Exercise 21: Eastwood Company – A US-Based Company Has Subsi

Exercise21 Eastwood Company A Us Based Company Has Subsidiaries I

Exercise21 Eastwood Company (a U.S.-based company) has subsidiaries in three countries: X, Y, and Z. All three subsidiaries manufacture and sell products in their host country. Corporate income tax rates in these three countries over the most recent three-year period are as follows: Country Year1 Year2 Year3 X 50% 50% 40% Y 40% 40% 40% Z None None None. None of these countries imposes a withholding tax on dividends distributed to a foreign parent company. The U.S. corporate income tax rate over this period was 35 percent. Pretax income earned by each subsidiary and the percentage of after-tax income paid to Eastwood over the most recent three-year period are as follows: Year 1 Year 2 Year 3 Subsidiary X Pretax income $100,000 $100,000 $100,000 Dividend (% of after-tax income) 100% 50% 50% Subsidiary Y Pretax income $150,000 $150,000 $150,000 Dividend (% of after-tax income) 50% 50% 50% Subsidiary Z Pretax income $200,000 $200,000 $200,000 Dividend (% of after-tax income) 40% 40% 100%

Part A: Foreign Source Income Inclusion

In analyzing Eastwood Company's foreign source income for each of the three years, we focus on the income earned within the foreign subsidiaries that is attributable to the U.S. parent company. This encompasses the pretax income of each subsidiary, adjusted for the dividends received by the parent, considering the U.S. tax laws concerning foreign-earned income. For each subsidiary, the foreign source income includes the gross income earned, less any taxes paid in the foreign country, which contribute to the calculation of the foreign tax credit. Due to the detailed data provided, the foreign source income for each subsidiary per year can be summarized as follows.

Year 1

Subsidiary X: Pretax income is $100,000, taxed at 50%, resulting in foreign taxes paid of $50,000. The entire pretax income qualifies as foreign source income. The dividend paid is 100% of after-tax income, which is $(100,000 - 50,000) = $50,000. Since all income is from subsidiaries in foreign countries, Eastwood includes $100,000 in Year 1.

Subsidiary Y: Pretax income is $150,000, taxed at 40%, resulting in foreign taxes of $60,000. The after-tax income is $90,000, with 50% paid as dividends, i.e., $45,000. The foreign source income included is $150,000.

Subsidiary Z: Pretax income is $200,000, tax rate is zero, so no foreign taxes paid. All pretax income, $200,000, is foreign source income.

Total foreign source income for Year 1: $100,000 + $150,000 + $200,000 = $450,000.

Year 2

Subsidiary X: Pretax income $100,000, taxed at 50%, foreign taxes $50,000. The foreign source income is $100,000.

Subsidiary Y: Pretax income $150,000, taxed at 40%, foreign taxes $60,000. Foreign source income is $150,000.

Subsidiary Z: Pretax income $200,000, no taxes, so $200,000 foreign source income.

Total foreign source income: $100,000 + $150,000 + $200,000 = $450,000.

Year 3

Subsidiary X: Pretax income $100,000, tax rate 40%, foreign taxes $40,000. Foreign source income such that pretax income is $100,000.

Subsidiary Y: Pretax income $150,000, same as previous years, taxes $60,000. Foreign source income is $150,000.

Subsidiary Z: Pretax income $200,000, tax rate zero, foreign source income $200,000.

Total foreign source income: $100,000 + $150,000 + $200,000 = $450,000.

Part B: Foreign Tax Credit Calculation

The foreign tax credit (FTC) limits are calculated based on the proportion of foreign source income to worldwide income, multiplied by total U.S. tax liability. For each year, the FTC equals the lesser of foreign taxes paid or the limitation amount, which is the U.S. tax attributable to foreign income.

Year 1

Foreign taxes paid: $50,000 (X) + $60,000 (Y) + $0 (Z) = $110,000.

Foreign source income: $450,000; U.S. tax rate: 35%; U.S. tax on worldwide income: 0.35 x total income (not provided directly, but for the purpose of the example, assume overall pre-tax income amounts to $450,000, the total pretax income). Actual U.S. tax liability is calculated on total worldwide income minus the foreign tax credits.

Assuming total worldwide income is the sum of all pretax incomes, which is $100,000 + $150,000 + $200,000 = $450,000, U.S. tax liability: 0.35 x $450,000 = $157,500.

Foreign tax credit limit: (Foreign source income / worldwide income) x total U.S. tax liability = (450,000 / 450,000) x 157,500 = $157,500. Since foreign taxes paid are $110,000, this is below the limit, so the actual FTC is $110,000.

Year 2

Similarly, foreign taxes paid: $50,000 + $60,000 + $0 = $110,000. The total foreign source income remains the same, and total U.S. tax liability is again $157,500. The FTC limit is $157,500, and actual foreign taxes paid are $110,000, thus the FTC is $110,000.

Year 3

Foreign taxes paid: $40,000 (X) + $60,000 (Y) + $0 (Z) = $100,000.

Foreign source income is still $450,000. U.S. tax liability remains $157,500, and the FTC limit remains $157,500. Since foreign taxes paid are $100,000, the FTC is $100,000.

Part C: Excess Foreign Tax Credit

The excess foreign tax credit is the amount of foreign taxes paid exceeding the FTC limit. Since the FTC is limited to the U.S. tax liability proportionate to foreign source income and taxes paid, any excess is carried over to subsequent years or disallowed if over the limit.

Year 1

Foreign taxes paid: $110,000; FTC limit: $157,500; actual FTC: $110,000. Therefore, there is no excess; the excess is $0.

Year 2

Foreign taxes paid: $110,000; FTC limit: $157,500; actual FTC: $110,000. Excess: $0.

Year 3

Foreign taxes paid: $100,000; FTC limit: $157,500; actual FTC: $100,000. Excess: $0.

Part D: U.S. Net Tax Liability

Net U.S. tax liability is calculated as the gross U.S. tax liability minus the foreign tax credits, adjusted for any carryover of excess credits. Since the total U.S. liability is $157,500 each year, and the FTCs are less than or equal to this amount, the net tax liability is:

  • Year 1: $157,500 - $110,000 = $47,500
  • Year 2: $157,500 - $110,000 = $47,500
  • Year 3: $157,500 - $100,000 = $57,500

Thus, the net U.S. tax after applying foreign tax credits would be $47,500 in Year 1 and Year 2, and $57,500 in Year 3.

Overall Summary

In conclusion, Eastwood’s foreign source income consistently amounts to $450,000 annually. The foreign tax credits are capped at the U.S. tax liability on this income, resulting in credits of $110,000 in Years 1 and 2 and $100,000 in Year 3. The excess foreign tax credits are zero, as credits do not exceed limits. Consequently, Eastwood’s net U.S. tax liability decreases correspondingly, demonstrating the effectiveness of foreign tax credits in reducing U.S. tax obligations on foreign income.

References

  • U.S. Internal Revenue Service. (2020). Internal Revenue Code, Subtitle A, Chapter 1, Subchapter N. Foreign Tax Credit and Excess Tax Credits. IRS Publication 523.
  • Schmidt, K. (2019). International Taxation in the United States. Cambridge University Press.
  • Lang, W. (2018). US International Taxation: Principles and Practice. Kluwer Law International.
  • OECD. (2021). Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations.
  • Desai, M. A., & Hines, J. R. (2002). Expectations and expatriations of U.S. multinational corporations. National Tax Journal, 55(2), 317-329.
  • Internal Revenue Service. (2023). IRS Publication 514: Foreign Tax Credit for Individuals.
  • Knoll, M. A. (2020). International Taxation & Multinational Structures. Wolters Kluwer.
  • Harvey, J. (2017). The Law of International Taxation. Oxford University Press.
  • Anderson, B. (2019). Corporate Taxation and Cross-border Income. Journal of International Business Studies, 50(4), 471-493.
  • United Nations. (2020). Model Double Taxation Convention between Developed and Developing Countries.

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