Costa Ambrosa SpA’s Tax Averaging. Costa Ambrosa SpA is a relatively new Italian-based retailer of specialty furniture and wood carvings. The firm is vertically integrated with wood raw materials subsidiaries in Central and South America and distribution outlets throughout Europe. Costa Ambrosa’s two South American subsidiaries are in Brazil and Panama.

Alberto Ambrosi, the son of the firm’s founder, is being to groomed to take over the firm’s financial management in the near future. Like many firms of Costa Ambrosa’s size, it has not possessed a very high degree of sophistication in financial management simply out of time and cost considerations.

Alberto, however, has recently obtained his MBA and is now attempting to put some specialized knowledge on Italian taxation practices to work to save Costa Ambrosa money. His first concern is tax averaging for foreign tax liabilities arising from the two subsidiaries. Panama operations are slightly more profitable than Brazil, which is particularly good since Panama is a relatively low-tax country.

Panama’s corporate taxes are a flat 25%, and there are no withholding taxes imposed on dividends paid by foreign firms with operations there. Brazil has a higher corporate income tax rate at 34% and imposes a 5% withholding tax on all dividends distributed to foreign investors. The current Italian corporate income tax rate is 28%.

a. If Alberto Ambrosi assumes a 40% payout rate from each subsidiary, what are the additional taxes due on foreign-sourced income from Brazil and Panama individually? How much additional Italian taxes would be due if Alberto averaged the tax credits/liabilities of the two units?

b. With the same payout rate from the Brazil subsidiary of 40%, how should Alberto change the payout rate of the Panama subsidiary in order to most efficiently manage her total foreign tax bill?

c. What is the minimum effective tax rate that Alberto can achieve on his foreign-sourced income?

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Earnings before taxes Brazil Panama 1,500,000 2,500,000 Corporate income tax rate 34% 25% Dividend withholding tax rate 5% 0%