A group of about 50 tax directors from many of the largest U.S. companies are sitting in a conference room at the J.W. Marriott Hotel in Washington, D.C. The tables are arranged in a rectangular pattern with the tax directors sitting on the outside of the tables. They are listening to a Republican staffer from the U.S. Senate Committee on Finance, who is discussing integration of the individual and corporate tax systems.
Republican Staffer: “As many of you may be aware, in December 2014, our staff issued a report in which we devoted about 100 pages to corporate integration—namely, that the earnings of a corporation should be subject to only a single level of tax and, in addition, the tax treatment of debt and equity should be brought into alignment.”
Some of the tax directors are listening politely to the staffer, while others are looking down, checking for messages on their Blackberries or iPhones.
Republican Staffer: “In our report, we discuss eight different methods of integration. However, more recently, we have settled on one method, which we believe may be the ideal method of integrating the individual and corporate-level taxes. That method is the dividends-paid deduction coupled with a withholding tax, which is designed to address tax-exempt and foreign shareholders.”
The staffer continues and makes a statement that seems to capture the attention of almost everyone in the room.
Republican Staffer: “There are a number of important aspects of the dividends-paid deduction. One is the financial accounting benefit.”
The tax directors who were listening politely are now focused intently on the staffer’s comments. Those tax directors checking their messages now look up, attempting to take in the comments of the staffer.
Republican Staffer continues: “Under current FASB rules, the dividends-paid deduction would create a permanent difference for financial accounting. As a result, it would lower a company’s effective tax rate, increase its net income, and increase its earnings per share. The other major methods of corporate integration have no financial accounting impact on the company.”
The tax directors nod, almost in unison, when the staffer discusses the importance of the financial accounting benefit of a dividends-paid deduction. After the presentation, a number of tax directors approach the staffer and ask how soon a dividends-paid deduction could be enacted and how corporate America could assist in its enactment.
I. Introduction
In the years leading up to the most recent tax reform effort, the Tax Cuts and Jobs Act, signed into law on December 22, 2017, by President Donald J. Trump, there was a lot of discussion among policymakers as to reforming the tax Code. On the individual side, there was very little agreement on what form tax reform should take. For example, some policymakers wanted to eliminate a number of exclusions, deductions, and credits, thereby broadening the income tax base, and coupling that with a reduction in the individual statutory tax rates. Others wanted to shift the tax system to a consumption-based tax system through, for example, enactment of a value-added tax or an exemption from the tax base for income derived from capital. Some policymakers wanted simply to retain the current individual income tax system, particularly after the enactment of a higher individual statutory tax rate as part of the fiscal cliff deal in early 2013.
While there was little agreement on the individual side, there seemed to be near unanimous agreement on the business side that the 35% top statutory corporate tax rate was too high and needed to be significantly reduced. There also seemed to be widespread agreement that the current international tax system needed to be substantially reformed. Although there was widespread agreement in corporate America and among policymakers to reduce the corporate tax rate and reform the international tax system, there was very little movement in doing so. As a result, business tax reform was at a standstill for a number of years.
Corporate integration, which is the concept of integrating the individual- and corporate-level tax systems into one system (if structured properly), seemed as if it could help break the business tax reform logjam in a bipartisan manner. However, as part of the Tax Cuts and Jobs Act, which was enacted by Republicans as part of the budget reconciliation process with no Democratic input or votes, Congress reduced the corporate tax rate from a top rate of 35% to a flat rate of 21%—a 40% reduction. In addition, Congress substantially reformed the U.S. international tax system, creating a hybrid between a territorial and a worldwide, no-deferral system. Although corporate integration was a substantial part of the discussion leading up to the enactment of the Tax Cuts and Jobs Act, given the 14-percentage point reduction in the corporate tax rate and a substantially revised U.S. international tax system, integration ideas simply fell by the wayside.
With the November 2020 election of Joseph Biden as president and majority control of both the House and the Senate in the hands of the Democrats, major changes to both the corporate and U.S. international tax systems are expected. Some of the expected changes include an increase in the corporate tax rate, an increase in the tax rate on dividends and capital gains, and a shift of the U.S. international tax system more towards a worldwide, no-deferral system. Such changes, which would make the United States a bit of an outlier in certain areas when compared to the other member countries of the Organisation for Economic Co-operation and Development (OECD), would increase the relevance and importance of corporate integration.
Corporate integration has been discussed by tax scholars and policymakers for many years. It has been strongly supported by both groups; however, corporate America has been traditionally lukewarm to corporate integration. This Article argues that, if structured properly, corporate America could support corporate integration. With the backing of both corporate America and policymakers on both sides of the aisle, corporate integration could be enacted, achieving many of the goals of sound tax policy.
Part II gives an introduction and some background on corporate integration. Part III provides a brief history of corporate integration proposals. Part IV explains how corporate integration achieved through a (partial) dividends-paid deduction could get the backing of corporate America and the entire business community. Part V explains how policymakers could, on a bipartisan basis, support corporate integration and, thereby, achieve meaningful business tax reform.
II. What Is Corporate Integration?
The United States has what is generally referred to as a classical system of taxing corporate earnings. The earnings of a corporation are taxed first at the corporate level. Then, when the corporation distributes the earnings to its shareholders in the form of a dividend, the earnings are taxed a second time at the shareholder level. For many years, the U.S. Treasury Department, the organized tax bar, and other interested parties have advanced a number of proposals to integrate the individual and corporate level of taxes so that corporate earnings are subject to only a single level of tax.
Eliminating the two-tier tax system would reduce or eliminate at least four distortions to economic and financial choices: (1) the incentive to invest in noncorporate businesses rather than corporate businesses, (2) the incentive to finance corporations with debt rather than equity, (3) the incentive to either retain or distribute earnings depending on the relationship among the corporation, the shareholder, and the capital gains tax rates, and (4) the incentive to distribute earnings in a manner to avoid or significantly reduce a second level of tax, such as payments giving rise to deductions or stock repurchases that give rise to basis recovery and capital gains.
Under an integrated system, the earnings of a corporation would only be subject to a single level of tax—either at the corporate level or at the shareholder level. In addition, under some methods of corporate integration, the tax treatment of debt and equity would be brought into alignment. Under current law, interest on debt is deductible, with some limitations, while dividends paid to shareholders are not. Equalizing the tax treatment of debt and equity could involve allowing a corporation to deduct dividends or disallowing a deduction for a corporation’s interest expense.
In December 2014, the Republican staff of the United States Senate Finance Committee released a 340-page report on comprehensive tax reform. A large portion of the report was devoted to corporate integration. As a result of the report, there was a resurgence of interest in corporate integration among tax scholars, corporate America, and even among some policymakers. Unfortunately, with the enactment of the Tax Cuts and Jobs Act in December 2017, interest in corporate integration subsided.
Tax scholars have been proposing corporate integration for many years. In addition, some administrations have shown interest in corporate integration, including the Carter, Reagan, Bush 41, and Bush 43 Administrations. The business community, however, has traditionally not shown a lot of interest in corporate integration. The lack of interest by the business community may be one reason why corporate integration has never been fully implemented. In fact, in 2016, Senator Orrin Hatch (R-UT), then chair of the Senate Finance Committee, stated: “[T]here is a graveyard near the White House full of prior [corporate] integration proposals.” But corporate integration, if done properly, can garner the backing of the business community.
With regard to policymakers, in recent times there has been a huge emphasis on tax reform generating economic growth, capital investment, and jobs. This may have been due, in part, to the adoption of dynamic scoring in the House of Representatives in 2015. From 2003 to 2014, the staff of the Joint Committee on Taxation (JCT) was required by House Rule XIII(3)(h)(2) to provide a macroeconomic impact analysis of all tax legislation reported by the Ways and Means Committee. In most cases, the expected effects were so minor that the JCT only provided a brief statement. On January 6, 2015, the House modified its rules requiring the use of dynamic scoring for the estimates of “major legislation,” which was defined to be any bill with a gross positive or negative revenue impact in any year in excess of 0.25% of gross domestic product (GDP). The new rule required a single point estimate (i.e., one figure) within the budget window of the revenue effect due to the macroeconomic response to the proposed legislation. A qualitative analysis was also required for the 20-year period after the budget window.
A bill could also be deemed major legislation by the chair of the Ways and Means Committee (for tax bills) or the chair of the Budget Committee (for spending bills scored by the Congressional Budget Office). In spring 2015, a similar rule was approved by both the House and the Senate in Congress’s joint budget resolution. As a result, 2015 was the first year that dynamic estimates had to be used in budget scoring (and not just as supplemental information). Although the House, in 2019, removed all requirements related to macroeconomic analysis and dynamic scoring, policymakers are still very focused on the impact on economic growth, capital investment, and jobs in any tax reform proposal. And, if control of the House changes in the near future, the requirement of macroeconomic analysis and dynamic scoring may be restored.
The last tax reform in 2017 was accomplished strictly along party lines. Republicans drafted the Tax Cuts and Jobs Act and passed it without a single Democratic vote in either the House or the Senate. The Biden Administration is proposing tax reform that may also be done strictly along party lines. Corporate integration could bring the parties together and achieve, at least in part, bipartisan business tax reform.
III. Brief History of Corporate Integration
In 1909, Congress enacted a corporate income tax and, four years later, an individual income tax. As a result, beginning in 1913, both corporations and individuals were subject to income taxes. Congress minimized the risk of double taxation of corporate earnings by excluding dividends from the normal tax on individual income.
In 1936, Congress enacted a dual or split-rate corporate income tax. Distributed corporate income (i.e., corporate income paid out as dividends) was taxed at rates ranging from 8 to 15%, and undistributed corporate income (i.e., corporate retained earnings) was subject to an additional surtax with rates ranging from 7 to 27%. The split-rate system, was a form of corporate integration, with the additional surtax on undistributed corporate income encouraging a substantial increase in dividend payouts. In 1938, the undistributed corporate income surtax was repealed.
During the 1950s and 1960s, there was very modest corporate integration. In the early to mid-1970s, serious interest began to surface with regard to integrating the individual and corporate-level taxes in the United States. The Treasury Department took the lead by stressing the need for integrating the individual and corporate taxes to keep pace with many foreign countries that had integrated their tax systems. Treasury noted the many benefits of integration including, eliminating the bias in favor of debt, improving the efficiency of capital allocation, making the capital markets more competitive, lessening the tension between ordinary income and capital gain, and significantly helping utilities and other industries whose investors rely on a steady stream of dividends.
In 1975, Treasury advanced its proposal for integration, with a combination of two methods. Corporations would deduct approximately half of their dividends (a dividends-paid deduction) and shareholders would be allowed a credit for the income taxes paid by the corporation (a shareholder or imputation credit mechanism).
Two years later, Treasury issued “Blueprints for Basic Tax Reform” proposing full corporate integration by having the income of a corporation flow through to its shareholders. As a result, corporate earnings would be fully taxed to the shareholders at the rates appropriate to each shareholder.
Also, in 1977, the JCT issued a pamphlet addressing the need for greater capital accumulation with a suggestion of integrating the corporate and individual income taxes. The JCT discussed three methods of integration: a shareholder or imputation credit in which the shareholders would claim a credit for the corporate income taxes allocable to the dividends received; a flow-through approach in which all corporate income would flow through to the shareholders along with the corporate income taxes paid that would be creditable by the shareholders; and a dividends-paid deduction in which corporations would deduct any dividends paid to the shareholders.
Later in 1977, the Treasury Department presented a proposal for integrating the individual and corporate income taxes through an imputation credit regime. A portion of the corporate income tax would be treated as a withholding tax on dividends to the individual shareholders who would then be allowed a credit in calculating the shareholder’s tax liability. The Carter Administration ultimately decided not to pursue corporate integration.
During the 1980s, the American Law Institute (ALI) joined the Treasury Department in actively proposing corporate integration. In 1982, the ALI published a Reporter’s Study on corporate distributions. The Reporter’s Study included three proposals, all of which were related to corporate integration: a dividends-paid deduction in an amount not exceeding a statutorily specified rate on newly issued stock; a flat-rate, compensatory withholding tax on nondividend distributions; and a proposal establishing differing tax treatment between direct and portfolio investment by a corporation in the stock of another corporation.
In November 1984, the Treasury Department issued a report advocating a substantial reform of the income tax system. As part of its report, which is generally referred to as Treasury I, Treasury proposed relief for the double taxation of corporate earnings through a dividends-paid deduction. However, Treasury limited the deduction to 50% of the dividends paid, based on revenue concerns.
In May 1985, President Ronald Reagan submitted to the Congress a revised version of the Treasury report generally referred to as Treasury II. In the report, the amount of the dividends-paid deduction was reduced from 50% (in Treasury I) to only 10% of the dividends paid, again based on revenue concerns.
In December 1985, the House of Representatives passed the Tax Reform Act of 1985. As part of its bill, the House included a ten percent dividends-paid deduction (like Treasury II) but phased it in over ten years. The House’s dividends-paid deduction proposal was not enacted as part of the Tax Reform Act of 1986.
In June 1989, the ALI issued a supplemental study to its 1982 corporate tax study proposing a dividends-paid deduction but only with respect to corporate equity acquired after the date of enactment (new equity). The ALI’s reasoning in limiting the dividends-paid deduction to new equity was that the capital markets had already discounted the price of pre-enactment corporate equity (old equity) to reflect the two levels of taxation of corporate earnings.
In January 1992, the Treasury Department published a report on integrating the individual and corporate tax systems noting that “most trading partners of the United States have integrated their corporate tax systems so as to tax business income only once.” In its report, Treasury did not endorse any specific integration proposal but discussed in detail four prototypes to achieve integration: a dividend-exclusion prototype, a shareholder allocation prototype, a comprehensive business income tax prototype, and an imputation credit prototype. In December 1992, Treasury issued a supplemental report to its integration study recommending that Congress enact the dividend-exclusion prototype to integrate the individual and corporate tax systems.
In March 1993, the ALI published an extensive report on corporate integration proposing an imputation credit prototype to alleviate double taxation. In essence, the ALI proposal would convert the corporate income tax into a withholding tax with respect to income distributed to shareholders.
In May 2003, Congress passed the Jobs and Growth Tax Relief Reconciliation Act of 2003. As part of the Act, Congress provided “preferential” tax treatment for dividend income thereby achieving partial corporate integration. Most types of dividend income would be taxed the same as net capital gain. The preferential tax treatment for dividend income was scheduled to expire at the end of 2008 but was extended and finally made permanent by the American Taxpayer Relief Act of 2012.
In 2005, the Bush Administration established a tax advisory panel on tax reform, and four years later, the Obama Administration established a similar tax reform panel. The Bush Administration panel, called the President’s Advisory Panel on Tax Reform, recommended two options that would integrate the individual and corporate-level taxes. Under the first option, which the panel called the Simplified Income Tax Plan, all dividends paid by U.S. corporations out of domestic earnings would be excluded from the shareholder’s gross income and 75% of the capital gains on the sale of stock of U.S. corporations would be excluded from gross income. Under the second option, which the panel called the Growth and Investment Tax Plan, a uniform tax would apply to a business’s cash flow with no deductions for interest or dividends. At the individual shareholder level, a flat rate tax of 15% would apply to dividends, interest, and capital gains.
The Obama Administration panel, called the President’s Economic Recovery Advisory Board, issued its report in 2010 on tax reform options noting that one option to achieving tax neutrality with respect to the organizational form of business is through integration. The board gave as an example the imputation credit method of achieving integration, noting that a number of OECD countries, including the United Kingdom, Canada, and Mexico, have used such a system.
In December 2014, the Republican staff of the Senate Finance Committee issued a report entitled, “Comprehensive Tax Reform for 2015 and Beyond.” In the report, the staff devoted over 100 pages to corporate integration, detailing eight different methods of integration, including the dividends-paid deduction, the dividend-exclusion method, and the shareholder-credit method. The Republican staff’s report generated a significant amount of interest in corporate integration.
In 2016, the Senate Finance Committee held two hearings on corporate integration—the first one focusing on the dividends-paid deduction and the second one on the differing tax treatment of debt and equity. Some of the witnesses included leading tax scholars advocating for a dividends-paid deduction, including Professors Michael Graetz, Alvin Warren, and Bret Wells, as well as a leading tax practitioner, John McDonald.
IV. Getting Corporate America and the Business Community on Board
Any business tax reform proposal has to get the backing of the business community to have much of a chance of enactment. The business community can be divided into the corporate world (e.g., C corporations) and the pass-through world (e.g., partnerships, S corporations, and sole proprietorships). The corporate world, in turn, can be subdivided into nonpublicly traded and publicly traded corporations. One reason why corporate America has been lukewarm on the idea of corporate integration may be due to the lack of a tax benefit to the corporation under most integration proposals. For example, under the dividend-exclusion method, a shareholder that receives a dividend from a corporation excludes the dividend from gross income. Most, if not all, shareholders would like this result. However, there is no direct tax benefit to the corporation under the dividend-exclusion method. Similarly, under the shareholder-credit method, a shareholder that receives a dividend also receives a credit for corporate taxes paid by the corporation. Again, most if not all shareholders would like the shareholder-credit method since it alleviates much of the tax owed by the shareholder upon receipt of the dividend. However, the corporation receives no direct tax benefit.
In contrast to the dividend-exclusion method and the shareholder-credit method, under the dividends-paid deduction, a corporation receives a tax benefit from deducting a dividend. The tax benefit increases the corporation’s cash flow. For nonpublicly traded corporations, cash flow is probably the single most important financial indicator. Of the 1.6 million C corporations currently in existence, about 4,000 are publicly traded. For the nonpublicly traded C corporations, the double tax of corporate earnings is of great concern to many of them. Many of the nonpublicly traded C corporations eliminate the double taxation through deductible payments, typically salary, to the shareholder/officers of the corporation. But the compensation must be reasonable, and any excessive compensation can be recharacterized as a dividend resulting in double taxation. In addition, when the shareholders sell the C corporation, double tax can result, which has given rise to the use of personal goodwill in an attempt to alleviate the double taxation. A dividends-paid deduction could reduce the two levels of taxation of corporate earnings, while also giving a cash-flow benefit to the corporation.
For publicly traded corporations, the financial accounting treatment is critically important—in many cases, more important than the tax treatment. In the past, there seems to have been little thought given to the financial accounting consequences of corporate integration. This is understandable, as the importance of financial accounting to publicly traded corporations seems to have increased in more recent times. Under some integration proposals, the corporation’s financial accounting consequences are not directly affected by corporate integration. However, the dividends-paid deduction can provide a financial accounting benefit, which is important for publicly traded corporations.
A. Background on Financial Accounting
One of the keys to getting the attention and support of much of corporate America with respect to any business tax reform is an appreciation for its financial accounting treatment. A publicly traded corporation “is required to compute its income for financial accounting purposes each year in accordance with generally accepted accounting principles. The resulting income figure is referred to as pretax financial income or pretax book income (PTBI).” The corporation will also compute its income tax expense for the year, which is subtracted from pretax financial income, resulting in the corporation’s net income. In addition, a corporation’s income is subject to taxation by federal, most state, and several local taxing authorities. As a result, a corporation must also compute its income for tax purposes in accordance with the applicable tax statutes and regulations of these various jurisdictions. The resulting income figure is referred to as taxable income. In almost all cases, a corporation’s taxable income will differ from its pretax financial income. In fact, the determinations of taxable income for these various jurisdictions almost always differ from each other and also from pretax financial income. These differences primarily reflect the different objectives behind the various taxing authorities and the accounting rules.
The tax rules are designed to provide equitable and efficient determination of tax liability and subsequent collection of revenue, and also to provide incentives for corporations and individuals to engage in a particular activity based upon the priorities and revenue needs of the various taxing authorities. The financial accounting rules are designed to paint a picture of the corporation’s operations that is consistent in its measurement on both an annual basis and across entities such that creditors, shareholders, management, and any other properly interested persons can evaluate the absolute and relative performance of the corporation. The Financial Accounting Standards Board (FASB) has written:
The objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful to existing and potential investors, lenders, and other creditors in making decisions about providing resources to the entity. Those decisions involve buying, selling, or holding equity and debt instruments and providing or settling loans and other forms of credit.
While the rules for determining pretax financial income are fairly rigorous and based upon underlying economic assumptions and principles, the various taxing authorities have promulgated laws and regulations for determining taxable income that do not necessarily follow rules grounded on the economic theories of financial reporting but, rather, may be based on political, social, or economic objectives. In addition, the difference between a corporation’s taxable income and its pretax financial income may be due to tax planning strategies engaged in by the corporation, resulting in lower taxable income relative to pretax financial income.
Numerous items create differences between taxable income and pretax financial income. Some of these differences are permanent differences and others are temporary differences (sometimes referred to as timing differences). Permanent differences are (1) items that enter into pretax financial income but never into taxable income or (2) items that enter into taxable income but never into pretax financial income. As a result, these items create a difference between pretax financial income and taxable income that will not reverse over time (i.e., they are permanent differences). FASB has not specifically defined permanent differences; however, FASB has written:
Some events do not have tax consequences. Certain revenues are exempt from taxation and certain expenses are not deductible. In some tax jurisdictions, for example, interest earned on certain municipal obligations is not taxable and fines are not deductible.
Temporary differences are generally (1) items that enter into pretax financial income earlier than when the item enters into taxable income or (2) items that enter into taxable income earlier than when the item enters into pretax financial income. As a result, pretax financial income is different from taxable income in the year in which the temporary difference arises. In a subsequent year(s), when the item giving rise to the temporary difference reverses, an offsetting difference is created between pretax financial income and taxable income. As a result, these items create a difference between taxable income and pretax financial income that will reverse over time (i.e., they are temporary differences).
B. The Focus of Corporate Management
Before discussing corporate integration in detail, it may be helpful to summarize the financial indicators that are critical to corporate management. The following is the first paragraph of a January 26, 2021, press release from Microsoft:
REDMOND, Wash.—January 26, 2021—Microsoft Corp. today announced the following results for the quarter ended December 31, 2020, as compared to the corresponding period of last fiscal year:
Revenue was $43.1 billion and increased 17%
Operating income was $17.9 billion and increased 29%
Net income was $15.5 billion and increased 33%
Diluted earnings per share was $2.03 and increased 34%
The following are the headline and the first three paragraphs of a CNBC news story on Microsoft earnings:
Microsoft reports 17% revenue growth as cloud business accelerates
Microsoft stock rose as much as 6% in extended trading on Tuesday after the company reported fiscal second-quarter earnings Azure cloud revenue growth and quarterly revenue guidance that exceeded analysts’ expectations.
Here’s how the company did:
- Earnings: $2.03 per share, adjusted, vs. $1.64 per share as expected by analysts, according to Refinitiv.
- Revenue: $43.08 billion, vs. $40.18 billion as expected by analysts, according to Refinitiv.
Microsoft revenue grew 17% on an annualized basis, up from 12% growth in the prior quarter, according to a statement.
As a general proposition, which is supported by the Microsoft press release and the CNBC news story, corporate management (and the business community) is extremely focused on the income statement, often called the statement of income or statement of earnings. In business parlance, it is usually referred to as the P&L statement (i.e., profit and loss statement). The income statement is the “report that measures the success of a corporation’s operations for a given period of time.” In looking at the income statement, several key items stand out. First, operating income and net income are viewed as the primary indicator of the performance of corporate management. In its press release, Microsoft reported operating income and net income for the quarter of $17.9 billion and $15.5 billion, respectively, and compared those figures to Microsoft’s operating and net income in the same period a year earlier. In many cases, the board of directors of a publicly traded corporation will focus on the income of the corporation in evaluating the performance of corporate management. Investors and analysts will also look at a company’s operating and net income in evaluating the company’s performance.
Corporate management desires a sufficient amount of income each quarter to try and meet or exceed the expectations of Wall Street so that the market price of the stock will increase. One effect of an increasing stock price is to increase the value, if any, of management’s stock options. Generally, corporations prefer, if possible, to show steady growth each period in operating and net income rather than wild swings in income from period to period.
While corporate management focuses on operating and net income, the financial world generally focuses on a corporation’s earnings per share (EPS). More specifically, EPS is considered to be the most significant business indicator in the financial world. In its press release, Microsoft reported EPS of $2.03 per (diluted) share and compared that figure to Microsoft’s performance a year earlier—an increase of 34%.
A corporation’s basic EPS is equal to its income available to common shareholders (i.e., income from continuing operations (operating income) or net income less dividends on preferred stock) divided by the weighted average number of common shares of its stock outstanding. Its diluted EPS is computed as if all convertible securities (outstanding convertible preferred shares, convertible debentures, stock options, and warrants) were exercised. Because EPS is calculated using the corporation’s net income (and income from continuing operations), both EPS and net income are directly related (i.e., a higher net income will lead to a higher EPS). A corporation must disclose its EPS on the face of its income statement.
A publicly traded corporation must also disclose its effective tax rate reconciliation in the footnotes to its financial statements filed as part of Form 10-K. This disclosure is referred to as the “tax footnote.” Generally, a publicly traded corporation desires that its effective tax rate be comparable to or lower than the industry average. More specifically, a corporation wants a lower effective tax rate than its main competitors. In addition, a publicly traded corporation desires to sustain a low effective tax rate.
The effective tax rate is computed by dividing the corporation’s income tax expense attributable to income from continuing operations by income from continuing operations. The income tax expense includes both current tax expense and deferred tax expense. The deferred tax expense is computed based on a corporation’s temporary differences. Because the tax effects of the temporary differences are included in deferred tax expense, a corporation’s effective tax rate is not affected by temporary differences (unless a rate change takes place).
Publicly traded corporations greatly value permanent differences, which may increase a corporation’s income and its EPS as well as lowering its effective tax rate. In contrast, temporary differences have no immediate impact on a corporation’s income, its EPS, or its effective tax rate. Generally, a temporary difference may provide a transitory cash-flow benefit. As a result, many, if not most, publicly traded corporations place little value on temporary differences.
C. Dividends-Paid Deduction as a Permanent Difference
As a general rule, when a corporation pays a dividend, it does not treat the dividend as an expense for financial accounting purposes, and it does not deduct the dividend for federal income tax purposes. The corporation reduces its retained earnings by the amount of the dividend so that the dividend has no impact on the corporation’s income statement.
The different methods of integration can have a widely different effect on the financial accounting treatment of the corporation. If the dividend-exclusion method of integration is adopted, the corporation’s financial statements should remain unchanged from current law. If, however, the dividends-paid deduction method is adopted, the financial accounting treatment may be quite beneficial to a corporation. FASB has provided that:
The amount allocated to continuing operations is the tax effect of the pretax income or loss from continuing operations that occurred during the year, plus or minus income tax effects of . . . tax-deductible dividends paid to shareholders.
The remainder is allocated to items other than continuing operations in accordance with the provisions of paragraphs 740-20-45-12 and 740-20-45-14.
As a result, the dividends-paid deduction creates a permanent difference for the corporation, in that the dividend is deductible for tax purposes but is not an expense for financial accounting purposes. By being a permanent difference, the dividends-paid deduction would decrease a corporation’s effective tax rate. It would also increase the corporation’s cash flow.
To illustrate the financial accounting treatment of the dividends-paid deduction, assume a publicly traded corporation has $1 million of pretax financial income and $1 million of taxable income. The corporation pays a dividend of $300,000. The corporation’s pretax financial income remains unchanged because the dividend is not an expense for financial accounting purposes. The corporation’s taxable income is reduced to $700,000. At a 21% corporate tax rate, the corporation will owe $147,000 in corporate income taxes. The corporation’s effective tax rate is lowered from 21% to 14.7% as a result of the dividends-paid deduction. The dividends-paid deduction creates a permanent difference for financial accounting purposes.
Figure 1, a portion of the information from Lockheed Martin’s 10-K for 2020, illustrates the effect of a dividends-paid deduction on its effective tax rate. Lockheed Martin notes in its 10-K that:
We receive a tax deduction for dividends paid on our common stock held by certain of our defined contribution plans with an employee stock ownership plan feature. The amount of the tax deduction has increased as we increased our dividend over the last three years, partially offset by a decline in the number of shares in these plans.
Figure 1*
