Tax Analysts Blog

Can Corporate Integration Save Tax Reform?

Posted on Sep 14, 2017

There’s no shortage of lofty ambitions when it comes to tax reform. Among the list of aspirational goals is the concept of corporate integration—that is, rationalizing the treatment of corporations and their shareholders in a way that mitigates the double taxation of business profits. Doing so would make our tax code more neutral and reduce distortions such as the bias in favor of debt financing.

Corporate integration does not necessarily require a complete overhaul of the tax code. That’s an important observation given the polarized environment in Washington. Moreover, integration could be accomplished in a manner that’s revenue neutral and preserves the current distributional burden – leaving the door open for that rarest of political phenomena, bipartisanship.

To that end, the Senate Finance Committee has been working on an integration proposal for several years. There’s now anticipation that we will soon see the fruit of the committee’s labor in the form of a detailed integration proposal, complete with a revenue score. Some insiders expect the plan to include a partial dividends paid deduction (DPD). The following brief synopsis offers an overview on corporate integration and previews how a partial DPD might function.

Double Taxation

Tax scholars began fretting about integration more than 100 years ago, dating back to the earliest days of the corporate income tax in the 1890s. The issue became more troublesome in the 1930s when dividend taxation was introduced. Since then, our tax code has featured a dual framework for corporate profits, with separate taxes imposed at the entity and shareholder levels. A simple example illustrates the current treatment.

Let’s assume Delta Corp. earns $100 of profit. It pays tax at the statutory rate, for a tax bill of $35. The remaining $65 of profits is distributed to shareholders as dividends. That results in a second layer of tax in the amount of $15.47 (the $65 dividend multiplied by 0.238, representing the top marginal rate on qualified dividends). If you’re keeping score, that’s $50.47 in combined taxes on $100 of profits, reflecting a combined tax burden exceeding 50 percent.

The extent of double taxation would be even greater if dividends were treated as ordinary income, rather than the preferred rates associated with capital gains. Under that scenario, the secondary tax could be as high as $25.74 (the $65 dividend multiplied by 0.396, representing the top marginal rate on ordinary income). That results in $60.74 in combined taxes on $100 in profits.

These examples make several assumptions. First, we’ve assumed that Delta Corp. pays tax at the statutory rate; most companies have effective rates that are much lower. Second, we’ve assumed dividends are fully taxable in the hands of shareholders. That’s not necessarily the case. A surprisingly large percentage of shareholders are nontaxable (e.g., pension funds and non-U.S. residents). That issue was highlighted in a May 2016 Tax Notes article by Steven Rosenthal and Lydia Austin of the Urban-Brookings Tax Policy Center. According to their analysis, roughly three-quarters of all dividends across the U.S. economy go untaxed at the shareholder level. Third, our calculations ignore state-level income taxes.

Been There, Done That

Recent decades have witnessed multiple attempts at corporate integration. None were successful, suggesting that the task is deceptively difficult.

In the 1970s, several European nations took steps to integrate their corporate tax regimes. The Treasury Department’s response was to propose an expansion of S corporation status. That approach would deliver the benefits of integration to eligible firms, but do little for multinationals or shareholders – since the benefits would accrue only at the entity level.

During the 1980s, Treasury released two impressive white papers on fundamental tax reform, affectionately known as Treasury 1 and Treasury 2. Those reports proposed a DPD to alleviate entity-level taxation, but only to the extent a company distributes dividends.

The DPD proposals were noteworthy because they would reconfigure the financial incentives for distributing profits to shareholders. A DPD would also cause retained earnings to be taxed at a higher rate. Arguably that could discourage firms from making necessary long-term investments – each incremental dollar in retained earnings is a dollar not producing a tax savings via the DPD. This underscores how every tax system has its unintended consequences: current law encourages excessive debt, a DPD encourages underinvestment.

As a practical matter, any tax reform proposal that reduces the shareholder-level tax on dividends would function as a backhanded exercise in corporation integration. The Bush-era tax cuts—specifically the Jobs and Growth Tax Relief Reconciliation Act of 2003—fall into that category.

The challenge for today’s policymakers is to get the desired result of integration without making the overall tax system more regressive. That’s difficult because dividend income by nature skews toward upper-income brackets. The optics of integration will always be challenging.

Partial Integration

The Senate tax reform plan might consist of three main pillars:

• A reduced corporate rate of 25 percent;

• A partial (40 percent) DPD; and

• A territorial regime for foreign profits backed up by stringent base erosion rules.

For purposes of this discussion, we will focus on the second of these design features. A similar model was discussed by professor Bret Wells of the University of Houston Law School at a policy forum hosted by Tax Analysts in June. Wells also testified on integration during congressional tax reform hearings in 2016. You can read his testimony here.

To get a better sense of the partial DPD, let’s return to our example involving Delta Corp. We’re again assuming the company has profits of $100, but adding the new wrinkle that it pays out half that amount in dividends.

Delta would be entitled to a DPD of $20. That’s the $50 dividend multiplied by 0.40. The deduction reduces the firm’s tax base from $100 to $80, and reduces its tax bill from $25 to $20 (that’s $80 multiplied by 0.25, corresponding to the reduced corporate rate).

The dividends would be taxed at the shareholder level in a manner consistent with current law, for a secondary tax of $11.90 ($50 multiplied by 0.238, still the top marginal rate for qualifying dividends). The combined entity/shareholder tax would be $31.90 – with $20 paid by the firm and $11.90 paid by shareholders.

Next, consider the results if Delta paid out all its profits as dividends. The company would be entitled to a DPD of $40. That’s $100 in dividends multiplied by 0.40. The deduction reduces the firm’s tax base from $100 to $60, and its tax bill from $25 to $15 ($60 multiplied by 0.25).

The dividends would continue to be taxable at the shareholder level, resulting in a secondary tax of $23.80 (the $100 dividend multiplied by 0.238). The combined tax would be $38.80 – with $15 paid by the corporation and $23.80 paid by shareholders. Note that as a consequence of Delta Corp. increasing the dividends it pays to shareholders from $50 to $100, it reduces its tax bill from $25 to $15. That’s no coincidence. Central to the framework of a DPD is that firms are able to reduce their tax burden through the “self-help” of increasing dividends.

Worth the Hassle? 

Many commentators view these outcomes as desirable, in part because they tend to level the tax treatment of equity and debt. However, a partial DPD fails to achieve perfect parity between the two. One quirk of a DPD is that firms like Delta Corp. would earn the deduction as dividends are paid – which is to say, on a cash basis. By contrast, interest deductions on debt instruments are typically permitted on the accrual basis. A more ambitious DPD model would also seek to remedy such timing differences, say, by recognizing DPDs on the accrual method – that is, when dividends were declared (rather than paid).

Proponents would also argue that this framework is more closely aligned with the available treatment for passthrough entities, such as partnerships, S corporations, or LLCs. By closing that gap, the tax code would remove incentives to shift to noncorporate structures solely for tax reasons.

Would the partial DPD appeal to the Republican lawmakers who now control Congress? The 25 percent rate is higher than many would like. Specifically, it’s higher than the rate proposed by the House GOP blueprint (20 percent) and the rate endorsed by the White House (15 percent). However, the suggested framework has a much stronger chance of being revenue neutral. In fact, there are variations of a DPD proposal that are revenue positive.

Perhaps the greatest obstacle facing the partial DPD is what to do about nontaxable shareholders, as referenced above regarding the Rosenthal-Austin paper. A future article will examine the pros and cons of imposing a withholding tax to address those concerns.

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