Workshop 10 solutions

UMAD5T-15-3 – International Financial Management

Workshop 10

Mini Cases (Source: Eun 9e):

  1. Sigma Corp.’s Location Decision. Sigma Corporation of Boston is contemplating establishing a wholly owned subsidiary operation in the Mediterranean. Two countries under consideration are Spain and Cyprus.  Sigma intends to repatriate all after-tax foreign-source income to the United States.  In the U.S., corporate income is taxed at 21 percent.  In Cyprus, the marginal corporate tax rate is 12.5 percent.  In Spain, corporate income is taxed at 25 percent.  Cyprus does not withhold tax on dividend income paid to the United States.  However, the withholding tax treaty rate Spain has with the U.S. on dividend income paid is 10 percent.

 

The financial manager of Sigma has asked you to help him determine where to locate the new subsidiary.  The location decision of Cyprus or Spain will be based on which country has the smallest total tax liability.

 

We need to calculate Sigma Corp.’s foreign tax liability as:

 

The total (income and withholding) tax liability in Cyprus will be:

 

Here, the foreign tax liability is lower than the US tax liability. Sigma can claim foreign tax credits but will still to pay the  additional taxes in the U.S., bringing the total tax liability up to the U.S. income tax rate of 21%.

 

The total (income and withholding) tax liability in Spain will be:

 

Since this is greater than the U.S. income tax rate of 21 percent, no additional taxes would be due in the U.S.  If there are excess foreign tax credits of  that can all be used by carrying them back one year and forward ten years.

In this situation, Sigma Corp. will either be paying a total tax of 21% on income sourced from its branch in Cyprus, or 32.5% on its income sourced from its branch in Spain. If excess foreign tax credits cannot all be used, as is more typically the case, the total tax liability can be as high as 32.5%.  Consequently, Sigma Corporation should establish its wholly-owned subsidiary in Cyprus.

 

  1. Eastern Trading Company’s Optimal Transfer Pricing Strategy. The Eastern Trading Company of Singapore ships prepackaged spices to Hong Kong, the United Kingdom, and the United States, where they are resold by sales affiliates. Eastern Trading is concerned with what might happen in Hong Kong now that control has been turned over to China. Eastern Trading has decided that it should reexamine its transfer pricing policy with its Hong Kong affiliate as a means of repositioning funds from Hong Kong to Singapore. Income taxes are 20% in Singapore and 17.5% in Hong Kong.

 

The following table shows the present transfer pricing scheme, based on a carton of assorted, prepackaged spices, which is the typical shipment to the Hong Kong sales affiliate.  What do you recommend that Eastern Trading should do?

 

Table 1: Eastern Trading Company Current Transfer Pricing Policy with Hong Kong Sales Affiliate

  Singapore Parent Hong Kong Affiliate Consolidated Company
Sales revenue S$300 S$500 S$800
Cost of goods sold 200 300 500
Gross profit 100 200 300
Operating expenses 50 50 100
Taxable income 50 150 200
Income taxes 10 26 36
Net Income 40 124 164

 

Eastern Trading is currently in a good situation.  Because the income tax rate in Hong Kong is less than in Singapore, Eastern Trading’s present low markup transfer price strategy results in larger pre-tax income in Hong Kong, which is taxed at only a 17.5% rate versus the 20% rate on taxable income in Singapore. If Eastern Trading is free to repatriate profits from Hong Kong, it defers paying the additional tax due (20% – 17.5% = 2.5%) in Singapore until the profits are actually repatriated.  Nevertheless, the marginal tax rate on Hong Kong taxable income will eventually be 20% upon repatriation. Therefore, since Eastern Trading is concerned about repatriation under Chinese control of Hong Kong, it might attempt to increase its transfer price.

 

If Eastern Trading is successful in increasing the transfer price, more of the taxable income per unit will be taxed at the current time in Singapore at 20%.  A 25% increase in the transfer price would raise it from S$300 to S$375 per unit.  At S$375, the split would be as follows:

  Singapore Parent Hong Kong Affiliate Consolidated Company
Sales revenue S$375 S$500 S$875
Cost of goods sold 200 375 575
Gross profit 175 125 300
Operating expenses 50 50 100
Taxable income 125 75 200
Income taxes 25 13 38
Net Income 100 62 162

 

The higher transfer price would result in only S$62 left to be repatriated from Hong Kong instead of S$124.

  1. Alpha SA Location Decision. Alpha SA is contemplating establishing a wholly owned subsidiary operation in Latin America. Two countries under consideration are Mexico and Bolivia.  Alpha intends to repatriate all after-tax foreign-source income to France.  In France, corporate income is taxed at 26.5 percent.  In Mexico, the marginal corporate tax rate is 30 percent.  In Bolivia, corporate income is taxed at 25 percent.  Bolivia does not withhold tax on dividend income paid to France.  However, the withholding tax treaty rate Mexico has with France on dividend income paid is 10 percent.

 

The financial manager of Alpha has asked you to help him determine where to locate the new subsidiary.  The location decision of Mexico or Bolivia will be based on which country has the smallest total tax liability.

We need to calculate Sigma Corp.’s foreign tax liability as:

 

The total (income and withholding) tax liability in Mexico will be:

 

Here, the foreign tax liability is higher than the France tax liability. Alpha will not pay any additional taxes to the French government. Excess tax credit of  can be carried back one year or forward ten years.

 

The total (income and withholding) tax liability in Bolivia will be:

 

Since this is lower than the French income tax rate of 26.5 percent, Alpha will pay additional taxes of to the French government, bringing its total tax liability to 26.5%.

In this situation, Alpha SA will either be paying a total tax of 26.5% on income sourced from its branch in Bolivia, or 37% on its income sourced from its branch in Mexico. If excess foreign tax credits cannot all be used, as is more typically the case, the total tax liability can be as high as 37%.  Consequently, Alpha SA should establish its wholly-owned subsidiary in Bolivia.