(Corp Finance) Effective Tax Rate, Split-rate corporate tax system

CFA Level II
#1

Hi all,

Please kindly show me how to approach this question. I am very confused…

Thanks!

International Pulp, a Swiss-based paper company, has annual pretax earnings (in Swiss francs) of SF 600. The corporate tax rate on retained earnings is 55%, and the corporate tax rate that applies to earnings paid out as dividends is 30%. Furthermore, International Pulp pays out 30% of its earnings as dividends, and the individual tax rate that applies to dividends is 40%.

What is the effective tax rate on corporate earnings paid out as dividends?

A)

70%.

B)

48%.

C)

58%.

Ans: C

#2

The corporation is taxed 30% on earnings paid as dividends, leaving 70% to be paid to the shareholders. The shareholders pay 40% taxes on the dividends, leaving them with 60% of the dividends paid. Thus, the shareholders end up with 42% (= 60% of 70%) of the earnings paid as dividends. If they end up with 42% of the earnings paid as dividends, the taxes paid amount to 58% of the earnings paid as dividends.

If you want a simple formula (I wouldn’t bother, personally), it’s:

1 – (1 – tc)(1 – ti) = 1 – (1 – tc – ti + tc_×_ti) = tc + ti – tc_×_ti

where:

  • tc = corporate tax rate (on earnings paid as dividends)
  • ti = individual tax rate (on dividends)

Here, that works out to:

30% + 40% – 12% = 58%.

#3

It’s pretty simple. If they spend $1 on dividends, only $0.70 gets to the stockholder because IP pays $0.30 as tax. The stockholder pays 40% of $0.70 = $0.28 in taxes, so IP and stockholder together pay $0.30 + $0.28 = $0.58 in taxes, or 58%.