Jean Dumenil is a senior executive for Dentex Ltd., a Canadian company operating a national chain of retail stores. His colleague and friend, George Watson, recently gave up his job as marketing manager with Dentex and has moved to the United States to start his own chain of retail stores.
Watson is trying to raise equity capital by selling shares of his new American corporation. He has approached Dumenil and offered him a 25% interest in that corporation in exchange for a $250,000 cash investment. Dumenil has confidence in Watson’s abilities and has agreed to the investment. Watson has assured Dumenil that the American corporation will pay regular dividends of $20,000 to Dumenil annually as soon as adequate cash flows permit.
Dumenil is subject to a personal marginal tax rate of 45% on income, except on Canadian dividends, which are taxed at a rate of 28% on eligible dividends and 35% on non-eligible dividends. Watson has informed Dumenil that the American corporation will pay tax at a rate of 40% on its business income. American withholding tax on dividends is 15% if paid to an individual and 5% if paid to a Canadian corporation owning more than 10% of the shares.
Required:
1. Determine the amount of tax that Dumenil will be required to pay if annual dividends of $20,000 are paid.
2. What is the combined rate of foreign tax and Canadian tax that will be paid on Dumenil’s share of the American business profits after they are distributed to him as dividends?
3. Would you advise Dumenil to create a Canadian holding corporation to own the shares of the American corporation? Explain, and provide supporting calculations.
4. If Dumenil uses a holding corporation but is going to require the annual dividends of $20,000 for personal use, how should he capitalize the holding corporation with his $250,000? Explain.