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Case Studies

Case Studies

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In 1999, Compaq Computer Corporation, Houston (Compaq US) was slapped with tax
deficiency notices and penalties (Exhibit B) by the IRS, which claimed that the
Houston based company, had underpaid its taxes in the US for years 1991 and 1992.
This related to transactions between Compaq US and its Singapore subsidiary,
Compaq Asia (Pte) Ltd. (Compaq Asia) for the purchase of printed circuit assemblies

13

ibid

14

“A Taxing Battle”, The Economist, 29 January, 2004

15

www.corpwatch.org

16

“GSK Vows to Fight $5.2bn US Tax Bill”, www.THISDAYOnline.com, January 12th

2004

17

Compaq Computer Corporation and Subsidiaries V. Commissioner of Internal Revenue,

United States Tax Court, Tax Ct. Docket No. 24238-96, Filed on July 2nd

1999

18

Compaq website, Investor Relations

486

Managerial Economics

(PCAs) during the period 1990-1993. The IRS claimed that these transactions were
not carried out at arms’ length prices and hence profits were shifted to Singapore.

Exhibit B
Taxes Claimed by the IRS from Compaq US

Taxable Year Ended

Deficiency

Penalty Sec. 6662(a)

Nov. 30, 1991

$42,422,470

Nov. 30, 1992

$33,533,968

$547,619

Source: Compaq Computer Corporation and Subsidiaries V. Commissioner of Internal

Revenue, United States Tax Court, Tax Ct. Docket No. 24238-96, Filed on July 2nd 1999

Sourcing PCAs

The PCA is an important electronic component of the Central Processing Unit (CPU)
of a computer. It consists of a printed circuit board, the communication platform to
which components are attached, and any number of combinations of chips, resistors,
and capacitors. These circuits and boards interconnect to deliver a desired electronic
function. PCAs fall into five different categories viz. processors, power supplies,
memory boards, video boards, and a general category entitled backplane/other.

Compaq US, which was engaged in the CPU manufacturing process decided in the
mid-1980s to leverage on the low cost of manufacturing of PCs and PCAs in the
Asian markets. But, after two failed attempts at sourcing PCAs from Singapore – one
in 1984 involving Automated Assembly of Singapore and the other in 1986 involving
Bolnar, Compaq finally decided to set up its wholly owned subsidiary, Compaq Asia
in Singapore in 1986. The company so formed was primarily engaged in the business
of manufacturing PCAs using latest technology supplied by its parent company. It was
this advanced technology that enabled Compaq Asia to produce PCAs that were far
superior from a quality point of view than other local manufacturers in Singapore.
Hence it did not have to compete with them in meeting the stringent requirements of
Compaq US.

Compaq US manufactured CPUs at its facilities in Houston(Compaq US),
Singapore(Compaq Asia) and Scotland(Compaq Computer Manufacturing Ltd.). It
had three sources from which to meet its PCA requirements. These were Compaq
Asia, various unrelated PCA contractors primarily from the US, and Compaq US
itself. However, Compaq Asia met 50% of all PCA requirements during 1990 through
1993 (Exhibit C).

Exhibit C

Purchase of PCAs by Compaq US, Houston from Compaq Asia, Singapore

Power
Supplies

Processors Memory
Boards

Video
Boards

Backplane/
Other

Total

1991

Unit sales

1,065,966

382,286

30,191

74,090

180,611

1,733,144

Revenue

$143,474,373 $167,151,642 $5,570,843 $11,632,130 $11,919,452 $339,748,44

0

1992

Unit sales

1,293,140

514,154

0

195,751

1,571,896 3,574,941

Revenue

$94,643,303 $187,135,315

$0

$24,260,291 $73,486,057 $379,524,96
6

Total for 1991 and 1992

Unit sales

2,359,106

896,440

30,191

269,841

1,752,507 5,308,085

Revenue

$238,117,676 $354,286,957 $5,570,843 $35,892,421 $85,405,509 $719,273,40

6

Source: Compaq Computer Corporation and Subsidiaries V. Commissioner of Internal
Revenue, United States Tax Court, Tax Ct. Docket No. 24238-96, Filed on July 2nd 1999

487

Transfer Pricing

Pricing PCAs

Both Compaq US and Compaq Asia tracked their manufacturing costs using a
standard cost system that assigned specific costs to arrive at material, labor and
overhead standards. Standard material costs (for both the Houston and Singapore
locations) were determined on the basis of estimates of future costs expected to be
paid for purchase of materials from vendors on the Compaq US Approved Vendor
List (AVL). However the standard labor and overhead costs for the two facilities
varied, based on forecasted production at the two locations. The standard costs for
material, labor, and overhead for Compaq Asia were generally much lower than that
of the parent company.

Purchases of PCAs from Compaq Asia were made at prices set semiannually by the
Compaq US tax department. These prices were based on Compaq US’s standard
manufacturing costs, which it also used as a benchmark for purchasing PCAs from
other unrelated subcontractors. Compaq U.S. paid what is recognized in the industry
as the turnkey price for the PCAs sourced from Compaq Asia with some adjustments
(Annexure 2). Compaq Asia sales to Compaq U.S. during 1991 and 1992 were 101.5
and 88.1 percent of Compaq US’s standard cost to produce the PCAs, respectively.
On an aggregate basis, Compaq Asia sold PCAs to Compaq US at an average transfer
price that was equal to 93.9% of Compaq US’s standard costs for 1991 and 199219
.

This was not acceptable to the IRS, which believed that this transfer price was too
high considering the low cost of manufacturing in Singapore and was intended at
shifting earnings to the low-tax country. On an enquiry (and subsequent notice) for the
sale price charged for the transactions with Compaq Asia, the parent company
justified its “Cost Plus” pricing by resorting to the Comparable Uncontrolled Price
(CUP) method of determining transfer prices. Compaq US argued that the prices as
paid to Compaq Asia were justified as the latter also incurred costs involving
compensation for overtime, rework performed, changes in material prices, changes in
the delivery schedule, material cancellation costs, inventory shrinkage, production
scrap, setup charges, or obsolete inventory. There was a difference in the way
Compaq US treated the management of leftover materials for Compaq Asia and other
subcontractors (Compaq Asia was responsible for leftover parts while Compaq US
reimbursed unrelated subcontractors for leftover parts). Also, Compaq US paid
Compaq Asia in 90.9 days while unrelated subcontractors were generally paid in 30.3
days on an average. Another transactional difference was that Compaq US paid for
setup charges in transactions with unrelated subcontractors (which amounted to a
whopping $2.9 million during 1991 and 1992) while not making comparable
payments to Compaq Asia20
.

During 1990 through 1993, 93% of Compaq U.S. purchases from subcontractors were
from subcontractors located in the United States21

. The prices that Compaq US paid to
these unrelated subcontractors were used as a benchmark for its standard
manufacturing costs. Since the whole issue was about pricing, the difficulty was to
prove that transactions with the US unrelated parties could be viewed at an even keel
with transactions with the Asian subsidiary for pricing purposes.

With a focus on quality, Compaq US had concentrated on developing its vendors. Its
vendor selection process was also very stringent and parameters like manufacturing
technology, financial stability and management excellence were used to select a
vendor. Compaq US also insisted (barring a few exceptions) that its vendors use the
same technology that it (and Compaq Asia) used in its manufacturing process. Hence

19

Compaq Computer Corporation and Subsidiaries V. Commissioner of Internal Revenue,

United States Tax Court, Tax Ct. Docket No. 24238-96, Filed on July 2nd 1999

20

ibid

21

Compaq Computer Corporation and Subsidiaries V. Commissioner of Internal Revenue,

United States Tax Court, Tax Ct. Docket No. 24238-96, Filed on July 2nd 1999

488

Managerial Economics

the technology as used by the U.S subcontractors could be considered to be the same
as that used by Compaq Asia for all practical purposes.

It was ultimately determined that the PCAs that Compaq US sourced from unrelated
subcontractors were nearly identical to PCAs sourced from Compaq Asia. After
adjustment for differences in physical property and circumstances of the sales, the
prices that Compaq US paid to the unrelated subcontractors for PCAs were
comparable to the prices that Compaq U.S. paid to Compaq Asia for PCAs. Hence the
court ruled that the IRS’s claim for more tax did not hold good.

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