Miami-based Florida Corporation manufactures electronic games that it has sold overseas for the past two years. Its foreign operations are conducted primarily through two distributors in South America who cater to the South American market and handle sales activities within their assigned areas. Florida has been shipping Spanish and Portuguese versions of its U.S. video games directly from Miami to its two South American distributors and billing the distributors for the shipments. All South American advertising, distribution, and billing activities are the responsibility of the two distributors.

In talking with Florida's chief financial officer (CFO), you learn that the company has been paying U.S. corporate income taxes at a 34% rate on its $2 million of profits generated from sales to the two distributors. The company has paid no foreign taxes on this profit because the sales to the two South American distributors have occurred in the United States. The CFO believes that the company can avoid foreign taxation because it has not set up a permanent establishment in any foreign country. The CFO indicates that she would like to reduce or defer the U.S. tax burden on part or all of these profits by setting up a South American subsidiary to distribute the games throughout South America. The subsidiary would be located in a South American country where the income tax rate is substantially less than the 34% U.S. corporate tax rate. She has found two countries with favorable business climates in which to establish an overseas presence. The maximum income tax rate in each country is 15%.

The CFO believes she can shift all or a large portion of the foreign sales profits to the country in which the subsidiary is established. By shifting part or all of the profits on the overseas sales to this country, the CFO hopes to defer the 34% U.S. corporate income tax until the profits are repatriated to the United States. Florida also hopes to obtain a tax holiday that would permit deferral or exemption of foreign income taxes as an incentive for investing in the foreign country. Ideally, the effective foreign tax rate would be 15% or lower.

Required:

Florida's CFO would like you to advise her on alternative ways to conduct the foreign sales so as to reduce and/or defer the company's worldwide tax liability. Compare the after-tax earnings that accrue to a foreign branch and a foreign subsidiary over a five-year period. What alternative business forms can Florida use to conduct its overseas activities? For each alternative, identify the U.S. tax treatment, determine the available tax savings, and indicate whether such savings reflect a tax deferral or a permanent exclusion from U.S. income taxation. In addition, identify whether Florida must establish a foreign office or manufacturing facility in a foreign country to obtain tax reductions or deferrals?