Question

Growco, a domestic corporation, is a manufacturer. Growco is planning to build a new production facility, and has narrowed down the possible sites for this new plant to either Happystan (a low tax foreign country) or Sadstan (a high tax foreign country). Growco will structure the new facility as a wholly-owned foreign subsidiary, Sproutco, and finance Sproutco solely with an equity investment. Growco projects that Sproutco’s results during its first year of operations will be as follows:

Sales................................................................................ $400,000

Cost of goods sold......................................................... (290,000)

Selling, general and administrative expenses.......... (60,000)

Income before income taxes.......................................... $50,000

   Assume that the U.S. corporate tax rate is 21%, the Happystan rate is 10%, and the Sadstan rate is 30%. Further assume that neither Happystan nor Sadstan imposes withholding taxes on interest or royalty payments paid by a local subsidiary to its U.S. parent company. Compute the total tax rate (U.S. plus foreign) on Sproutco’s profits under the following assumptions:

a.   The new production facility is located in Happystan. Assuming profits are repatriated.

b.   The new production facility is located in Sadstan.Assuming profits are repatriated.

c.   The new production facility is located in Sadstan, but Growco modifies its plans. Specifically, Growco will finance Sproutco with both debt and equity, such that Sproutco will pay Growco $15,000 of interest each year. Growco will also charge Sproutco an annual royalty of $10,000 for the use of Sproutco’s patents and trade secrets.

Answer 1

Total tax to be paid on income generated from a foreign subsidiary will be higher of two country's income tax rates.

In the given case,

US tax rate 21%

Happystan tax rate               10%

Sadstan tax rate                30%

a.

Tax as per US @ 21% on $50,000    $10,500     

    Tax paid as per Happystan @ 10% on $50,000                                   $5,000

Additional tax due in US ($10,500 - $5,000)                                        $5,500

   Total tax rate on Sproutco' profit [($5,000 + $5,500)/$50,000]*100         21%

Here, higher rate was 21%.

b.

    Tax as per US @ 21% on $50,000    $10,500     

    Tax paid as per Sadstan @ 30% on $50,000                                  $15,000

Tax credit in US ($15,000 - $10,500)                                    $4,500

    Total tax rate on Sproutco' profit ($15,000/$50,000)*100                     30%

Here, higher rate was 30%.

c.

   Income before Income Taxes                                                              $50,000

   Interest paid                                                                                        $15,000

   Royalty paid                                                                                        $10,000

   Profit remaining           $25,000

Tax as per US @ 21% on $50,000    $10,500     

    Tax paid as per Sadstan @ 30% on $25,000                                  $7,500

Additional tax due in US ($10,500 - $7,500)                         $3,000

    Total tax rate on Sproutco' profit [($7,500 + $3,000)/$50,000]*100         21%

Here, higher rate was 21%.