The Senate Finance Committee held a hearing Tuesday on integrating the corporate and individual tax codes, specifically in terms of allowing corporations to deduct the dividends they pay shareholders from their taxes.
“In any discussion of an integrated system, the fundamental design choice that has to be made is whether the single instance of taxation should fall on the corporation or the shareholders,” said Senate Finance Committee chairman Orrin Hatch, R-Utah, during his opening statement. “Given the substantial burdens our corporate tax system already imposes on U.S. businesses, coupled with the relatively high mobility of corporate residence in the age of globalization, as illustrated by the recent wave of inversions and foreign takeovers, some have questioned the wisdom of collecting the tax on the corporation side. Another method of integrating the two systems would be to impose a single layer of tax at the shareholder level by allowing companies to deduct any dividends they pay out.”
Hatch described some of the benefits of such an approach. “First, a deduction for dividends paid would allow businesses to cut their own effective tax rates,” he said. “There is bipartisan agreement on the need to bring down corporate tax rates. A dividends-paid deduction could accomplish the same goal without many of the trade-offs associated with a reduction in the statutory tax rate. Second, this type of deduction would create greater parity between debt and equity. As I noted earlier, current law generally allows corporations to deduct earnings paid out as interest on debt obligations. A dividends-paid deduction would provide similar tax treatment for earnings paid out as dividends to investors, allowing companies to make debt-vs.-equity decisions after considering market conditions instead of simply referencing biases in the tax code. Third, a dividends-paid deduction could help with some of our international tax problems by reducing the pressure on companies to invert and greatly reducing the lock-out effect.”
Hatch said he plans to unveil a tax reform proposal in the next several weeks that would eliminate double taxation of corporate income by providing such a deduction. However, he acknowledged that some groups such as tax-exempt entities and retirement plans might have some concerns with a dividends-paid deduction, but said he believes lawmakers could craft a system where these parties would be treated in a way comparable to current law and in many cases would be better off.
Sen. Ron Wyden, D-Ore., the ranking Democrat on the committee, questioned the negative impact on retirement savings plans from such a deduction.
“It looks, on its face, like this proposal could go from double taxing corporate income to double taxing retirement plans,” said Wyden. “Here’s why. Today, most middle-class savers put their money into retirement plans that are tax-deferred. It’s a good deal for workers, and this country’s savings crisis would probably be a lot worse without it. Retirement plans invest in a lot of stocks and bonds. But under a corporate integration plan, when you withhold a chunk of the dividends and interest payments that go to retirement plans, suddenly they could get hit with a big, new tax bill for the first time. Their special tax-deferred status—which today is the key that unlocks opportunities to save for millions of Americans—would go away.”
Wyden pointed out that most IRA and 401(k) plan savers already face a tax bill when they take money out of their accounts. “Corporate integration could often add a second tax hit up front,” he added. "So if you’re an electrician in Medford or a teacher in Salem and you’ve got an IRA or a 401(k), you’d have to wonder if this system says the dollar you socked away is worth less than it used to be. If the math on retirement plans suddenly looks worse to small business owners, there’s a possibility they might think twice about offering a plan to their employees.”
Michael Graetz, a professor at Columbia Law School, described the history of proposals to integrate the corporate and individual tax systems in his testimony at the hearing. “In the 1990s, principally because of its administrative advantages, the Treasury Department recommended taxing business income once—at the business level,” he said. “This form of integration was advanced by President George W. Bush in 2003, but Congress instead simply lowered shareholders’ income tax rates on dividends. That approach is no longer apt today. Locating the income tax at the shareholder level would be more progressive and, given the mobility of business capital and operations, makes much more sense in today’s global economy.”
Judy A. Miller, director of retirement policy for the American Retirement Association and executive director of the American Society of Pension Professionals and Actuaries’ College of Pension Actuaries, argued against the proposal. “The tax incentives for employer-sponsored plans in place today do an efficient and effective job in allowing Americans across the income spectrum to build a secure retirement,” she said. “These incentives play a critical role in encouraging small business owners to establish and maintain a qualified retirement plan. Nondiscrimination rules combined with compensation and contribution limits assure that non-highly compensated employees also benefit from these programs. Proposals such as corporate integration that would reduce the incentives for small business owners to save for themselves through a qualified retirement plan will discourage the establishment and maintenance of these retirement plans, and so reduce the availability of workplace retirement savings.”
Steven M. Rosenthal, a senior fellow at the Urban-Brookings Tax Policy Center, expressed doubts that such a proposal would discourage corporations from moving their tax addresses abroad. “The United States could allow corporations to deduct dividends paid to shareholders,” he said. “That would reduce the taxable income of corporations and increase that of shareholders. By our calculations, however, only about a quarter of dividends are paid to taxable accounts. So, the shift might generate relatively little revenue. To keep reform revenue neutral, Congress would need to substantially increase the tax rate on dividends and capital gains—perhaps both to individuals and tax-exempt accounts and institutions. Equivalently, the United States might tax corporate earnings at the entity level but allow the shareholders to claim a credit for the tax paid by the corporation (or, alternatively, permit a dividends paid deduction coupled with a withholding tax on dividends paid to shareholders). Presumably, the credit or withholding tax would be nonrefundable to prevent a windfall for tax-exempt shareholders. But if these taxes were nonrefundable, tax-exempt shareholders, who represent the largest block of shareholders, might still pressure their corporations to shift income to lower-tax jurisdictions—or to move abroad.”
Bret Wells, a professor at the University of Houston Law Center, saw much to commend in the proposal, but cautioned about some of the possible consequences. “Focusing specifically on the dividends paid deduction regime, this particular method of achieving corporate integration would, as to distributed earnings, harmonize the tax treatment between debt and equity and would level the playing field between pass-through entities and C corporations.”
He pointed out, however, that a dividends-paid deduction would not eliminate the financial advantages that motivate earning stripping or that fuel corporate inversions.
“In order to address these two key international tax challenges, the United States must impose an equivalent withholding tax, or a surtax, on all of the related party base erosion strategies and not just on interest-stripping transactions or royalty-stripping transactions,” said Wells. “As to the lock-out effect, the dividends-paid deduction regime should substantially eliminate the lock-out effect with respect to the repatriation of low-tax foreign earnings. For companies that repatriate a significant amount of low-tax foreign income, the dividends-paid deduction regime will likely represent a net benefit versus existing law. But, outside that low foreign tax context, the interplay of the dividends-paid deduction regime with the U.S. foreign tax credit regime creates complex trade-offs. In particular, where a high percentage of a company’s total income constitutes foreign income that has been subjected to high foreign taxes, the dividends-paid deduction regime likely represents a net cost over existing law. Finally, under a dividends-paid deduction regime, a new tax design challenge will be added to our tax laws. In this regard, to the extent that the shareholder withholding tax can be cross-credited against the shareholder’s residual income tax liability arising from other income, the marketplace will attempt to structure transactions that will exploit that cross-crediting opportunity and, if successful, will create a new set of tax distortions to plague the U.S. tax laws."
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