Baseline Values Case 1 Case 2
a Foreign corporate income tax rate 28% 45%
b U.S. corporate income tax rate 35% 35%
c Foreign dividend witholding tax rate 15% 0%
d U.S. ownership in foreign firm 100% 100%
e Dividend payout rate of foreign firm 100% 100%
b. What is the effective tax rate paid on this income by the U.S.-based parent company?
c. What would be the total tax payment and effective tax rate if the foreign corporate tax rate was 45% and
there were no withholding taxes on dividends?
Problem 15.1 Avon’s Foreign-Source Income
a. What is the total tax payment, foreign and domestic combined, for this income?
Avon is a U.S.-based direct seller of a wide array of products for women. Avon markets leading beauty,
fashion and home products in more than 100 countries. As part of the training in its corporate treasury
offices, it has its interns build a spreadsheet analysis of the following hypothetical subsidiary
earnings/distribution analysis. Use the spreadsheet presented in Exhibit 15.6 for your basic structure.
Country Hong Kong United States
Corporate income tax rate 16.5% 35.0%
Dividend payout rate 75.0%
Withholding tax on dividends 0.0%
Jewel Hong Kong Income Items (millions US$) 2011 2012 2013 2014
Earnings before interest and taxes (EBIT) 8,000 10,000 12,000 14,000
Less interest expenses (800) (1,000) (1,200) (1,400)
Earnings before taxes (EBT) 7,200 9,000 10,800 12,600
Less Hong Kong corporate income taxes (1,188) (1,485) (1,782) (2,079)
a. Net income 6,012 7,515 9,018 10,521
Retained earnings 1,503 1,879 2,255 2,630
Dividend remitted to U.S. parent 4,509 5,636 6,764 7,891
United States Taxation: Grossup 2011 2012 2013 2014
Gross dividend remitted 4,509$ 5,636$ 6,764$ 7,891$
Less withholding taxes – – – –
b. Net dividend remitted 4,509$ 5,636$ 6,764$ 7,891$
Add back proportion of corp income tax 891$ 1,114$ 1,337$ 1,559$
Add back withholding taxes paid – – – –
Grossed-up dividend for US tax purposes 5,400$ 6,750$ 8,100$ 9,450$
Theoretical US tax liability (1,890) (2,363) (2,835) (3,308)
Foreign tax credits (FTCs) (891) (1,114) (1,337) (1,559)
Additional US taxes due? (999) (1,249) (1,499) (1,748)
Excess foreign tax credits? – – – –
c. Net dividend, after-tax 3,510$ 4,388$ 5,265$ 6,143$
Total taxes paid on this income 1,890 2,363 2,835 3,308
Income before tax 5,400 6,750 8,100 9,450
d. Effective tax rate 35.0% 35.0% 35.0% 35.0%
(taxes paid/income before tax)
c. After estimating the theoretical U.S. tax liability on the expected dividend (what is often termed gross-up in the U.S.), what is the total
dividend after tax (all Hong Kong and U.S. taxes) expected each year?
d. What is the effective tax rate on this foreign-sourced income per year?
Problem 15.2 Pacific Jewel Airlines (Hong Kong)
Pacific Jewel Airlines is a U.S.-based air freight firm with a wholly owned subsidiary in Hong Kong. The subsidiary, Jewel Hong Kong,
has just completed a long-term planning report for the parent company in San Francisco, in which it has estimated the following expected
earnings and payout rates for the years 2011–2014.
The current Hong Kong corporate tax rate on this category of income is 16.5%. Hong Kong imposes no withholding taxes on dividends
remitted to U.S. investors (per the Hong Kong-United States bilateral tax treaty). The U.S. corporate income tax rate is 35%. The parent
company wants to repatriate 75% of net income as dividends annually.
b. What is the amount of the dividend expected to be remitted to the U.S. parent each year?
a. Calculate the net income available for distribution by the Hong Kong subsidiary for the years 2011–2014.
b. If Kraftstoff was attempting to choose between a 40% and 60% payout rate to stockholders, what arguments and values
would management use in order to convince stockholders which of the two pay-outs is in everyone’s best interest?
Problem 15.3 Kraftstoff of Germany
Kraftstoff’s primary problem is that the German corporate income tax code applies a different income tax rate to income
depending on whether it is retained (45%) or distributed to stockholders (30%).
a. If Kraftstoff planned to distribute 50% of its net income, what would be its total net income and total corporate tax bills?
Kraftstoff is a German-based company that manufactures electronic fuel-injection carburetor assemblies for several large
automobile companies in Germany, including Mercedes, BMW, and Opel. The firm, like many firms in Germany today, is
revising its financial policies in line with the increasing degree of disclosure required by firms if they wish to list their
shares publicly in or out of Germany. The company’s earnings before tax (EBT) is €483,500,000.
Problem 15.4 Gamboa’s Tax Averaging
c. What is the minimum effective tax rate which Maria can achieve on her foreign sourced income?
Subsidiary Income Statement BELIZE COSTA RICA Total Income
Earnings before taxes 1,000,000$ 1,500,000$
Less corporate income tax 40% (400,000) 30% (450,000)
Net income 600,000$ 1,050,000$
Retained earnings 300,000 525,000
Distributed earnings 50.000% 300,000 50.000% 525,000
Less withholding taxes on dividends 10% (30,000) 0% –
Net dividend remitted to U.S. parent 270,000 525,000
US Tax Calculation (individually)
Net dividend remitted 270,000$ 525,000$ 795,000$
Gross-up:
Withholding taxes paid 30,000 –
Foreign corporate income tax paid 200,000 225,000
Grossed-up dividend 500,000$ 750,000$ 1,250,000$
Theoretical U.S. tax liability 35% 175,000 35% 262,500 437,500$
Foreign tax credits 230,000 225,000 455,000$
Additional US taxes due? –$ 37,500$ 37,500$
Excess foreign tax credits? 55,000$ –$ 55,000$
TAX AVERAGING (combined)
Total additional US taxes due after averaging –$
Excess FTCs to carry forward/back? 17,500$
Effective tax rate on foreign source income 36.4%
a. If Maria Gamboa assumes a 50% payout rate from each subsidiary, what are the additional taxes due on foreign-sourced
income from Belize and Costa Rica individually? How much in additional U.S. taxes would be due if Maria averaged the tax
credits/liabilities of the two units?
b. Keeping the payout rate from the Belize subsidiary at 50%, how should Maria change the payout rate of the Costa Rican
subsidiary in order to most efficiently manage her total foreign tax bill?
Gamboa, Incorporated, is a relatively new U.S.-based retailer of specialty fruits and vegetables. The firm is vertically integrated
with fruit and vegetable-sourcing subsidiaries in Central America, and distribution outlets throughout the southeastern and
northeastern regions of the United States. Gamboa’s two Central American subsidiaries are in Belize and Costa Rica.
Maria Gamboa, the daughter of the firm’s founder, is being groomed to take over the firm’s financial management in the near
future. Like many firms of Gamboa’s size, it has not possessed a very high degree of sophistication in financial management
simply out of time and cost considerations. Maria, however, has recently finished her MBA and is now attempting to put some
specialized knowledge of U.S. taxation practices to work to save Gamboa money. Her first concern is tax averaging for foreign
tax liabilities arising from the two Central American subsidiaries.
Costa Rican operations are slightly more profitable than Belize, which is particularly good since Costa Rica is a relatively low-tax
country. Costa Rican corporate taxes are a flat 30%, and there are no withholding taxes imposed on dividends paid by foreign
firms with operations there. Belize has a higher corporate income tax rate, 40%, and imposes a 10% withholding tax on all
dividends distributed to foreign investors. The current U.S. corporate income tax rate is 35%.
c. The minimum Maria can reach on her foreign source income, assuming something is repatriated from abroad, is the U.S.
corporate rate of 35%, like that achieved in part b.
a. As seen above, with 50% payouts, after gross-up and tax averaging (cross-crediting), Maria owes no additional taxes to the
U.S. tax authorities. She has a $17,500 tax credit to carry forward. The effective tax rate on foreign source income is then 36.4%.
b. If Maria changes the payout rate for the Costa Rican subsidiary to 73.33% (found by trial and error), the cross-credits are equal
on the U.S. parent company level and no additional U.S. taxes are due on the remittance and repatriation. The effective tax rate
on foriegn source income is then 35% — the statutory U.S. corporate income tax rate.
Assumptions Hong Kong Great Britain
Corporate income tax rate 16.0% 30.0%
Desired markup on transfers 15.0% 15.0%
Volume 1,000
Constructing Transfer (Sales) Chinglish Dirk Torrington Edge Consolidated
Price Per Unit (British pounds) (British pounds) (British pounds)
Direct costs £10,000 £16,100
Overhead 4,000 1,000
Total costs £14,000 £17,100
Desired markup 2,100 2,565
Transfer price (sales price) £16,100 £19,665
Income Statement (prices x volume)
Sales price £16,100,000 £19,665,000
Less total costs (14,000,000) (17,100,000)
Taxable income £2,100,000 £2,565,000
Less taxes (336,000) (769,500) £1,105,500
Profit, after-tax £1,764,000 £1,795,500 £3,559,500
Assumptions Hong Kong Great Britain
Corporate income tax rate 16.0% 30.0%
Desired markup on transfers 20.0% 10.0%
Volume 1,000
Constructing Transfer (Sales) Chinglish Dirk Torrington Edge Consolidated
Price Per Unit (British pounds) (British pounds) (British pounds)
Direct costs £10,000 £16,800
Overhead 4,000 1,000
Total costs £14,000 £17,800
Desired markup 2,800 1,780
Transfer price (sales price) £16,800 £19,580
Income Statement (prices x volume)
Sales price £16,800,000 £19,580,000
Less total costs (14,000,000) (17,800,000)
Taxable income £2,800,000 £1,780,000
Less taxes (448,000) (534,000) £982,000
Profit, after-tax £2,352,000 £1,246,000 £3,598,000
Problem 15.5 Chinglish Dirk (A)
Baseline Analysis
Repositioned Profits
Use the following company case to answer questions 5 through 7. Chinglish Dirk Company (Hong Kong) exports razor blades to
its wholly owned parent company, Torrington Edge (Great Britain). Hong Kong tax rates are 16% and British tax rates are 30%.
Chinglish calculates its profit per container as follows (all values in British pounds).
Corporate management of Torrington Edge is considering repositioning profits within the multinational company. What happens
to the profits of Chinglish Dirk and Torrington Edge, and the consolidated results of both if the markup at Chinglish was increased
to 20% and the markup at Torrington was reduced to 10%? What is the impact of this repositioning on consolidated tax payments?
By increasing the markup in Hong Kong, the company has repositioned more of its profits in the lower tax environment,
Hong Kong, where the tax rate is 16% compared to Great Britain’s 30%. Note that the final sales price has actually fallen.
Baseline Repositioned Change
Consolidated profits, after-tax £3,559,500 £3,598,000 1.08%
Consolidated tax payments £1,105,500 £982,000 -11.17%
Assumptions Hong Kong Great Britain
Corporate income tax rate 16.0% 30.0%
Desired markup on transfers 15.0% 15.0%
Volume 1,000
Constructing Transfer (Sales) Chinglish Dirk Torrington Edge Consolidated
Price Per Unit (British pounds) (British pounds) (British pounds)
Direct costs £10,000 £16,100
Overhead 4,000 1,000
Total costs £14,000 £17,100
Desired markup 2,100 2,565
Transfer price (sales price) £16,100 £19,665
Income Statement (prices x volume)
Sales price £16,100,000 £19,665,000
Less total costs (14,000,000) (17,100,000)
Taxable income £2,100,000 £2,565,000
Less taxes (336,000) (769,500) £1,105,500
Profit, after-tax £1,764,000 £1,795,500 £3,559,500
Assumptions Hong Kong Great Britain
Corporate income tax rate 16.0% 30.0%
Desired markup on transfers 25.0% 8.1%
Volume 1,000
Constructing Transfer (Sales) Chinglish Dirk Torrington Edge Consolidated
Price Per Unit (British pounds) (British pounds) (British pounds)
Direct costs £10,000.00 £17,500.00
Overhead £4,000.00 £1,000.00
Total costs £14,000.00 £18,500.00
Desired markup £3,500.00 £1,498.50
Transfer price (sales price) £17,500.00 £19,998.50
Income Statement (prices x volume)
Sales price £17,500,000.00 £19,998,500.00
Less total costs -£14,000,000.00 –£18,500,000.00
Taxable income £3,500,000.00 £1,498,500.00
Less taxes -£560,000.00 -£449,550.00 £1,009,550
Profit, after-tax £2,940,000.00 £1,048,950.00 £3,988,950
The company is working with two constraints. First, the final sales price by Torrington Edge needs to be 20,000 or
less. Secondly, the British tax authorities have established a maximum transfer price on the blades at 17,800.
Problem 15.6 Chinglish Dirk (B)
Baseline Analysis
Repositioned Profits
Encouraged by the results from the previous problem’s analysis, corporate management of Torrington Edge wishes to continue to
reposition profit in Hong Kong. It is, however, facing two constraints. First , the final sales price in Great Britain must be £20,000
or less to remain competitive. Secondly, the British tax authorities — in working with Torrington Edge’s cost accounting staff —
has established a maximum transfer price allowed (from Hong Kong) of £17,800. What combination of markups do you
recommend for Torrington Edge to institute? What is the impact of this repositioning on consolidated profits after-tax and total tax
payments?
The optimal combination appears to be a 25.0% markup in Hong Kong, resulting in a transfer price of 17,500. This in
turn allows Torrington Edge to impose an 8.1% markup on its sales and still stay under a sales price of 20,000.
Baseline Repositioned Change
Consolidated profits, after-tax £3,559,500 £3,988,950 12.06%
Consolidated tax payments £1,105,500 £1,009,550 -8.68%
Assumptions Hong Kong Great Britain
Corporate income tax rate 16.0% 30.0%
Desired markup on transfers 15.0% 15.0%
Volume 1,000
Constructing Transfer (Sales) Chinglish Dirk Torrington Edge Consolidated
Price Per Unit (British pounds) (British pounds) (British pounds)
Direct costs £10,000 £16,100
Overhead 4,000 1,000
Total costs £14,000 £17,100
Desired markup 2,100 2,565
Transfer price (sales price) £16,100 £19,665
Income Statement (prices x volume)
Sales price £16,100,000 £19,665,000
Less total costs (14,000,000) (17,100,000)
Taxable income £2,100,000 £2,565,000
Less taxes (336,000) (769,500) £1,105,500
Profit, after-tax £1,764,000 £1,795,500 £3,559,500
Assumptions Hong Kong Great Britain
Corporate income tax rate 16.0% 30.0%
Desired markup on transfers 35.0% 4.64%
Volume 1,000
Constructing Transfer (Sales) Chinglish Dirk Torrington Edge Consolidated
Price Per Unit (British pounds) (British pounds) (British pounds)
Direct costs £10,000.00 £15,862.50
Overhead £1,750.00 £3,250.00 5,000
Total costs £11,750.00 £19,112.50
Desired markup £4,112.50 £886.82
Transfer price (sales price) £15,862.50 £19,999.32 (Still under 20,000)
Income Statement (prices x volume)
Sales price £15,862,500.00 £19,999,320.00
Less total costs -£11,750,000.00 -£19,112,500.00
Taxable income £4,112,500.00 £886,820.00
Less taxes -£658,000.00 -£266,046.00 £924,046
Profit, after-tax £3,454,500.00 £620,774.00 £4,075,274
Problem 15.7 Chinglish Dirk (C)
Baseline Analysis
Repositioned Profits
Not to leave any potential tax repositioning opportunities unexplored, Torrington Edge wants to combine the components of
Problem 15.6 with a redistribution of overhead costs. If overhead costs could be reallocated between the two units, but still total
£5,000 per unit, and maintain a minimum of £1,750 per unit in Hong Kong, what is the impact of this repositioning on
consolidated profits after-tax and total tax payments?
By both increasing the markup in Hong Kong (and decreasing it in Great Britain), and reallocating overhead cost to
Great Britain, Torrington’s consolidated profits improve once again by positioning profits (losses) in the low-tax (high-tax)
environments. Note that this is an extreme result. A 35% markup in Hong Kong with only a 4.64% markup in Great
Britain would probably in the end raise the attention of the British tax authorities.
Baseline Repositioned Change
Consolidated profits, after-tax £3,559,500 £4,075,274 14.49%
Consolidated tax payments £1,105,500 £924,046 -16.41%