Question

Fullerton Company (a U.S. taxpayer) has wholly-owned subsidiaries located in Hungary and Hong Kong. The Hungarian operation purchases electric generators manufactured by Fullerton and sells them throughout Eastern Europe; 90 percent of sales are made outside of Hungary. The Hungarian subsidiary generated pretax income of $ 200,000 in the current year. The Hong Kong subsidiary is an investment company that makes investments in world financial markets; 100 percent of its income is generated from passive investments. The Hong Kong subsidiary generated pretax income of $ 100,000 in the current year. Both subsidiaries distribute 100 percent of income to Fullerton Company as a dividend each year. Corporate income tax rates and withholding rates are provided in Exhibits 8.1 and 8.3.

Required: a. Explain why the income earned by the subsidiaries in Hungary and Hong Kong should be included in Fullerton’s U.S. taxable income.

b. Determine the amount of foreign tax credit allowed by the United States in the current year and the amount of excess foreign tax credit, if any.

Exhibit 8.1 International Corporate Tax rates, 2017

Country Effective Tax Rate (%)

Hong Kong   16.5
Hungary 9

United States 40

Exhibit 8.3

Nontreaty Withholding Rates in Selected Countries, 2017

Country Dividend Interest Royalties

Hong Kong     0 0 4.95
Hungary 0 0 0

US 30 30 30

United States 40

Answer 1

a.

Hungary meets the definition of a tax haven with respect to Subpart F income rules (Hungary’s tax rate of 9% is less than 90% of the U.S. tax rate of 21%). The Hungarian subsidiary primarily makes sales outside of its home country, which is foreign base company sales income (Subpart F income). Because non-home country sales are greater than 70% (90%) of total sales, 100% of the Hungarian subsidiary’s before-tax income is taxable in the United States, and should be allocated to the General Income FTC basket.

Hong Kong meets the definition of a tax haven with respect to Subpart F income rules (Hong Kong’s tax rate of 16.5% is less than 90% of the U.S. tax rate of 21%). The Hong Kong subsidiary generates income from passive investments, which is foreign base company passive income (Subpart F income). All of the Hong Kong subsidiary’s income is generated from passive investments, so 100% of its before-tax income is taxable in the United States, and should be allocated to the Passive Income FTC basket.

b.

		General Income Basket	Passive Income Basket
		Hungary	Hong Kong
	Pre-tax income	200,000	100,000
	Income tax rate	9%	16.5%
	Income tax	18,000	16,500
	Net income	182,000	83,500
	Dividend withholding tax rate	0%	0%
	Withholding tax	0	0

	Calculation of FTC
	Pre-tax income	200,000	100,000
	U.S. tax rate	21%	21%
	U.S. tax before FTC	42,000	21,000
	FTC allowed*	18,000	16,500
	Net U.S. tax liability	24,000	4,500
	Excess FTC	0	0
	*Calculation of FTC allowed
	(a) Taxes paid	18,000	16,500
	(b) Overall FTC limitation =	42,000	21,000
	Pre-tax income	200,000	100,000
	x U.S. tax rate	21%	21%
	FTC allowed -- lesser of (a) and (b)	18,000	16,500

General Income basket: Fullerton is allowed an FTC of $18,000, must pay an additional $24,000 in U.S. income tax, and has no excess FTC.

Passive Income basket: Fullerton is allowed an FTC of $16,500, must pay an additional $4,500 in U.S. income tax, and has no excess FTC.