Mikco, a foreign corporation, owns 100% of Flagco, a domestic corporation. Mikco manufactures a wide variety of fl ags for worldwide distribution. Flagco imports Mikco's fi nished goods for resale in the United States. Flagco's average fi nancial results for the last three years are as follows:
Sales
$20 million
Cost of goods sold
($15 million)
Operating expenses
($4 million)
Operating profi t
$1 million
Flagco's CFO has decided to use the comparable profi ts method to assess Flagco's exposure to an IRS transfer pricing adjustment by testing the reasonableness of Flagco's reported operating profi t of $1 million. An analysis of fi ve comparable uncontrolled U.S. distributors
indicates that the ratio of operating profi ts to sales is the most appropriate profi tability measure. After adjustments have been made to account for material differences between Flagco and the uncontrolled distributors, the average ratio of operating profi t to sales for each uncontrolled distributor is as follows: 6%, 8%, 10%, 10%, and 14%.
Using this information regarding comparable uncontrolled U.S. distributors, apply the comparable profi ts method to assess the reasonableness of Flagco's reported profi ts. In addition, if an adjustment to Flagco's reported profi ts is required, compute the amount of that adjustment.