Corporate Tax Bulletin (January 2003)
Bush Administration Proposes Eliminating
Double Tax on Corporate Earnings
a tax partner in the New York office of Pillsbury
Winthrop Shaw Pittman LLP. Other tax partners
contributing to this article are
James T. Chudy
Julie A. Divola and
Keith R. Gercken
(San Francisco) and
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January 21, 2003 explanation of the
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Broad Implications and Technical Complexity
Current federal income tax law generally subjects
corporate earnings to two levels of taxation first at
the corporate level and then again at the shareholder level.
On January 7, 2003, President Bush announced a
proposal to eliminate the double tax by excluding from
shareholder income dividends paid out of previously taxed
corporate earnings. Two weeks of speculation and
confusion followed, quelled somewhat by the January 21
release of a detailed explanation that significantly altered
Further details will likely be fleshed out through
additional public statements, more comprehensive written
guidance and wrangling in the tax legislative and lobbying
community. The timing of actual
draft legislation may depend on the
speed of the budget process.
Deceptive in its apparent
simplicity, the proposal has broad
implications for investors and
corporations, and raises complex technical issues.
The proposal would integrate corporate and
shareholder income taxation by excluding certain
dividends from shareholder income.
- The exclusion would apply only to dividends paid
out of earnings that had been fully taxed at the
corporate level, with a two year lag. For example, a
dividend paid in 2006 would be excludable only if
the corporation showed a 2004 tax liability on its
return filed during 2005.
- Corporations would maintain an "excludable
dividend account," or EDA, to determine fully taxed
income from which excludable dividends could be
- Corporations would continue to maintain earnings
and profits, or E&P, accounts as under current law.
- A corporation that did not distribute its entire EDA
as an excludable dividend could allocate retained
EDA (up to its E&P) to its shareholders, permitting
them to increase their stock bases. This "retained
earnings basis adjustment," or REBA, would reduce
the amount of any gain (or increase any loss) on a
later sale of the stock.
- Corporations would be required to maintain
records of the total REBAs made with respect to
prior tax years. This calculation would be known
as the cumulative REBA, or CREBA.
- Dividends in excess of the EDA would be treated
(i) first as a return of basis and then as capital gain
to the extent of CREBA, (ii) then
as a taxable dividend to the extent
of E&P, (iii) then as a return of
capital to the extent of the
shareholder's remaining basis and
(iv) thereafter as capital gain.
- The proposal generally would be effective for
dividends paid on or after January 1, 2003, with
respect to corporate earnings after 2001.
The proposal has broad implications for investors and
Corporate Finance. Although the proposal would not
make dividends deductible, it may lower the cost of equity
financing sufficiently to bring preferred stock back into
favor. Corporations may choose to refinance debt with
equity. Would the terms of preferred stock include
provisions to "gross up" dividends paid to shareholders to
make them whole if dividends were to become taxable
again in the future? Would it mean the demise of "hybrid"
preferred securities that pay interest for tax purposes?
While the proposal would generally repeal the 70
pecent and 80 percent dividends received deductions, or
DRD, available to corporate shareholders, it would remain
available for distributions of pre-2001 E&P made before
2006, but only with respect to stock issued before February
3, 2003. For stock issued on or after that date, dividends
paid to corporate shareholders would be taxable to the
extent the proposed exclusion did not apply.
Choice of Investment Vehicle. Distributions from
401(k) accounts and IRAs would still be taxable, even if
dividends paid into the accounts would have been
excludable by a taxpaying shareholder. Would individuals
shift dividend-paying investments out of 401(k) accounts
and IRAs and into their taxable investment accounts?
Could we expect significant changes in the marketing of
mutual funds to different investor bases?
Effective Tax Rate Management
Corporate tax shelters, offshore
other tax-reduction techniques could be turned on
their heads. Since corporations that do not pay taxes
would have no benefit to pass on to their shareholders,
could the proposal create new incentives for a corporate
tax manager to pay income taxes? That might depend on
the composition of his shareholder base.
Corporate managers, as well as investors, generally
prefer corporate earnings not to fluctuate from year to
year. Taxable income, generally only an internal concern,
tends to fluctuate more than earnings. Would the proposal
put pressure on a tax manager to make taxable income
follow earnings more closely?
Dividend Policy. The proposal is intended to bring
tax-neutrality to dividend policy. Would cash-rich
corporations come under pressure from investors to pay
or increase their dividends? What about cash-strapped
but otherwise tax-paying corporations?
Traditionally, dividends have been a way to
demonstrate that claimed earnings are real. Would
corporate managers lose some of the discretionary control
they have over the use of cash reserves? The proposal may
generally foster increased corporate transparency and
accountability as shareholders focused on what
corporations were doing with those reserves.
State and Local Finance. Would states and cities that
base their own income taxes on federal taxable income
suffer significant reductions in tax revenues? Would their
financing costs increase as a result of the competition
posed by tax-free dividends?
Margin Accounts. Under the proposal, otherwise
excludable dividends on debt-financed stock would be
includable in shareholders' income. Investors might move
away from holding dividend-paying stocks in margin
Stock Loan Transactions. Would the proposal make
short selling more complicated and costly? Would
shareholders insist that their shares not be lent around
the time of a dividend if it would result in their receiving
a taxable fee in lieu of an excludable dividend? Would
only tax-exempt investors, such as pension funds and
charitable organizations, be willing to lend stock? Would
stock lenders demand higher fees?
Dividend Reinvestment Programs. The proposal would
presumably eliminate any current bias against dividend
Compensation Planning. In the closely-held context,
with individual rates higher than corporate rates (and
employment taxes as an additional cost of compensation),
would there be a new preference for dividends over salary
payments to employee-shareholders?
Choice of Business Entity. To what extent would the
proposal slow the ascension of the limited liability
company as the small business entity of choice? To what
extent would it push the S corporation further into
Tax complexity abounds in this seemingly simple
Corporate Income Tax. Corporations would continue
to calculate and pay income tax under current rules and
rate schedules. The corporate alternative minimum tax,
or AMT, would continue to apply.
Earnings and Profits. Corporations would continue
to maintain calculations of E&P as under current law.
Calculating EDA. Corporations generally would pay
excludable dividends in a particular year to the extent of
EDA for that year. The formula for calculating EDA would
divide the U.S. income taxes (other than estimated taxes)
shown on the corporation's returns filed in the
immediately preceding year (i.e., in respect of earnings
from two years before the year of the dividend payment)
by the maximum corporate tax rate (currently 35 percent),
then subtract the taxes shown on the return. (This is
mathematically the same as multiplying taxes paid by
approximately 1.86.) For this purpose, U.S. income taxes
would include taxes on foreign source income that had
been offset by foreign tax credits. (This would presumably
add pressure to the perennial problem of excess foreign
tax credits.) They would also include AMT. For purposes
of calculating EDA, U.S. income taxes paid at lower
graduated rates, or at the AMT rate, would be treated as
having been paid at the maximum 35 percent rate,
effectively understating the pool of taxed earnings in most
Income taxes paid for a particular year would also
include deficiency assessments paid in that year, and would
be reduced (but not below zero) by any income tax refunds
received during that year.
An EDA would include excludable dividends received
from other corporations in the prior year and any REBAs
for the prior year with respect to stock owned by the
It is not clear whether other permanently excludable
items (e.g., tax-exempt interest) would also be included
in a corporation's EDA.
Distributions and CREBA. A corporation that did not
distribute its entire EDA for a particular year could, to the
extent of its E&P, allocate all or a portion of its
undistributed EDA to its shareholders, thereby increasing
their stock bases. Any such retained earnings basis
adjustments, or REBA, would not be taxable, but would
reduce the corporation's EDA and E&P.
Basis increases would be allocated in the same manner
as distributions, except that they could not be allocated to
preferred stock. (It is not entirely clear how a corporation's
EDA would be distributed among multiple classes of
A corporation would be required to maintain records
of its cumulative REBA, or CREBA.
A corporation that distributed dividends in excess of
its EDA would still be able to pay those amounts tax-free
to its shareholders to the extent of its CREBA. Such
amounts would be a tax-free return of capital to the
shareholders, resulting in a stock basis reduction, and
thereafter would be taxable as capital gain. Any further
distributions in excess of the CREBA would be a taxable
dividend to the extent of E&P, then a tax-free return of
capital to the extent of the shareholder's remaining basis
and thereafter capital gain.
Redemptions. Under current law, a stock redemption
may be treated either as a sale or exchange or, under certain
circumstances, as a dividend. The proposal would retain
current rules, but could modify certain attribution rules,
particularly as they relate to options.
A redemption treated as a sale or exchange would
reduce pro rata the corporation's current year EDA and
Other Anti-"Bailout" Provisions. In addition to the
rules treating certain redemptions as dividends, a number
of other provisions that convert capital gains into
dividends would be retained. Feared for decades, these
provisions could suddenly become popular, turning
decades of tax planning around 180 degrees.
Tax Refunds. In general, if a refund was due in a
particular calendar year, the refund would be paid to the
extent the corporation had paid taxes shown on a final
return previously filed in that calendar year. If any refund
remained unpaid, the corporation could recompute its
EDA for the current year as if the refund had reduced the
tax previously used to compute that year's EDA. This
would permit the corporation to receive an additional
refund amount. Any unpaid refund would be credited
against future tax liability (and therefore presumably
against future EDAs).
Net Operating Loss Carrybacks. Under current law,
net operating losses, or NOLs, may be carried back two
years. Under the proposal, a corporation would be able
to carry back an NOL only one year. If an NOL were
carried back, the EDA for the loss year would have to be
Carryover of Tax Attributes. Current rules providing
for the carryover of certain tax attributes in a tax-free
reorganization or liquidation would be amended to
provide for the carryover of a target's EDA and CREBA.
Rules would also provide for the allocation of CREBA in
a tax-free spin-off.
Current section 269, intended to discourage
tax-motivated transactions, would apply to acquisitions
undertaken to obtain an EDA or CREBA. Since EDAs
generally would expire at the end of each year, however,
the proposal does not contemplate a rule, similar to section
382, to limit attribute use after a change of control.
Consolidated Returns. Consolidated return
regulations would be amended, for example to provide
that EDA be calculated on a consolidated group basis,
based on income taxes of the group, and then allocated
among members based on their separate taxable income.
No EDA would be allocated to a member that generated a
loss, however. Current investment adjustment rules, rather
than the basis adjustment rules contained in the proposal,
would continue to apply to members of a consolidated
Corporate Penalty Taxes. The proposal contemplates
repeal of the accumulated earnings tax and personal
holding company tax.
Foreign Corporations. U.S. income taxes on effectively
connected income would be treated as U.S. income taxes
in calculating a foreign corporation's EDA. Branch profits
taxes would not be so treated, however, and they would
reduce the foreign corporation's EDA. The corporation's
EDA would also be increased by any excludable dividends
it received as a shareholder, as well as allocations of
CREBA, and reduced by any U.S. withholding taxes, which
would not be treated as U.S. income taxes for purposes of
the EDA computation.
U.S. shareholders would not be entitled to foreign tax
credits for taxes paid or accrued with respect to EDA and
It is unclear to what extent the proposal would
necessitate changes to the various complex anti-deferral
measures relating to non-repatriated foreign earnings,
such as the CFC (controlled foreign corporation) and
PFIC (passive foreign investment company) rules.
Real Estate Investment Trusts and Mutual Funds.
REITs and mutual funds would be permitted to pass on
to shareholders their excludable dividend income and
REBA basis adjustments. However, they would not be
entitled to a deduction for distributions designated as
excludable or from CREBA. For purposes of their
distribution requirements, excludable dividends would be
treated in the same manner as tax-exempt interest.
S Corporations. The S corporation rules would be
retained, with certain modifications. An S corporation
liable for corporate income tax (e.g., because of built-in
gain) would have an EDA. Distributions in excess of EDA
and CREBA would generally be treated as they are under
Shareholder Limits. Many of the rules limiting the
shareholder benefits of tax-exempt interest or dividends
otherwise eligible for the DRD would apply to otherwise
excludable dividends. These would include the
holding-period rules under current section 246(c) limiting
eligibility for the DRD, the extraordinary dividend stock
basis reduction rules under section 1059, the section 246A
DRD prohibition for debt-financed portfolio stock and
the section 852(b)(4) loss disallowance rule for mutual
fund shareholders that receive exempt-interest dividends
on shares held for six months or less.
Shareholder AMT. The proposal would not affect the
AMT. Excludable dividends would not be an AMT
adjustment or preference. In addition, they would not be
a preference for adjusted current earnings for corporate
Foreign Shareholders. U.S. withholding tax would
continue to apply to dividends paid to foreign shareholders
out of E&P, and would apply to distributions from CREBA.
Withholding would not apply to REBA allocations, which
would not increase a foreign shareholder's basis (and a
distribution from CREBA would not decrease basis).
In the case of a foreign corporate shareholder,
distributions of excludable dividends (reduced by U.S.
withholding taxes), but not REBAs, would increase the
foreign corporation's EDA. Distributions from a
corporation's CREBA would be treated the same as an
Employee Stock Ownership Plans. Under the proposal,
an otherwise excludable dividend would be taxable, and
would not reduce EDA, if it was deductible by the paying
corporation. REBA basis adjustments would not be
permitted to be made to stock held by an ESOP. A
corporation would be permitted a deduction for
distributions from CREBA in respect of shares held by an
ESOP, and such distributions would not reduce stock basis
and would be taxable to the ESOP.
Private Foundations. Excludable dividends and
CREBA distributions would not be taxable to a private
foundation as net investment income.
The proposal has encountered widely differing
amounts of enthusiasm and opposition from various
lawmakers, economists, business leaders, editorialists and
others in a position to influence policy. It remains to be
seen whether the proposal will be enacted in its current
Material Available On-Line
We have posted a copy of the January 21, 2003
explanation of the President's proposal from the
U.S. Department of the Treasury,
Eliminate the Double
Taxation of Corporate Earnings, which is also available
via ftp at:
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