Issues regarding incidence of two-tier tax

There is considerable uncertainty about the economic effects of the two-tier tax or the extent of the possible distortions it may cause. While taxes are generally considered to provide a disincentive to savings and investment, there is little agreement concerning the effect of the two-tier tax on economic activity. One source of the uncertainty is the widely varying circumstances of corporations and their shareholders-differing effective tax rates, degree of ownership, behavioral assumptions, etc. Another source is lack of agreement about who bears the burden of the corporate tax either in the short run or the long run.

Many, especially those who favor relief from the two-tier tax, believe that the imposition of the two-tier tax reduces the rate of return for individuals on assets placed in corporate solution. If so, the tax is effectively borne by shareholders whose income then is considered to be overtaxed, with resulting disincentives for savings and investment in activities appropriately conducted in corporate form.

Others, however, believe that the imposition of the two-tier tax results in higher prices for products produced by the corporate sector of the economy, lower wages for workers in the corporate sector, or both, in order that an adequate return remains for the capital invested therein. Thus, to the extent that higher prices or lower wages result from the corporate tax, the burden of the tax is borne by either consumers or workers. To any such extent, the twotier tax would not necessarily constitute a disincentive for investment in corporate form, although issues would remain relating to the neutrality of the tax system with respect to decisions about debt or equity financing and income retention or distribution. 36

Some have suggested that relief from the two-tier tax should be granted only as an incentive for particular goals. For example, some proponents of broader employee ownership of corporations have suggested that relief for distributed earnings could be granted only when a corporation has a specified percentage of employee stock ownership, or has an increasing percentage of such ownership. Similarly, it has been suggested that the present law deductibility of interest be limited to situations where the debt is incurred to advance the desired goal.37

Method of granting relief

The 10-percent dividends paid deduction contained in the Administration proposal would be a modest step toward elimination of the two-tier tax. Assuming that the rate reductions in the Administration proposal are enacted, the effect of the dividends paid deduction would be to reduce the burden of the two-tier tax from 23 to 20 percentage points.38

36 Further, to the extent that the corporate tax is "passed on," it could not be said to contribute to the progressivity of the tax system.

37 Employee stock ownership plans are discussed in a separate pamphlet prepared by the Staff of the Joint Committee on Taxation. See n. 2, supra.

38 Under present law, where corporate earnings are taxed at a 46 percent rate and the aftertax earnings are distributed to an individual shareholder who is taxed at a 50 percent rate, the total taxation is 73 percent (.46 + .50(1-.46)) or 23 percentage points greater than a single shareContinued

In view of revenue needs and the existing uncertainty regarding whether a two-tier tax is inappropriate, some have questioned whether the modest reduction in the possible distortions that the Administration proposal affords in any particular case is worth the estimated five-year (fiscal years 1986-1990) aggregate revenue cost of $21.3 billion. 38

Others contend that some measure of relief from the two-tier tax is appropriate. In addition, some contend that the Administration's proposed mechanism for relief may establish an approach that could be expanded if further relief were desired in the future.

Assuming relief from the two-tier tax is considered desirable, a number of different mechanisms-of which the Administration's dividends paid deduction is one-could be considered.

Full integration

Full integration through a deemed distribution and reinvestment system is generally considered to be the most theoretically desirable method of providing the relief, since all income earned at the corporate level would be taxed directly and currently to the shareholders, leaving none of the possible distortions described above.

However, such a system is also considered to be difficult to implement. One traditional objection to this form of relief, concern that imposition of tax at individual rates on allocated corporate income may result in liquidity problems for shareholders whose marginal rates exceed the rate of tax collected at the corporate level, has been substantially diminished by the closer approximation of the top nominal corporate and individual tax rates, though the actual effective tax rate of a particular shareholder and a particular corporation might differ within the range up to the top nominal rates.

Nevertheless, considerable administrative difficulties are inherent in a system of full integration. For example, the need to allocate a corporation's tax attributes among all its shareholders (particularly in the case of a widely held public corporation the shares of which change hands frequently, and adjustments to whose tax attributes is commonplace), as well as the resulting need for individuals to account for potentially complex items such as foreign tax credits, intangible drilling costs and the like, pose what many consider to be insurmountable obstacles to the general implementation of this system.

Lowering corporate taxes

Lowering corporate taxes would reduce the extent of double taxation of corporate earnings. This method of affording relief from the two-tier tax could reduce concerns about incentives for debt financing and under investment in the corporate sector. However, such concerns would not be eliminated so long as there is a corpo

holder level tax of 50 percent. Under the Administration proposal, where corporate earnings are taxed at a 33 percent rate but the corporation receives a 10 percent dividends paid deduction, and the after-tax earnings are distributed to an individual shareholder who is taxed at a 35 percent rate, the total taxation is 55 percent ((.33-.033) +.35(1-(.33-.033)) or 20 percentage points greater than a single shareholder level tax of 35 percent.

38 Staff of the Joint Committee on Taxation, Estimated Revenue Effects of the President's Tax Reform Proposal (JCS-26–85), July 26, 1985.

rate level tax. Moreover, the lower the corporate effective tax rate relative to the individual effective tax rate, the greater the incentive will be for a corporation to retain rather than distribute earnings.

Dividends paid deduction vs. shareholder credit

The dividends paid deduction (proposed by the Administration) and the shareholder credit are generally considered the two most feasible methods of implementing some relief from the two-tier tax and are generally considered economic equivalents. They operate to provide relief only with respect to distributed income. The main economic distinction between the two methods (where a credit is refundable) is that the dividends paid deduction initially puts cash generated by the tax relief in the hands of the corporation, while an imputation system puts the cash in the hands of the sharehold

ers.

The Administration proposal states that the dividends paid deduction is chosen primarily because the Administration considers it somewhat easier than an imputation system to implement. A dividends paid deduction requires no additional accounting by individual recipients of dividends, though it would impose some additional accounting and reporting requirements on a corporation paying dividends. A corporate recipient of dividends would also have accounting requirements that might prove difficult to administer, since accurate accounting for a recipient corporation's QDA may require adjustment to reflect subsequent adjustments in a payor corporation's income tax liability.

An imputation system would impose accounting and reporting requirements similar to those required for the dividends paid deduction on corporations paying and receiving dividends. However, it would also require individual shareholders to account for dividends differently, not simply by including them in income but by using the gross-up and credit calculation.

Nevertheless, an imputation system may offer some advantages over the dividends paid deduction if it is considered desirable to limit the relief in the case of certain shareholders-for example, foreign or tax-exempt shareholders. (See discussion under "International Aspects-Foreign shareholders" and under "tax-exempt shareholders", below.) Accordingly, despite the relatively small additional administrative burden placed on individuals, consideration may be given to use of an imputation system rather than a dividends paid deduction if relief from the two-tier tax is to be implemented.

Dividend exclusion for individuals

The Administration proposal would eliminate the present-law dividend exclusion for individuals. As discussed above, the dividend exclusion for individuals tends to benefit high-bracket taxpayers more than low-bracket taxpayers. A dividend credit system, as described above, could provide more equal benefits.

Moreover, according to the Treasury Department, over three quarters of individuals who report dividend income receive the benefit of the entire amount of the exclusion available under present law. For these individuals the exclusion does not lower the margin

al income tax rate on dividend income, and thus it appears that the exclusion generally does not encourage additional investment in corporate equity in any significant way, Furthermore, the present dividend exclusion eliminates the tax-based incentives relating to debt or equity financing or the distribution or retention of earnings only to a minimal extent.

Treatment of intercorporate distributions—the dividends received deduction

Distributions out of untaxed earnings

Under the Administration proposal, the dividends paid deduction and the corporate dividends received deduction generally operate to relieve corporate level tax only when earnings are distributed and to ensure that intercorporate distributions do not result in additional corporate level tax.

Under the Administration proposal (as under present law), a corporate shareholder is entitled to a dividends received deduction even when the corporate earnings from which the dividends were paid bore no corporate tax. The proposal grants a 100 percent dividends received deduction in any such case, while present law would grant a 100 percent deduction in the case of certain direct investments and an 85 percent deduction in the case of portfolio investments.

To the extent that permitting a dividends received deduction for corporate shareholders is justified as a means of ensuring that earnings bear only one corporate tax, it may not be appropriate to permit a dividends received deduction where the effect of doing so is to prevent any corporate tax at all.

The ability to pass through losses through intercorporate stock investment can place additional pressure on distinctions between equity and debt. Under present law, preferred stock is often structured so that it has characteristics that make it very similar to debt. For example, the dividend rate on the stock may be related to prevailing interest rates but provide an after-tax yield that is more favorable to a corporate shareholder than fully taxable interest and less costly to the corporate issuer. Either public trading or a call feature (where there is an intention to call) might provide the holder of the preferred stock with access to the return of the advanced funds. A corporation with substantial net operating losses (and thus no current tax liability) may issue preferred stock to another corporation instead of issuing debt. Since the interest deductions on additional debt would not be of any immediate benefit to the issuing corporation, a benefit is effectively transferred to the purchasing corporation which receives dividend income that is 85 percent tax-free instead of fully taxable interest income. Thus, the issuance of preferred stock to a corporation may be considered a technique for transferring tax benefits.

Consideration could be given to limiting the availability of the dividends received deduction to amounts paid out of earnings that have been taxed. An account like the QDA might be used for the purpose of determining whether dividends are paid out of earnings that have been taxed, regardless of whether a dividends paid deduction is implemented.

On the other hand, some may contend that to the extent a corporation has funds available for distribution that have not been taxed and this is a result of tax incentives at the corporate level, the benefit of those incentives should be preserved and passed through as long as the earnings remain in corporate solution. (See discussion under "Treatment of tax preference items," below.)

Portfolio investment

Under the Administration proposal, the dividends paid and dividend received deductions operate to relieve corporate level tax on intercorporate distributions without regard to whether the distributee corporation is a mere portfolio investor or is a direct investor that could be viewed as effectively operating through the payee corporation. The Administration proposal is similar to present law in this respect, although present law does impose a maximum 6.9 percent ordinary income tax on intercorporate dividends on portfolio stock, while dividends to a direct corporate investor are not taxed.

Some contend that allowing corporate shareholders a dividends received deduction with respect to portfolio investment is contrary to the general treatment of corporations and shareholders as separate taxable entities. Furthermore, as noted above, given the ability to structure preferred stock so that it closely mimics debt, it is contended that the dividends-received deduction for portfolio investment may frequently permit loss passthroughs between otherwise unrelated corporations. 39

Dividends received deduction and shareholder basis

Under present law, as under the Administration proposal, the basis of a corporate shareholder's stock in another corporation is not generally reduced when dividends that are excludable from the recipient's income are paid.4 40

Present law does require reduction of basis where certain “extraordinary dividends" are paid on stock held less than a year (sec. 1059). This rule, added by the Deficit Reduction Act of 1984, is intended to prevent certain "tax arbitrage" transactions. In these transactions, a corporation would buy stock of another corporation prior to a large dividend payment (at a purchase price reflecting the value of the dividend). The corporate stockholder would receive the dividend subject to a maximum 6.9 percent tax due to the dividends received deduction, retain its original stock basis, and then sell the stock, after the dividend, at a loss (reflecting a market decline of approximately the amount of the dividend) worth up to 46

39 In the past, Congress has limited the benefits of the dividends received deduction in certain cases. For example, in the Deficit Reduction Act of 1984, Congress added section 301(f), which provides that certain provisions of section 312 (relating to the computation of earnings and profits) would not apply with respect to distributions to certain "20-percent shareholders," where the effect of applying such provisions would tend to treat a greater amount of distributions as eligible for the dividends received deduction. That Act also added section 246A, which limits the availability of the deduction in certain cases where a corporate shareholder holds portfolio stock that was debt financed.

40 Under Treasury regulations, in the case of affiliated corporations filing a consolidated tax return, the basis of a parent corporation's stock is generally reduced by dividends out of preaffiliation earnings (deemed reflected in the parent's basis) or out of post-consolidation earnings and profits that have increased basis (Treas. Reg. sec. 1.1502-32).