Question

Assume a Chinese affiliate repatriates as dividends one-quarter of the after-tax profits it earns (ie, dividend payout ratio = 25%). If the income tax rate in China is 30% and there is a withholding tax of 15%, what is the effect on the parent comany's US tax bill if the Chinese affiliate had pre-tax profit equal to $1,000,000 USD? Assume the US Tax rate is 35%. Please show work.

Answer 1

The effect on the parent company’s tax bill if the Chinese affiliate had pre-tax profit equal to $1,000,000

Foreign subsidiary income before local taxes                                  $1,000,000

Less Foreign income tax at 30 %                                                            - 300,000

Income Available for dividends                                                              700,000

Declared as a dividend (25% payout)                                                    175,000

Less foreign dividend withholding tax at 15%                                      -26,250

Cash dividend amount received in the U.S.                                        $148,750

While calculating the amount of foreign tax credit allowed, the U.S. parent can take all of the withholding tax plus that portion of foreign income taxes paid. The formula to calculate the amount of creditable deemed-paid tax is following

Deemed-paid credit = {Dividends received (including withholding tax) / after-tax net earnings and profits of foreign corporation} * creditable foreign taxes

= {175,000/700,000} *300,000

= 75,000

Therefore the tax credit calculation is as follows-

Dividend received (before withholding tax)                                                    $175,000

Plus foreign deemed-paid tax 75,000

Gross dividend included in U.S. taxable income                                               250,000

U.S. (tentative) tax thereon at 35 %                                $ 87,500

Less credit for

    Foreign income taxes paid                                           - 300,000

    Foreign withholding taxes paid                                    -   26,250

Additional U.S. taxes due                                                    none

Total taxes actually paid ($300,000+$26,250)                                             $326,250

No additional U.S. taxes are due because the combined foreign income and withholding tax rate exceeds the U.S. tax rate.