Manufacturing Capacity Decisions with Demand Uncertainty and Tax Cross-Crediting

Abstract

The U.S. tax law taxes the global income of multinational firms (MNFs) at their home country tax rate. To avoid double taxation, it permits tax cross-crediting. Through this strategy, global firms can use excess foreign tax credits (FTCs), the portion of foreign tax payments that exceed their home country tax liabilities, generated from a subsidiary located in a high-tax country to offset the tax liabilities of their low-tax divisions. This paper studies manufacturing capacity decisions in the subsidiary of an MNF with tax cross-crediting. Casting the problem on a newsvendor model, and assuming the objective of maximizing the global firm’s worldwide after-tax profits, we show that the optimal capacity decision under the effects of tax cross-crediting can behave very differently from that of the traditional newsvendor model. In particular, we show that an improvement in the firm’s after-tax profitability (through tax cross-crediting, an increased profit margin, or a reduced tax rate) might reduce the optimal capacity and that the optimal capacity decision under certain circumstances can be made without the knowledge of the demand distribution. We also discuss the issue of motivating the division manager to use an after-tax performance measure with a managerial tax rate.