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Outsourcing Is a Taxing Issue

The decision to outsource (or transfer certain operations to an outside company) is a financial one that many companies have to deal with at some point. Basically, a company has to decide whether another company could perform one or more of its operations comparably and more cheaply than it currently performs them.

The risks associated with outsourcing translate into potential costs, but as long as the amount the company saves by outsourcing the operation exceeds the expected costs associated with risk, then outsourcing makes sense.

To decide whether outsourcing is right for your company, you can use a practice known as transfer pricing. In this practice, each function of the company essentially “purchases” and “sells” to the other functions in the company.

Imagine an automotive manufacturing plant, where all the functions of building a car occur in the same plant. One of the functions is to put tires on each car. So the tire installation function of the plant purchases each car, finished up until the point of adding tires, from the function before it.

When that function has finished installing the tires, it sells the car with its tires installed to the next function in the process at an established profit margin. The plant’s overhead costs are attributed to each function in the proportion that the particular function utilizes them.

Why on Earth would a company go to all the trouble of considering every single function of its operations as independent customers and sellers to each other? Because doing so allows that company to determine whether it has competitive pricing in each of its functions.

If, through transfer pricing, the company discovers that another company in a different country is capable of selling cars with tires on them cheaper than the company can do so, even including the cost of shipping, the company may decide to outsource the tire installation function.

The company would ship the cars to the foreign company to have the tires put on, and then that company would ship the cars with tires back to the original company for the next phase of production.

Transfer pricing is pretty standard in the form of accounting called activity-based costing, but many companies prefer to use other accounting methods and rely on this form of analysis only when considering outsourcing.

Although outsourcing sounds like a win-win in the preceding example, it often comes with additional costs. Here are a couple of the big ones:

  • In international finance, outsourcing any function overseas requires the transfer of assets over international boundaries. Sometimes outsourcing requires a company to either export or import some item, sometimes it requires a company to both export and import an item, and sometimes (as is the case with customer service or accounting) outsourcing just requires the transfer of funds to pay the other company.

    If the other company is providing goods or services to the end user, then outsourcing may also require bringing funds back to the parent company.

  • Outsourcing to another country involves taxation for companies and governments. Companies have to pay tariffs on goods they send to another country, and then they have to pay more tariffs on those goods when they receive them back again. These costs can add up very quickly, discouraging outsourcing and trade.

    In order to ease the burden on companies some nations have set up trade agreements that allow for reduced or eliminated taxation on the transition of goods across national borders. Others allow tax-free capital movement under certain circumstances.

    For example, free-trade zones in China allow businesses to send goods to China, tax-free, for the purpose of altering those goods and then re-exporting them. So if the car company from the preceding example were from the U.S. and sent its cars to China for tire installation, it would only pay taxes on those cars if the cars were sold to customers in China.

    At the same time, the U.S. car manufacturer would only have to pay import taxes on the value of the work done in China, not the value of the entire car.

Not all nations are as sensitive as China to the needs of businesses. Some nations even go as far as to limit or prohibit any money from leaving the country. In these cases, companies have to carefully manage their capital movement to make outsourcing work for them. Companies can choose from a number of ways to manage their capital movements when they choose to outsource.

For instance, they can acquire resources from within the foreign nation and send the resources back to their headquarters in their own country, allowing them to allocate their foreign earned income as costs instead of attempting to transfer the money itself at high tax rates or even illegally.

If these transfers occur between related companies (for example, subsidiary and parent), then they can even alter the total amount that they’re taxed on their earnings by transferring assets to countries with low tax rates.

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