USAco, a domestic corporation, plans to locate a new factory in either country L or country H.

USAco will structure new fac as a wholly owned foreign subsidiary, FORco, and finance FORco solely with an equity investment. USAco projects that in first year of operations, it will generate 10 million of taxable income, all from active foreign manufacturing activities. Assume U.S. corporation tax rate is 35%. To simplify the analysis, further assume that USAco's only item of income during the year derived from FORco. The total tax rate on FORco earnings will vary significantly, depending on a number of factors including: 1 Whether FORco is located in a low tax or high tax foreign country 2 The extent to which USAco repatriates FORco's earnings

3 Whether USAco repatriates FORco's earnings through dividend distributions, as opposed to interest, rental, or royalty paym

4 The availability of favorable tax treaty withholding rates on dividends, interest, and other payments made by FORco to USA

y H. USAco will structure new facility vestment. USAco projects that in FORco's manufacturing activities. Assume that the y item of income during the year is that

ors including:

to interest, rental, or royalty payments, and

ayments made by FORco to USAco

Case 1

Low-Tax Country with No Dividends

Country L has corporate tax rate of 25%, which is 10 percentage points lower than the US rate. If USAco locates FORco in country L and FORco pays no dividends, the total tax rete on its earnings will be 25%, computed as follows;

Foreign Income Tax FORco's taxable income Country L income tax rate Country L income tax

$10,000,000 0.25 $2,500,000

Foreign withholding taxes on repatriated earnings US tax on repatriated earnings

$0 $0

Total taxes Worldwide tax rate

$2,500,000 25%

This example illustrates that USAco can reduce the current year worldwide tax rate on the new manufacturing fa the U.S. tax rate of 35% by locating the factory in L, a low tax foreign country

Case 2 Low-Tax Country that Pays Dividend with Tax Treaty

Assume that country L has a tax treaty with the United States that provides a 10% withholding tax rate on divide USAco locates FORco in country L and repatriates half of FORco's after tax earnings through a dividend distribu total tax rate on its repatriate and unrepatriated earnings will be 30%, computed as follows Foreign Income Tax FORco's taxable income Country L income tax rate Country L income tax

$10,000,000 25% $2,500,000

Foreign withholding taxes on repatriated earnings FORco's after-tax earnings Percentage repatriated through dividend Dividend distribution Withholding tax rate (per treaty)

$7,500,000 50% $3,750,000 10%

Country L withholding tax

$375,000

US tax on repatriated earnings Dividend from FORco Code Sec. 78 gross-up USAco's taxable income US tax rate Pre credit U.S. tax Foreign tax credit US income tax Total taxes Worldwide tax rate

$3,750,000 1,250,000 $5,000,000 35% $1,750,000 ($1,625,000) $125,000 $3,000,000 30%

Foreign withholding taxes Deemed paid taxes 2500000*(3750000/7500000) Creditable foreign taxes (375000 + 1250000) General limitation: $1750000*($5000000/$5000000)

$2,500,000 $375,000 $1,750,000

$3,750,000 $1,250,000 $1

Thus, by repatriating half of FORco's earnings through a dividend distribution, USAco increases the worldwide tax rate on FORco's earnings from 25% in Case 1 to 30% in Case 2. The 30% rate is a blended rate, whereby th $5 million of income that USAco recognizes by virture of the dividends is, in effect, taxed one time at the U.S. rat 35%, and FORco's remaining $5 million of earnings is taxed one time at the country L rate of 25%

Case 3: Low Tax Country That Pays Dividend with No Tax Treaty

An important assumption in Case 2 is that country L had a tax treaty with the United States that provided for a 10% withholding tax rate on dividends. Now assume that there is no tax treaty between the United States a country L, and that country L's statutory withholding rate on dividends is 30%. The lack of a favorable treaty with increases the total tax rate on FORco's repatriated and unrepatriated earnings from 30% in case 2 to 36.25% in computed as follows.

Foreign Income Tax FORco's taxable income Country L income tax rate Country L income tax

$10,000,000 25% $2,500,000

Foreign withholding taxes on repatriated earnings

FORco's after-tax earnings Percentage repatriated through dividend Dividend distribution Withholding tax rate (per treaty) Country L withholding tax

$7,500,000 50% $3,750,000 30% $1,125,000

US tax on repatriated earnings Dividend from FORco Code Sec. 78 gross-up USAco's taxable income US tax rate Pre credit U.S. tax Foreign tax credit US income tax Total taxes Worldwide tax rate

$3,750,000 1,250,000 $5,000,000 35% $1,750,000 ($1,750,000) $0 $3,625,000 36.25%

Foreign withholding taxes Deemed paid taxes Creditable foreign taxes General limitation:

$2,500,000 $1,125,000 $5,000,000

$3,750,000 $1,250,000 $1

Thus, assuming USAco repatriates some of FORco's earnings through a dividend distribution, the availability of treaty withholding rate on dividends is critical to the ability of USAco to obtain the benefits of lower tax rates abro

Case 4 High-Tax Country with No Dividends

Country H has a corporate tax rate of 45%, which is ten points higher than the U.S. rate. If USAco locates FORc in country H and FORco pays no dividends, the total tax rate on its earnings will be 45%, computed as follows

Foreign Income Tax FORco's taxable income Country L income tax rate Country L income tax

$10,000,000 0.45 $4,500,000

Foreign withholding taxes on repatriated earnings US tax on repatriated earnings

$0 $0

Total taxes

$4,500,000

Worldwide tax rate

45%

The 45% worldwide tax rate indicates that the total tax rate on USAco's new manufacturing facility will exceed the US tax rate of 35% if USAco locates the factory in H, a high tax foreign country

Case 5: High-tax Country that Pays Dividend with Tax Treaty

Assume that country H has a tax treaty with the United States that provides a 10% withholding tax rate on divide If USAco locates FORco country H and repatriates half of FORco's after tax earnings through a dividend distribu total tax rate on its repatriated and run repatriated earnings will be 47.75%, computed as follows Foreign Income Tax FORco's taxable income Country L income tax rate Country L income tax

$10,000,000 45% $4,500,000

Foreign withholding taxes on repatriated earnings FORco's after-tax earnings Percentage repatriated through dividend Dividend distribution Withholding tax rate (per treaty) Country L withholding tax

$5,500,000 50% $2,750,000 10% $275,000

US tax on repatriated earnings Dividend from FORco Code Sec. 78 gross-up USAco's taxable income US tax rate Pre credit U.S. tax Foreign tax credit US income tax Total taxes Worldwide tax rate

$2,750,000 2,250,000 $5,000,000 35% $1,750,000 (1,750,000) $0 $4,775,000 47.75%

Foreign withholding taxes Deemed paid taxes Creditable foreign taxes General limitation:

$4,500,000 $275,000 $1,750,000

$2,750,000 $2,250,000 $5,000,000

By repatriating half of FORco's earnings through a dividend distribution, USAco increased the worldwide tax rate earnings from 45% in Case 4 to 47.75% in case 5. The foreign withholding tax on the dividend distribution is resp the the increase in the total tax rate.

Case 6: High Tax Country the Pays Dividend with no Tax Treaty

A comparison of Cases 4 and 5 indicates that repatriating half of of FORco's earnings through a dividend distribu through a dividend distribution increases the worldwide tax rate on FORco's earnings from 45% ti 47.75%. Now that there is no tax treaty between the United States and country H, and that country H's statutory withholding ra dividends is 30%. The lack of a favorable treaty withholding rate increases the total tax rate on FORco's repatria and unrepatriated earnings from 47.75% in Case 5 to 53.25% ub Case 6, computed as follows:

Foreign Income Tax FORco's taxable income Country L income tax rate Country L income tax

$10,000,000 45% $4,500,000

Foreign withholding taxes on repatriated earnings FORco's after-tax earnings Percentage repatriated through dividend Dividend distribution Withholding tax rate (per treaty) Country L withholding tax

$5,500,000 50% $2,750,000 30% $825,000

US tax on repatriated earnings Dividend from FORco Code Sec. 78 gross-up USAco's taxable income US tax rate Pre credit U.S. tax Foreign tax credit US income tax Total taxes Worldwide tax rate

$2,750,000 2,250,000 $5,000,000 35% $1,750,000 (1,750,000) $0 $5,325,000 53.25%

Foreign withholding taxes Deemed paid taxes Creditable foreign taxes General limitation:

$4,500,000 $825,000 $1,750,000

$2,750,000 $2,250,000 $5,000,000

Case 7: High Tax Country with Earnings Stripping and Tax Treaty

If USAco locates FORco in country H, one strategy for reducing the excess credits on FORco's earnings is to en in earnings stripping, that is, to repatriate FORco's profits through deductible interest, rental, and royalty paymen nondeductible dividend distributions. For example, assume that USAco modifies its plans for FORco, as follows 1 Finance FORco with both debt and equity, such that Forco will pay USAco $3 million of interest each year 2 Charge FORco an annual royalty of $2 million for the use of USAco's patents and trade secrets, and 3 Eliminate FORco's dividend distribution Assume that the applicable tax treaty withholding rate is 0% for both interest and royalties. As the following computations indicate, debt financing charges for technology transfers reduce the total tax rate on country earnings from 47.75% in Case 5 to 40%, computed as follows Foreign Income Tax FORco's income before interest and royalties Interest paid to USAco Royalties paid to USAco FORco's taxable income Country H income tax rate

$10,000,000 (3,000,000) (2,000,000) 5,000,000 45%

Country H income tax

$2,250,000

Foreign withholding taxes on repatriated earnings Withholding tax on interest (per treaty) Withholding tax on royalties (per treaty) Country H withholding tax

$0 $0 $0

US tax on repatriated earnings Interest from FORco Royalties from FORco USAco's taxable income US tax rate Pre credit U.S. tax Foreign tax credit US income tax Total taxes Worldwide tax rate

3,000,000 2,000,000 $5,000,000 35% $1,750,000 $1,750,000 $4,000,000 40.00%

Foreign withholding taxes Deemed paid taxes Creditable foreign taxes General limitation:

$0 $0 $1,750,000

$0 $2,000,000 $5,000,000

The 40% worldwide tax rate on country H earnings is a blended rate, whereby $5 million of unrepatriated earning

one time at the US rate of 35%, and $5 million of unrepatriated earnings is taxed one time at the country H rate o Thus, earnings stripping can be an effective method for reducing the worldwide tax rate on the earnings of a high subsidiary

Case 8: Low Tax Country with Earnings Stripping and Tax Treaty

In contrast to the benefits illustrated in Case 7, debt financing and charges for technology transfers will have no on FORco's total tax rate if FORco is located in country L (the low tax country). As in Case 2, where FORco repa its earnings through dividend distributions, the worldwide tax rate on FORco's repatriated and unrepatriated earn computed as follows

Foreign Income Tax FORco's income before interest and royalties Interest paid to USAco Royalties paid to USAco FORco's taxable income Country H income tax rate

$10,000,000 (3,000,000) (2,000,000) 5,000,000 25%

Country H income tax

$1,250,000

Foreign withholding taxes on repatriated earnings Withholding tax on interest (per treaty) Withholding tax on royalties (per treaty) Country H withholding tax

$0 $0 $0

US tax on repatriated earnings Interest from FORco Royalties from FORco USAco's taxable income US tax rate Pre credit U.S. tax Foreign tax credit US income tax Total taxes Worldwide tax rate

3,000,000 2,000,000 $5,000,000 35% $1,750,000 $1,750,000 $3,000,000 30.00%

Foreign withholding taxes Deemed paid taxes Creditable foreign taxes General limitation:

$0 $0 $1,750,000

$0 $2,000,000 $5,000,000

on its earnings will be

n the new manufacturing facility below

hholding tax rate on dividends. If through a dividend distribution, the

$7,500,000

375,000 1,250,000 1,625,000 1,750,000

increases the worldwide a blended rate, whereby the ed one time at the U.S. rate of

tates that provided etween the United States and k of a favorable treaty withholding rate 0% in case 2 to 36.25% in Case 3

$7,500,000

3,750,000 1,250,000 2,375,000 5,000,000

ribution, the availability of a favorable efits of lower tax rates abroad

te. If USAco locates FORco %, computed as follows

uring facility will exceed

hholding tax rate on dividends. through a dividend distribution, the

$5,500,000 $5,000,000

2,750,000 2,250,000 2,525,000 1,750,000

sed the worldwide tax rate on FORco's dividend distribution is responsible for

through a dividend distribution from 45% ti 47.75%. Now assume H's statutory withholding rate on x rate on FORco's repatriated

$5,500,000 $5,000,000

2,750,000 2,250,000 3,075,000 1,750,000

FORco's earnings is to engage rental, and royalty payments, rather than ans for FORco, as follows

of interest each year e secrets, and

lties. As the following l tax rate on country

$0 $5,000,000

2,000,000 1,750,000

on of unrepatriated earnings is taxed

time at the country H rate of 45% e on the earnings of a high tax foreign

ogy transfers will have no effect Case 2, where FORco repatriated ted and unrepatriated earnings is 30%,

$0 $5,000,000

2,000,000 1,750,000

Sign up to vote on this title
UsefulNot useful

Master Your Semester with Scribd & The New York Times

Special offer for students: Only $4.99/month.

Master Your Semester with a Special Offer from Scribd & The New York Times

Cancel anytime.