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Joint Committee on Taxation, Overview of Approaches to Corporate Integration (JCX-44-16), May 13, 2016

The Joint Committee on Taxation (JCT) has issued a report on ways of eliminating or lessening the effects of double taxation of corporate income.

Background—double taxation of corporations A C corporation is subject to Federal income tax as an entity separate from its shareholders. A C corporation’s income generally is taxed when earned at the corporate level and is taxed again at the individual level when distributed as dividends to its shareholders. Corporate deductions and credits reduce only corporate income (and corporate income taxes) and are not passed directly through to shareholders.

Corporate income that is not distributed to shareholders generally is subject to current tax at the corporate level only. However, to the extent that income retained at the corporate level is reflected in an increased share value, the shareholder may be taxed at capital gains rates upon sale or exchange (including certain redemptions) of the stock or upon liquidation of the corporation.

In practice, present law does not always result in the actual payment of two levels of tax on corporate earnings. The shareholder-level tax is eliminated entirely for C corporate income distributed as dividends to tax-exempt shareholders (such as charitable organizations) or individual shareholders with taxable income that would otherwise be taxed at a rate below 25%. For other shareholders, the burden may be substantially reduced, even for amounts distributed to taxable shareholders, by the lower rates applicable to dividends paid to individuals and to amounts treated as capital gains (e.g., amounts paid in certain stock redemptions). Certain foreign shareholders of U.S. corporations may also be subject to a lower rate of tax on dividends to the extent allowed by treaty.

Background—corporate income tax distortions. The report points out that the present law structure of a separate entity level tax on C corporate income creates a variety of economic distortions.

The two levels of tax on corporate form income (entity and shareholder level), as compared to the single level of tax imposed on passthrough entities (such as S corporations or partnerships), create a bias against the corporate form of organization, even in situations where nontax considerations indicate that corporate form would otherwise be preferable.

Second, there may be incentives for the retention of earnings in the corporation, which may lead to distortions in the allocation of capital to the extent that corporations with current earnings have less favorable investment opportunities than would their shareholders.

An additional distortion resulting from the present law corporate income tax rules is the incentive to finance new investments from debt rather than equity on account of the deductibility of interest payments on debt but no comparable deduction for dividends paid on equity. The tax inducement to overleverage increases both the risk of financial distress and the tolerance of corporate equity owners for operational risk (by reducing the extent to which their equity capital is at stake).

In addition, present law results in considerable complexity and tax planning as taxpayers seek to structure the most tax-favorable form of doing business and providing returns to investors.

JCT’s ideas for mitigating the distortions of double taxation. The JCT report considers several possible approaches that would mitigate the distortions of double taxation:

Complete integration. Relief from the two-tier tax can be achieved by eliminating the corporate tax and including undistributed, as well as distributed, earnings in shareholders’ gross income. Under this approach, a corporation’s undistributed earnings would be deemed to have been distributed to and reinvested by the shareholders each year. Tax could be collected at the corporate level (in effect using the corporation as a withholding agent for shareholders), or tax could be collected solely at the shareholder level without withholding. Shareholders would be subject to income tax on their allocated earnings and would adjust basis in their shares accordingly.

In one form of this mechanism, all corporations would be treated in a manner similar to either partnerships or S corporations; this treatment would include the passing through of credits and losses as well as the character (ordinary or capital gain) and source (domestic or foreign) of income. Other versions could provide for the pass through of net income but not losses in excess of income.

Full integration generally is considered to be the most theoretically desirable method of providing relief from the two-tier tax, since all income earned at the corporate level would be taxed directly and currently to the shareholders, leaving none of the possible distortions between corporate and noncorporate investment, debt and equity finance, or retention and distribution of corporate income.

However, 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 (where share ownership changes and tax attribute adjustments are common), 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. While S corporation taxation is quite similar to full integration, the use of S corporations is restricted by capital structure and the number and type of permitted shareholders, so the S corporation rules do not have to address the administrative difficulties or complexity that could arise in a broadly applicable system of full integration.

Dividend relief at the corporate level. The report suggests two techniques for providing relief at the corporate level:

(1) Deduction for dividends paid. The double taxation of corporate income may be alleviated at the corporate level by allowing a deduction for dividends paid to shareholders. Dividend payments reduce taxable income of the payor corporation, and shareholders include dividends received in gross income.

In the absence of any other provision, the result of allowing a dividends-paid deduction is to subject retained earnings to the corporate tax and distributed earnings to tax at the shareholder’s marginal rate. However, to ensure that corporate earnings bear not less than one level of tax at the corporate rate, the dividends-paid deduction must be limited to corporate earnings subject to full corporate taxation. In other words, dividends paid out of earnings not subject to full taxation by reason of corporate tax preferences should not give rise to a dividends-paid deduction. One option is for corporations to track such fully-taxed earnings in a special account. Another is for all dividends to be subject to a withholding tax (e.g., at a rate equal to the corporate tax rate), with shareholders receiving a credit.

Allowing a dividends-paid deduction brings the treatment of equity closer to that of debt, to some extent eliminating the preference in the tax law in favor of the latter.

(2) Reduction of corporate tax rate on distributed earnings. The tax burden on distributed corporate earnings could also be relieved, in part, by reducing the corporate income tax rate on those earnings (i.e., a split-rate corporate income tax). This method of providing relief from the two-tier tax could reduce concerns about incentives for debt financing and inadequate investment in the corporate sector. However, such concerns would not be eliminated so long as the corporate tax rate on distributed earnings exceeds zero.

Dividend relief at the shareholder level. The report also suggests two techniques for providing relief at the shareholder level:

(1) “Imputation” credit. One approach is to give shareholders an income tax credit to reflect all or a portion of the corporate-level tax paid with respect to dividends. The amount of the credit may be adjusted based on the degree to which partial (or full) relief from the two-tier tax is desired. Under such a system, shareholders who receive dividends are required to “gross up” the dividend by the amount of the credit for corporate taxes paid, and include the grossed-up amount in income, while using the credit as an offset to their tax liability. The gross-up and credit mechanism is analogous to the credit for taxes withheld on wages under present law. Gross-up and credit systems, also known as “imputation” systems, are used by several countries, including Australia, Canada, and Mexico. A number of these countries grant the shareholder a credit only to the extent that the corporation actually has paid tax on dividends (which is accomplished by a corporate minimum tax on distributions).

(2) Reduction of shareholder tax rates. The tax burden on both distributed and retained corporate income could also be relieved, in part, by reducing the tax rate on dividends and the tax rate on capital gains on stock sales.

Under any system of corporate integration, one question is whether dividends and capital gains should be subject to tax at the same or a similar rate. If dividends and stock sales are considered as alternative methods for shareholders to realize corporate profits, then the question arises whether, and how closely, to coordinate the tax rate on capital gains from sales of corporate stock with the tax rate on corporate distributions. Disparate tax rates on dividends and on gains may create an unintended incentive to either hold or sell stock.

And, disparate corporate and individual tax rates may create an incentive to organize business activities in corporate or noncorporate form. For example, an individual income tax rate that is substantially higher than the corporate income tax rate may create an incentive to organize business activity in corporate rather than passthrough form.

References: For corporate income tax in general, see FTC 2d/FIN ¶  D-1000  et seq.; United States Tax Reporter ¶  114  ; et seq.TaxDesk ¶  600,200  et seq.; TG ¶  4000  et seq.