54 Tax Notes 114

Tax Notes

JANUARY 13, 1992

LENGTH: 1810 words

DEPARTMENT: This Week's Tax News (NEW)

CITE: 54 Tax Notes 114

HEADLINE: 54 Tax Notes 114 - INTEGRATION DISCUSSION HIGHLIGHTS ALI MEETING IN SAN ANTONIO.

AUTHOR: Johnson, Calvin

Tax Analysts

INDEX: rates, corporate corporate tax, integration dividends tax policy

TEXT: 13 JAN 92

Professor Alvin Warren of Harvard Law School presented the American Law Institute's thinking about integration of the corporate income tax at a meeting of tax law professors on January 4. Warren is the reporter of the current ALI project on corporate integration. In a presentation at the Association of American Law Schools (AALS) meeting in San Antonio, Texas, Warren argued that the United States is the last of the developed countries to give up the classical corporate tax system, which taxes distributed corporate income twice. He presented the issues and alternatives that will arise in moving to a single-level tax on corporate income. (For related news, see the preceding story.)

The classical, double tax on corporate income distorts economic choices in several ways: The double tax discourages investment in new shares; It encourages corporations to finance projects with retained earnings or debt, rather than sale of shares; It encourages corporations to distribute earnings in redemptions or other nondividend distributions, so that shareholders can use their basis and be eligible for capital gain; and it encourages corporations to retain corporate earnings to avoid shareholder-level taxes.

Warren warned that the last distortion is not true when corporate rates are higher than individual rates, as they are now. In fact, corporations now have an incentive to distribute their earnings rather than retain them to achieve compounding of investment income under the lower shareholder rates.

Warren presented four alternative approaches to avoid the economic distortions: repeal both the corporate tax and the realization convention and tax shareholders on increases in the value of unsold shares that are due to corporate earnings; tax such corporations as partnerships and S corporations and pass through earnings to the shareholders; exclude dividends from shareholder tax; and treat the corporate tax as if it were a withholding tax paid by a corporation on behalf of its shareholders and thus allow shareholders a refundable credit for the corporate tax that they could use against their tax due on dividends.

ALI Approach

The ALI will pursue the last alternative, treating the corporate tax as a withholding tax. The ALI study did not intend to preclude the possibility of some system of valuation of shares or allocation of corporate earnings, but those remedies seemed initially to involve too complicated a change from current law. Exclusion of dividends, while simple, would preclude imposing the variable shareholder tax rates that arise in a progressive tax system. Warren treated the withholding alternative as equivalent in result to a corporate deduction for dividends paid.

Warren identified a number of issues under the withholding tax regime. Sometimes the money a corporation has distributed has not borne corporate tax. The nontaxation might arise, for instance, from corporate borrowing on appreciated but unsold assets. Or it might arise from intended or accidental tax preferences.

The general solution among U.S. trading partners is enactment of an auxiliary tax on corporate distributions to ensure that shareholder credit is given only for corporate tax that has in fact been paid. Warren was unsympathetic to 'super-integration' systems that give shareholders tax credits with respect to distributions although no corporate tax has been paid, but he allowed that specifically identified tax credits might be passed through to shareholders as incentives.

Awaiting distributions to give shareholders credit presents problems. If corporate rates are higher than the shareholder's tax rate, then retained earnings are discouraged. Shares that are sold, moreover, bear a second tax, a capital gains tax, on share gains that result from corporate earnings.

The ALI will pursue a solution first suggested by the Canadian Carter Commission. Corporations will be able to treat retained earnings as if they had distributed the earnings to identified shareholders and then received them back as contributions that increase share basis. The corporate tax will be set equal to the highest individual rate so that the constructive dividend will involve either no added shareholder tax or a refund to the shareholders to whom the constructive dividends are allocated.

Warren also suggested that nondividend distributions, treated as a sale or exchange to the shareholders under current law, would carry out some pro rata portion of the previously taxed corporate income.

Tax-exempt shareholders such as pension funds and charities present problems because some corporate earnings have borne tax before distributions and some have not. Interest on debt, for instance, bears no tax. But nominally tax-exempt shareholders in fact bear tax on dividends because their corporations pay tax. Warren argues for neutrality as to corporate decisions. In conjunction with integration, a decision must be made whether to increase, decrease, or maintain the status quo level as to tax borne by tax-exempts.

Warren suggested a new explicit tax on investment income received by pension funds and charities, at whatever level is decided on, that would apply to dividends and interest equally. The tax- exempts could use the corporate tax as a withholding tax for which they would receive a full, even refundable credit. Warren suggested that the ALI corporate integration project need not solve all problems of tax-exempts (for instance, unrelated business income), but that integration would need to provide a framework that would accommodate whatever decisions are made as to the level of tax on charities and pension funds.

Handling Foreign Investment

The ALI project might treat inbound foreign investment in much the same way as tax-exempts, Warren suggested. Foreign investors would be subject to an explicit tax on debt and dividends, at a level considered to be appropriate, but the U.S. corporate tax credited to them under the withholding regime might satisfy the tax obligations.

Warren suggested that U.S. shareholders in corporations making outbound investments should get a passthrough of their corporation's foreign tax credits, up to the level of the U.S. tax rate, or that foreign income might be converted to tax-exempt income to the U.S. shareholders.

On transitions, Warren was unsympathetic to grandfathering that would apply integration only to capital contributed to the corporation after the change. Professor William Andrews of Harvard, as reporter for the ALI project on reform of the classical corporate system, has suggested that only new capital should get the benefit of the new advantageous proposal to allow deduction of some part of dividends. Warren argued that everyone should expect taxes to change, at least over some phase-in period, so that there is no need to offset either favorable or adverse tax changes for existing investors.

Warren was on an AALS panel discussing integration that also included Professor Scott Taylor of New Mexico Law School and Professor James Eustice of N.Y.U. Law School. Taylor reviewed his paper, 'Corporate Integration in The Federal Income Tax: Lessons from the Past,' 10 Virginia Tax Review 237 (1990), and argued that the United States has had a pure, classical, double corporate tax for only 28 of the 87-year history of the tax.

From 1913 through 1935, for instance, dividends were exempt from shareholder 'ordinary tax,' but not from the surtaxes on higher incomes. From 1954 through 1986, $100 of corporate dividends was excluded from shareholder tax. The audience laughed when Taylor told them that the 1954 committee reports argued that the $100 exclusion covered the ground because it excluded the average amount of dividends--computing 'average' by dividing total dividends by total shareholders.

Official v. 'Self-Help'

Eustice argued that there has been a great deal of integration under current law, some of it official and some of it of the self- help variety. The 1981 Economic Recovery Tax Act, he argued, effected corporate integration by effectively repealing tax on corporate income, although we did not see it at the time. Corporate tax was repealed by debt-financed investments in accelerated depreciation. Repeal was helped along by safe harbor leasing. 'Safe harbor leasing was like a gigantic consolidated return that covered all corporations.'

Eustice cited several instances of official integration. Partnerships and S corporations get a single tax explicitly. Eustice expected that the rules for S corporations would eventually get looser to cover all but the publicly held corporations. The new game in town, he said, is Wyoming limited-liability companies, treated as partnerships because they achieve a 2-2 tie under the factors of the Treasury section 7701-2 regs. Limited-liability companies are super S corporations in which shareholders can participate in management without forfeiting their limited liability or their tax rights as partners.

Mutual funds, regulated investment companies, real estate investment trusts, and real estate mortgage investment conduits get official corporate integration in another way by getting a deduction for dividend distributions that they must make to shareholders. Consolidated returns allow integration, at least among corporations, to avoid triple or quadruple tax.

Corporations also can achieve self-help integration by making distributions of tax-deductible interest, salaries, rent, or royalties, rather than dividends. Sometimes corporations overdo the self-help integration. Leveraged buyouts avoided corporation tax so well that now more attention is paid to net operating losses than to corporate income.

Eustice ended by pleading for only small, incremental changes. He noted that integration is expensive and will have to be paid for by taxes elsewhere. Managers of large firms dislike integration because it favors greater distributions. The tax provisions will be complicated. Congress is capable of butchering the technical aspects of a tax revision, he argued, and integration will be multisection legislation affecting all questions in the taxation of corporations.

Warren countered that the existing muddle is unsatisfactory. He argued that homemade integration is at least as complicated as statutory integration would be, and homemade integration causes economic distortions. Tax-induced economic distortions are the problem, Warren maintained.

The AALS panel was planned and moderated by Professor Robert Peroni of George Washington Law School.

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-- Calvin H. Johnson

University of Texas

Special to Tax Notes

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