Growco, a domestic corporation, is a tire manufacturer. Growco is planning to build a new production facility, and has narrowed down the possible sites for this new plant to either Happystan (a low-tax foreign country) or Sadstan (a high-tax foreign country). Growco will structure the new facility as a wholly-owned foreign subsidiary, Sproutco, and finance Sproutco solely with an equity investment. Growco projects that Sproutco’s results during its first year of operations will be as follows:
Sales............................................................................................. $400,000,000
Cost of goods sold............................................................................... (290,000,000)
Selling, general, and administrative expenses...................................................................... (60,000,000)
Net profit....................................... .............................. $ 50,000,000
Assume that the U.S. corporate tax rate is 35%, the Happystan rate is 20%, and the Sadstan rate is 40%. Further assume that both Happystan and Sadstan impose a 5% withholding rate on dividend distributions, but neither country imposes withholding taxes on interest or royalty payments.
Compute the total tax rate (U.S. plus foreign) on Sproutco’s profits under the following assumptions:
1. The new production facility is located in Happystan and Sproutco repatriates none of its profits during the first year.
2. The new production facility is located in Happystan and Sproutco repatriates 30% of its profits during the first year through a dividend distribution.
3. The new production facility is located in Sadstan and Sproutco repatriates none of its profits during the first year.
4. The new production facility is located in Sadstan and Sproutco repatriates 30% of its profits during the first year through a dividend distribution.
5. The new production facility is located in Sadstan and Growco modifies its plans for Sproutco as follows:
a. finance Sproutco with both debt and equity, such that Sproutco will pay Growco $15 million of interest each year,
b. charge Sproutco an annual royalty of $10 million for the use of Sproutco’s patents and trade secrets,
c. and eliminate Sproutco’s dividend distribution.
What do the results of these various scenarios suggest regarding the differential tax costs of operating in low- versus high-tax countries?