If double taxation were to occur, with a US tax rate of 34% and a foreign tax ra

Question

If double taxation were to occur, with a US tax rate of 34% and a foreign tax rate of 52%, what would be the effective tax rate on a US company generating $10,000 of taxable income in the foreign country? Now consider that the foreign tax credit (FTC) scheme is available to this US company and it operates in two countries, Canada (tax rate = 30%) and Mexico (tax rate = 52%). Assume $10,000 of taxable income in both countries. If the company has a 100% dividend policy in Canada, what should its dividend policy be in Mexico to give it the maximum tax advantage? (Show your work systematically assuming US tax rate of 34%)

Explanation / Answer

1)

Effective tax=Income *foreign tax rate +Income*(1-foreign tax rate)* US tax rate

Effective tax=10000*0.52+10000*(1-0.52)*0.34=$6832

2)

With foreign tax, the tax credit is lesser of foreign tax paid or the US tax liability

With tax credit, Net tax payable=Income*Effective tax rate-Income*Min(US tax rate, Foreign tax rate)

Net tax payable = Income *foreign tax rate +Income*(1-foreign tax rate)* US tax rate-Income*Min(US tax rate, Foreign tax rate)

For Canada net tax payable= 10000*0.3+10000*(1-0.3)*0.34-10000*Min(34%,30%)

For Canada net tax payable= 10000*0.3+10000*(1-0.3)*0.34-10000*0.3=$2380

For Mexico net tax payable= 10000*0.52+10000*(1-0.52)*0.34-10000*Min(34%,52%)

For Mexico net tax payable= 10000*0.52+10000*(1-0.52)*0.34-10000*0.34=$3432

If the US tax rate is more equal to or more than the foreign tax rate, you are applicable for claiming full tax credit you paid in the foreign country otherwise you will end up paying the higher of US tax rate and foreign tax rate.

Since the tax rate in Mexico is higher than US, it would be better to pay zero dividends in Mexico to provide maximum tax advantage

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