More Complex Situations


With the preceding four lessons as essential background, this webpage covers more complex situations involving combinations of multiple years, jurisdictions, and persons. To determine the MTR, build a model or equation that appropriately considers present value concepts, combines MTRs from separate jurisdictions, and blends each person’s separate MTR. This lesson illustrates these concepts using: (1) retirement contributions that defer federal and state income tax, (2) corporate earnings distributed to shareholders in a future year, (3) a U.S. parent company with a foreign subsidiary that remits E&P annually as dividends, and (4) a U.S. parent company with a foreign subsidiary that defers dividends.


Multiple Years and Jurisdictions

The “Multiple Years” lesson illustrated how income put aside for retirement in a qualified plan might yield a fairly lowMTR. The discounted future tax payment reduces the present value of incremental tax appearing in the numerator of the MTR formula. The “Multiple Jurisdictions” lesson showed the combined effect federal and state income taxes have on the overall MTR. When retirement savings defer both U.S. and state income taxes, the following model captures the combined effect on the MTR:


(1)

Equation 1 is identical to one appearing in the “Multiple Jurisdictions” lesson except for the discount factor.

Example 1:

Allie earns $400,000 in salary and bonuses this year. Assume this income places her beyond phase-out ranges so that 35% and 6% are the federal and state tax rates, respectively, applying to any incremental income. An opportunity for $20,000 additional compensation arises. If Allie accepts this opportunity, she plans to contribute $20,000 to a qualified retirement plan. She would plan not to withdraw the $20,000 for 12 years, after which she expects her federal and state income tax rates would be 27% and 6%, respectively. Using an 8% discount rate, Allie determines her MTR related to this incremental income as follows:

 

 


 

If Allie earns the $20,000 but does not save it for retirement, her MTR related to the incremental income would be considerably higher, as shown here:

    MTR = .06 + .35 (1 - .06) = 38.9%


Multiple Years and Persons

The “Multiple Years” lesson explained how present value concepts affect the MTR. The equations in the “Multiple Persons” lesson assumed corporations annually distribute the after-tax portion of incremental income. Retaining E&P for future distribution defers the shareholder-level tax and impacts the shareholder’s MTR on corporate earnings as follows for individual and corporate shareholders, respectively:


(2)


(3)

These equations are identical to two appearing in the “Multiple Persons” lesson except for discounting the second term.

Example 2:

Bennie’s income corresponds with the 27% tax bracket. He owns all shares in Culpepper Corporation whose annual taxable income exceeds $20 million. Assuming a 5% discount rate, Bennie’s MTR related to Culpepper earning an additional $1 million profit, none of which will be distributed as a dividend for eight years, can be calculated as follows:

 

 


 

In contrast, an immediate dividend of Culpepper’s E&P attributable to the $1 incremental income would increase Bennie’s MTR to 44.8%.


Multiple Jurisdictions and Persons

The “Multiple Jurisdictions” lesson illustrated the combined effect U.S. and foreign income taxes have on the overall MTR of one person. The examples in that lesson involved a U.S. corporation and its foreign branch (i.e., a single entity). As an extension, this section considers the combined impact of U.S. and foreign income tax on two related persons--a U.S. corporation and its wholly-owned foreign subsidiary. Two assumptions simplify the analysis. The foreign subsidiary:

(1)

Resides in one foreign country and derives all its income from the same country and

(2)

Distributes all E&P currently so that both corporations incur all income taxes within one year.

Three taxes may apply to profit the foreign subsidiary earns. First, the foreign country imposes an income tax. Second, theforeign country may withhold tax on dividends the subsidiary distributes from its after-tax profit (or E&P). Third, the United States taxes the entire foreign profit. However, §902 and §903 allow the U.S. parent to claim a foreign tax credit (FTC) for foreign income tax the subsidiary pays attributable to the dividend and the dividend withholding tax, respectively. When the U.S. income tax before the FTC exceeds the sum of foreign income tax and dividend withholding tax, the foreign country can be viewed as a low-tax jurisdiction, and the following equation captures the MTR computation:


(4)

The three terms appearing in Equation 4 correspond with the three taxes the prior paragraph discusses. The second term subtracts the foreign marginal tax rate since the subsidiary no longer has the portion of profit paid as foreign income tax available for dividends. The subtractions in the third term relate to the FTC. Given the assumed low-tax jurisdiction, the U.S. residual tax (i.e., the third term) assures the MTR equals the U.S. marginal tax rate applicable to an equal amount of U.S. income.

Example 3:

Duncan, Inc., a U.S. corporation in the 34% U.S. tax bracket, creates Everest Corporation in Latvia to exploit new market opportunities. Latvia imposes a flat 25% income tax and withholds 5% on dividends remitted to a nonresident. Assuming Everest remits all E&P during the year earned, Duncan’s MTR on the incremental profit from doing business in Latvia equals:

 

 

MTR = .25 + .05 (1 - .25) + [.34 - .25 - .05 (1 - .25)] = 34%

Alternatively, if the sum of foreign income tax and dividend withholding tax exceeds the U.S. income tax before the FTC, the foreign country can be viewed as a high-tax jurisdiction. In that case, no U.S. residual tax results from the U.S. parent’s receipt of dividends since the FTC eliminates U.S. tax liability attributable to foreign profit. Equation 5 provides the MTR calculation when the foreign subsidiary resides in a high-tax foreign country:


(5)

Equation 5 is the same as Equation 4 but without the last term; U.S. residual tax disappears.

Example 4:

Assume the same facts as the prior example except Duncan establishes Everest in Spain where the foreign marginal tax rate on corporate profit is 35% and a 10% withholding tax rate applies to dividends remitted abroad. The MTR is determined as follows:

 

 

MTR = .35 + .1 (1 - .35) = 41.5%


Multiple Years, Jurisdictions, and Persons

This section explains and illustrates how a U.S. corporation determines its MTR related to incremental income of a foreign subsidiary. However, unlike the prior section, we relax the assumption that the foreign subsidiary immediately remits E&P as dividends. So, the material in this section involves multiple years (i.e., deferred dividends and related taxes), multiple jurisdictions (i.e., U.S. and foreign taxes), and multiple persons (i.e., U.S. corporation and its subsidiary). In addition to deferring actual dividends, we assume no §951 constructive dividend occurs.

Starting with Equation 6, deferring dividends requires that the MTR reflect the present values of the two taxes that apply only after the foreign subsidiary remits profits as dividends—foreign withholding tax and the U.S. residual tax. So, the last two terms appearing in Equation 4 must be discounted to determine the MTR from profit earned in a low-tax jurisdiction as follows:


(6)

Example 5:

Assume the same facts as in Example 3 except Everest does not plan to pay dividends from its current profit for 12 years and the applicable discount rate is 7%. With these changes, Duncan’s MTR attributable to Everest’s foreign profit equals:

 

 


  The dividend deferral causes the MTR to decline five percentage points vis-à-vis the MTR in Example 3.

Similarly, you can modify Equation 5 to allow for dividend deferral. Discounting the dividend withholding tax (i.e., second term) leads to the following MTR formula for profit earned in a high-tax jurisdiction via a foreign subsidiary:


(7)

Example 6:

Assume the same facts as in Example 4 except Everest does not plan to pay dividends from its current profit for 12 years and the applicable discount rate is 7%. With these changes, Duncan’s MTR attributable to Everest’s foreign profit equals:

 

 


  The dividend deferral causes the MTR to decline more than three percentage points vis-à-vis the MTR in Example 4.

This lesson explains how to compute MTRs in more complex situations involving combinations of multiple years, jurisdictions, and persons. Please take the self-tests covering these more complex situations to assure your understanding. Also, please complete the “Short Exit Questionnaire” before leaving the site.