Senate Finance Committee Chair Orrin G. Hatch, R-Utah, may offer a long-awaited corporate integration proposal during markup of the tax reform bill in his committee that’s limited to a temporary 12.5 percent dividends paid deduction (DPD), representing a small step toward a single-level tax system.
Although congressional staff had alluded to a partial DPD potentially being part of the Senate’s tax reform plan, the most cited rate has been 40 percent without any hint that it would be introduced on a temporary basis. Hatch’s proposed amendment would limit the deduction allowed to corporations to 12.5 percent of dividends paid, but the provision would sunset after five years.
Hatch has championed corporate integration since he introduced a December 2014 tax reform report that outlined the alternatives to eliminate the two-tier corporate tax system to reduce distortions in the economic and financial choices companies make. In his amendment, Hatch emphasizes that his current proposal would reduce two distortions: the bias for debt financing over equity financing and the bias for selecting a noncorporate business form over a corporate form.
“I like the direction of the [amendment], but because it’s not giving the dividends paid deduction as the amount that’s held by the taxable shareholders . . . and because we are giving a concessionary tax rate to passthrough entity taxation, the combination of those two things [is] not allowing us to achieve parity in a way that would have occurred with a more robust dividends paid deduction proposal,” Bret Wells of the University of Houston Law Center said. He speculated that the proposal was likely limited by budget constraints.
In 2016 Hatch purportedly favored a 100 percent DPD approach with a nonrefundable withholding tax rate of 35 percent on both interest payments and dividends. Under the DPD method, corporate integration is achieved by eliminating the corporate-level tax. Corporations would be allowed to deduct dividends when distributed, and shareholders would continue to include dividends in gross income. But the withholding of dividends and interest as applied to tax-exempt entities has been an impediment to advancing corporate integration.
Tax-exempt investors — who own a substantial portion of U.S. equities — present challenges because earnings distributed to shareholders as dividends are taxed once at the corporate level, while earnings distributed to tax-exempt bondholders as interest are not taxed at all. If the objective is to tax corporate income at one level, the question becomes how to address currently exempt pension funds and charitable organizations, as well as foreign investors that avoid taxes on dividends because treaty agreements reduce the withholding rate to zero. According to estimates from Steven M. Rosenthal of the Urban-Brookings Tax Policy Center, tax-exempts, including foreign shareholders, hold about 75 percent of U.S. equities.
A congressional aide told Tax Analysts that the idea of partial integration arose when staffers dealing with issues of withholding tax on dividends paid to tax-exempts determined that they could get an equivalent result by cutting back on the DPD and removing the withholding tax. They realized that there’s an equivalence between imposing a withholding tax on dividends paid to tax-exempts for which the corporation is allowed a 100 percent deduction and simply not allowing that deduction for that portion of the dividends and not imposing a withholding tax. With the partial DPD, if tax-exempt investors own 60 percent of corporate equities, then corporations would only be allowed a 40 percent DPD, and dividend income would be taxed at least once.
Congressional aides also said they were considering how to address the issue concerning foreign investors, noting that rather than deal with treaty issues, one alternative might be to consider limiting the DPD rate rather than increasing the withholding tax in the treaty.
While the partial DPD does not fully address the debt-equity bias, it brings the tax treatment of debt and equity closer into alignment, which could lessen the incentives for inversions and earnings stripping.
Rate Reduction Complement
In September Hatch said he viewed corporate integration as a complement to a statutory corporate tax rate reduction, not a substitute. That means lawmakers should get the corporate statutory rate as low as possible and then implement a partial DPD to get the effective rate even lower, congressional aides told Tax Analysts. They said while a 40 percent DPD was being considered as a way to reach a 15 percent corporate rate without a full statutory rate cut to the same, it was not the only percentage option available under a partial DPD plan that could depend on where the statutory rate ended up.
According to the aides, a 20 percent statutory tax rate would require a 25 percent DPD, and a 22.5 percent rate would require a 33 percent DPD if the DPD were used for that purpose — achieving a 15 percent effective corporate tax rate.
Applying the math to Hatch’s proposed amendment of a 12.5 percent DPD and assuming a corporate statutory rate of 20 percent — as proposed by House and Senate taxwriting committees — that could result in a 17.5 percent effective corporate tax rate but with some corporate earnings subject to two levels of tax.
As Hatch discloses more details about his specific corporate integration proposal, the rationale for a 12.5 percent DPD available for only five years may become more apparent. Other questions remain concerning the interplay between the allowance for deducting dividends paid and the limitation on net interest expense deductions and the international tax system reforms. The Senate has proposed taxing accumulated offshore earnings, estimated at $2.6 trillion, at a substantially reduced rate — 10 percent for cash and 5 percent for other assets.
“To the extent that foreign earnings are either exempt or the earnings are not taxed because of foreign tax credit relief . . . we need to not allow that to be distributed in a way that creates a double deduction,” Wells said, urging against the adoption of a deduction that might allow for a negative tax rate.