Problem 15.

1 Texmanchester's Foreign-Source Income

TexManchester is a textile manufacturing firm based in Manchester, U.K. The firm distributes linen and
clothing items in over 50 nations worldwide. The strategy team is in the process of constructing the firms
five-year strategy. They need to build a spreadsheet analyzing the subsidiary earnings/distribution in 2015
and in 2020 (including impending changes) as detailed in the table below.
a. Calculate the combined total payment of foreign and domestic taxes on TexManchesters income (given th
b. Calculate the effective tax rate paid by the UK-based parent company on its income.
c. Assuming that there were no withholding taxes on dividends, calculate the total tax payment and
effective tax rate if the foreign corporate tax rate was 45%.
d. Calculate the total tax payment and effective tax rate if the income was earned by a branch of
TexManchester.
Values
a
b
c
d
e

Foreign corporate income tax rate

UK corporate income tax rate
Foreign dividend witholding tax rate
UK ownership in foreign firm
Dividend payout rate of foreign firm

Foreign Subsidiary Tax Computation

1
Taxable income of foreign subsidiary
2
Foreign corporate income tax
3
Net income available for distribution
4
Retained earnings
5
Distributed earnings
6
Distribution to UK parent company
7
Withholding taxes on dividends
8
Net remittance to UK parent
UK Corporate Tax Computation on Foreign-Source Income
9
Dividend received (before withholding)
10 Add-back foreign deemed-paid tax
11 Grossed-up foreign dividend
12 Tentative UK tax liability
13 Less credit for foreign taxes
a. foreign income taxes paid
b. foreign withholding taxes paid
c. total
14 Additional UK taxes due
15 Excess foreign tax credits
16 After-tax income from foreign subsidiary
Tax Burden Measurement
17 Total taxes paid on remitted income
18 Effective tax rate on foreign income

2015
20%
21%
12%
100%
100%

2020 (exp)
45%
30%
0%
70%
50%

3,400,000.00
(680,000)
2,720,000.00
2,720,000
2,720,000
326,400
2,393,600.00

3,400,000.00
(1,530,000)
1,870,000.00
935,000
935,000
654,500
654,500.00

2,720,000.00
680,000
3,400,000.00
714,000

654,500.00
535,500
1,190,000.00
357,000

(680,000)
(326,400)
-1,006,400.00
292,400
2,393,600.00

(535,500)
-535,500.00
178,500
654,500.00

1,006,400.00
29.6%

535,500.00
45.0%

Problem 15.2 EcuAir (Ecuador)

MexAir is a Mexican-based airline firm with a wholly owned subsidiary in Ecuador. The subsidiary, EcuAir, has just completed a strategic
planning report for its parent company, MexAir. The following table summarizes the estimates of expected earnings and payout rates for
the years 20122015.
The current Ecuadorian corporate tax rate on this category of income is 20%. Ecuador imposes no withholding taxes on dividends
remitted to Mexican investors (per the MexicanEcuadorian bilateral tax treaty). The Mexican corporate income tax rate is 25%. The
parent company wants to repatriate 50% of net income as dividends annually.
a. What is the net income available for distribution by the Ecuadorian subsidiary for the years 20122015?
b. What is the amount of the dividend remittance expected to the Mexican parent each year?
c. After calculation ofMexican tax liabilities, what is the total dividend after tax (all Ecuadorian and Mexican taxes) expected each year?
d. What is the effective tax rate on this foreign-sourced income per year?
Country
Corporate income tax rate
Dividend payout rate
Withholding tax on dividends

Ecuador
20.0%
50.0%
0.0%

Mexico
25.0%

EcuAir Income Items (millions MXN)

Earnings before interest and taxes (EBIT)
Less interest expenses
Earnings before taxes (EBT)
Less Ecuador corporate income taxes
a. Net income
Retained earnings
Dividend remitted to Mexican parent

2012
100,000
(8,500)
91,500
(18,300)
73,200
36,600
36,600

2013
120,000
(10,000)
110,000
(22,000)
88,000
44,000
44,000

2014
135,000
(13,000)
122,000
(24,400)
97,600
48,800
48,800

2015
150,000
(15,000)
135,000
(27,000)
108,000
54,000
54,000

2012

2013

2014

2015

MXN 36,600.00
36,600.00

MXN 44,000.00
44,000.00

MXN 48,800.00
48,800.00

MXN 54,000.00
54,000.00

MXN 9,150.00
MXN 45,750.00
(11,438)
(9,150)
(2,288)
-

MXN 11,000.00
MXN 55,000.00
(13,750)
(11,000)
(2,750)
-

MXN 12,200.00
MXN 61,000.00
(15,250)
(12,200)
(3,050)
-

MXN 13,500.00
MXN 67,500.00
(16,875)
(13,500)
(3,375)
-

34,312.50

41,250.00

45,750.00

50,625.00

11,438
45,750

13,750
55,000

15,250
61,000

16,875
67,500

25.0%

25.0%

25.0%

25.0%

Mexican Taxation: Grossup

Gross dividend remitted
Less withholding taxes
b. Net dividend remitted
Add back proportion of corp income tax
Add back withholding taxes paid
Grossed-up dividend for Mexican tax purposes
Theoretical Mexican tax liability
Foreign tax credits (FTCs)
Additional Mexican taxes due?
Excess foreign tax credits?
c. Net dividend, after-tax
Total taxes paid on this income
Income before tax
d. Effective tax rate
(taxes paid/income before tax)

Problem 15.3 Kraftstoff of Germany

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 companys earnings before tax (EBT) is 483,500,000.
Kraftstoffs 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?
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 everyones best interest?
Assumptions
Dividend payout rate
Corporate income tax rate, retained
Corporate income tax rate, distributed
Added tax for retained over distributed

Part a)
50.0%
45.0%
30.0%
15.0%

Part b)
40.0%
45.0%
30.0%
15.0%

Part b)
60.0%
45.0%
30.0%
15.0%

483,500,000
(145,050,000)
338,450,000

483,500,000
(145,050,000)
338,450,000

483,500,000
(145,050,000)
338,450,000

169,225,000
169,225,000.0

135,380,000
135,380,000.0

203,070,000
203,070,000.0

Retained income
Less added tax
Retained income after-tax

169,225,000
(25,383,750)
143,841,250

203,070,000
(30,460,500)
172,609,500

135,380,000
(20,307,000)
115,073,000

Total net income, after-tax

313,066,250

307,989,500

318,143,000

Total taxes paid

170,433,750

175,510,500

165,357,000

Kraftstoff's Income Items ()

Earnings before taxes (EBT)
Less corporate income taxes @ 30%
Net income (preliminary)
Distributed income
Less any added corporate tax
Distributed income after-tax

Problem 15.4 Gamboa's Tax Averaging

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%.
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?
c. What is the minimum effective tax rate which Maria can achieve on her foreign sourced income?

Subsidiary Income Statement

Earnings before taxes
Less corporate income tax
Net income
Retained earnings
Distributed earnings
Less withholding taxes on dividends
Net dividend remitted to U.S. parent

BELIZE
$
40%

$
50.000%
10%

1,000,000
(400,000)
600,000
300,000
300,000
(30,000)
270,000

COSTA RICA
$
30%

$
50.000%
0%

1,500,000
(450,000)
1,050,000
525,000
525,000
525,000

US Tax Calculation (individually)

Net dividend remitted
Gross-up:
Withholding taxes paid
Foreign corporate income tax paid
Grossed-up dividend
Theoretical U.S. tax liability
Foreign tax credits
Additional US taxes due?
Excess foreign tax credits?
TAX AVERAGING (combined)

270,000

30,000
200,000
500,000
175,000
230,000

35%

$
$

55,000

525,000

225,000
750,000
262,500
225,000

35%

$
$

37,500
-

Total additional US taxes due after averaging

Excess FTCs to carry forward/back?
Effective tax rate on foreign source income
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.
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.

e firm is vertically integrated

ut the southeastern and
e and Costa Rica.

l management in the near

in financial management
ow attempting to put some
is tax averaging for foreign

osta Rica is a relatively low-tax

dividends paid by foreign
% withholding tax on all

due on foreign-sourced
if Maria averaged the tax

t rate of the Costa Rican

Total Income

795,000

1,250,000

$
$

437,500
455,000

$
$

37,500
55,000

$
$

17,500
36.4%

no additional taxes to the U.S.

ce income is then 36.4%.

or), the cross-credits are equal

ation. The effective tax rate on

from abroad, is the U.S.

Problem 15.5 Chinglish Dirk (A)

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?
Baseline Analysis
Assumptions
Corporate income tax rate
Desired markup on transfers
Volume
Constructing Transfer (Sales)
Price Per Unit
Direct costs
Overhead
Total costs
Desired markup
Transfer price (sales price)
Income Statement (prices x volume)
Sales price
Less total costs
Taxable income
Less taxes
Profit, after-tax

Hong Kong
16.0%
15.0%
1,000

Great Britain
30.0%
15.0%

Chinglish Dirk
(British pounds)
10,000
4,000
14,000
2,100
16,100

Torrington Edge
(British pounds)
16,100
1,000
17,100
2,565
19,665

16,100,000
(14,000,000)
2,100,000
(336,000)
1,764,000

19,665,000
(17,100,000)
2,565,000
(769,500)
1,795,500

Consolidated
(British pounds)

1,105,500
3,559,500

Repositioned Profits
Assumptions
Corporate income tax rate
Desired markup on transfers
Volume
Constructing Transfer (Sales)
Price Per Unit
Direct costs
Overhead
Total costs
Desired markup
Transfer price (sales price)
Income Statement (prices x volume)
Sales price
Less total costs
Taxable income
Less taxes
Profit, after-tax

Hong Kong
16.0%
20.0%
1,000

Great Britain
30.0%
10.0%

Chinglish Dirk
(British pounds)
10,000
4,000
14,000
2,800
16,800

Torrington Edge
(British pounds)
16,800
1,000
17,800
1,780
19,580

16,800,000
(14,000,000)
2,800,000
(448,000)
2,352,000

19,580,000
(17,800,000)
1,780,000
(534,000)
1,246,000

Consolidated
(British pounds)

982,000
3,598,000

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.

Consolidated profits, after-tax

Consolidated tax payments

Baseline
3,559,500
1,105,500

Repositioned
3,598,000
982,000

Change
1.08%
-11.17%

Problem 15.6 Chinglish Dirk (B)

Encouraged by the results from the previous problems 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 Edges 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?
Baseline Analysis
Assumptions
Corporate income tax rate
Desired markup on transfers
Volume
Constructing Transfer (Sales)
Price Per Unit
Direct costs
Overhead
Total costs
Desired markup
Transfer price (sales price)
Income Statement (prices x volume)
Sales price
Less total costs
Taxable income
Less taxes
Profit, after-tax

Hong Kong
16.0%
15.0%
1,000

Great Britain
30.0%
15.0%

Chinglish Dirk
(British pounds)
10,000
4,000
14,000
2,100
16,100

Torrington Edge
(British pounds)
16,100
1,000
17,100
2,565
19,665

16,100,000
(14,000,000)
2,100,000
(336,000)
1,764,000

19,665,000
(17,100,000)
2,565,000
(769,500)
1,795,500

Consolidated
(British pounds)

1,105,500
3,559,500

Repositioned Profits
Assumptions
Corporate income tax rate
Desired markup on transfers
Volume
Constructing Transfer (Sales)
Price Per Unit
Direct costs
Overhead
Total costs
Desired markup
Transfer price (sales price)
Income Statement (prices x volume)
Sales price
Less total costs
Taxable income
Less taxes
Profit, after-tax

Hong Kong
16.0%
25.0%
1,000

Great Britain
30.0%
8.1%

Chinglish Dirk
(British pounds)
10,000.00
4,000.00
14,000.00
3,500.00
17,500.00

Torrington Edge
(British pounds)
17,500.00
1,000.00
18,500.00
1,498.50
19,998.50

17,500,000.00
-14,000,000.00
3,500,000.00
-560,000.00
2,940,000.00

19,998,500.00
-18,500,000.00
1,498,500.00
-449,550.00
1,048,950.00

Consolidated
(British pounds)

1,009,550
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.
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.

Consolidated profits, after-tax

Consolidated tax payments

Baseline
3,559,500
1,105,500

Repositioned
3,988,950
1,009,550

Change
12.06%
-8.68%

Problem 15.7 Chinglish Dirk (C)

Not to leave any potential tax repositioning opportunities unexplored, Torrington Edge wants to combine the components of
question 5 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?
Baseline Analysis
Assumptions
Corporate income tax rate
Desired markup on transfers
Volume
Constructing Transfer (Sales)
Price Per Unit
Direct costs
Overhead
Total costs
Desired markup
Transfer price (sales price)
Income Statement (prices x volume)
Sales price
Less total costs
Taxable income
Less taxes
Profit, after-tax

Hong Kong
16.0%
15.0%
1,000

Great Britain
30.0%
15.0%

Chinglish Dirk
(British pounds)
10,000
4,000
14,000
2,100
16,100

Torrington Edge
(British pounds)
16,100
1,000
17,100
2,565
19,665

16,100,000
(14,000,000)
2,100,000
(336,000)
1,764,000

19,665,000
(17,100,000)
2,565,000
(769,500)
1,795,500

Consolidated
(British pounds)

1,105,500
3,559,500

Repositioned Profits
Assumptions
Corporate income tax rate
Desired markup on transfers
Volume
Constructing Transfer (Sales)
Price Per Unit
Direct costs
Overhead
Total costs
Desired markup
Transfer price (sales price)
Income Statement (prices x volume)
Sales price
Less total costs
Taxable income
Less taxes
Profit, after-tax

Hong Kong
16.0%
35.0%
1,000

Great Britain
30.0%
4.64%

Chinglish Dirk
(British pounds)
10,000.00
1,750.00
11,750.00
4,112.50
15,862.50

Torrington Edge
(British pounds)
15,862.50
3,250.00
19,112.50
886.82
19,999.32

(Still under 20,000)

15,862,500.00
-11,750,000.00
4,112,500.00
-658,000.00
3,454,500.00

19,999,320.00
-19,112,500.00
886,820.00
-266,046.00
620,774.00

924,046
4,075,274

Consolidated
(British pounds)
5,000

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.

Consolidated profits, after-tax

Consolidated tax payments

Baseline
3,559,500
1,105,500

Repositioned
4,075,274
924,046

Change
14.49%
-16.41%