Subsidiary Alpha in Country Able faces a 40% income tax rate.Subsidiary Beta in Country Baker faces only a 20% income tax rate. Presentlyeach subsidiary imports from the other an amount of goods and services exactlyequal in monetary value to what each exports to the other. This method ofbalancing intra-company trade was imposed by a management keen to reduce all costs, including the costs (spreadbetween bid and ask) of foreign exchange transactions. Both subsidiariesare profitable, and both could purchase all components domestically atapproximately the same prices as they are paying to their foreign sistersubsidiary. Does this
seem like an optimal situation?

            Eachsubsidiary can produce the currently traded items at approximately the sameprice as is being paid for the import-export transactions. Hence the only gainmust come from either the avoidance of foreign exchange costs (as intended bythe present firm) or from the tax effect. The foreign exchange spread is probablyminimal. The tax effect suggests that the worldwide firm would be better off ifincome were transferred from Country Able to Country Baker.

            Income couldbe transferred from Country Able to Country Baker by having Beta, Inc.,continue to manufacture and ship to Alpha, Inc. The profit on this transactionwould be taxed at only 20%, whereas ifAlpha, Inc., makes the goods and includes the same implied market up in itsinternational costing, Alpha, Inc. will pay more income taxes.