities undertaken or to be undertaken by the taxpayers. This would relate to both companies since it is indicated in this regulation that functions such as research and development, product design and engineering, and purchasing and materials management to name a few, are to be accounted to determine comparability. Contractual agreements are also considered since these would greatly affect the transactions of each company. The Regulation has set two rules when identifying contractual terms. This greatly relates to the two companies in the case in that regulation specified that if there is a written agreement, this agreement should be respected if such terms are consistent with economic substance of underlying transactions. If there is no written agreement, the district director may impute contractual agreement between controlled taxpayer consistent with economic substance of transaction. Risks are also considered since these affect prices charged or paid and also the profit that would be earned. Some of the risks included are market risks, financial risks, and product liability risk. In relating to the two companies, the regulation has a rule on how to identify the taxpayer that bears the risk. Accordingly, the rule set forth in identifying contractual terms is applied. Economic condition is a factor with the same impact as risks. Various factors such as similarity of geographic markets and level of market are included. The last factor is property or services, in which comparison includes any intangibles that are embedded in tangible property or services being transferred.

3. What are the different methods of transfer pricing acceptable for royalty arrangements? Describe how the factors identified in Question 2 impact PrimeCo’s choice of transfer pricing methods.

The different methods of transfer pricing acceptable for royalty arrangements set forth in Treasury Regulation 1.482-4 are:

1) Compare Uncontrolled Transaction Method - The comparable uncontrolled transaction method evaluates whether the amount charged for a controlled transfer of intangible property was arm's length by reference to the amount charged in a comparable uncontrolled transaction
2) Comparable Profits Method - The comparable profits method evaluates whether the amount charged in a controlled transaction is arm's length based on objective measures of profitability (profit level indicators) derived from uncontrolled taxpayers that engage in similar business activities under similar circumstances (§ 1.482-5)
3) Profit Split Method - The profit split method evaluates whether the allocation of the combined operating profit or loss attributable to one or more controlled transactions is arm's length by reference to the relative value of each controlled taxpayer's contribution to that combined operating profit or loss (§ 1.482-6).
4) Unspecified Methods - Consistent with the specified methods, an unspecified method should take into account the general principle that uncontrolled taxpayers evaluate the terms of a transaction by considering the realistic alternatives to that transaction, and only enter into a particular transaction if none of the alternatives is preferable to it.

The methods provided in the Treasury Regulation are grounded on the comparability factors enumerated. Thus, all those comparability factors must be thoroughly considered by PrimeCo to aid in the selection of a transfer pricing method.

4. How does income tax law affect PrimeCo’s transfer pricing decision? Explain IRC 482 position on transfer pricing as well as the position of Japan’s National Tax Authority. The income tax law greatly affects the transfer pricing decision of PrimeCo. As already discussed above, comparability factors as well as pricing methods have been set forth by the IRC section 482. The IRC 482 has the primary purpose of ensuring that taxpayers clearly reflect income attributable to controlled transactions, and prevent avoidance of taxes involving such transactions. IRC 482 laid out principles and guidelines regarding transfer pricing involving both tangible and intangible properties. Japan is part of the Organization for Economic Co-operation and Development. This organization has been formed to 1) Achieve highest maintainable economic growth and employment and a sustained rising standard of living in member countries, 2) result in sound economic expansion, and 3) contribute to expansion of world trade through multilateral, non-discriminatory basis. US is also a member of this organization wherein the tax authorities of the country has helped in establishing guidelines and policies on transfer pricing. Japan also based its transfer pricing policies on the arm’s length principle.

5. What is an Advance Pricing Arrangement? Is it possible for PrimeCo and SubCo to establish an agreement? Explain.

Advance Pricing Arrangement is a binding advance agreement between the tax authorities and the taxpayer, which set out the method for determining transfer pricing for inter-company transactions (Stone, 2012).

In Japan, APA is practiced. Thus PrimeCo and SubCo can have an agreement. According to Stone, the APA in Japan is bilateral. Bilateral APA is an ultimate transfer prising risk avoidance tool to eliminate the occurrence of double taxation by the two tax authorities agreeing on the applied methodologies. Under the APA in Japan, a taxpayer submits its transfer pricing methodology to be used to determine the arm’s-length price and specific content to the Regional Tax Bureau of Japan. The period to be covered by an APA is three to five years.

6. What ethical concerns should James and Gold consider in deciding on an appropriate transfer pricing method? Can PrimeCo use multiple transfer pricing methods? Explain.

Some of the ethical concerns that James and Gold should consider are the tendency of tax evasion because a manager may focus on increasing income and reduce foreign exchange risks. Another ethical issue would be the effect on the new workforce of the company. It can be observed that Gold is very concerned of earning profit because it would reflect his performance as manager. This should be taken into consideration because it would give pressure to the new workforce of the company. Moreover cultural differences should also be considered.

References:

www.irs.gov/

http://www.palgrave.com/business/lambin/students/pdfs/Note%2013.pdf

http://uwf.edu/rsjoland/12%20Market%20Entry%20Strategies%20as%20Used%2004%201.pdf