University of Chicago Tax Conference · Conference November 6, 2015 Corporate Tax Integration . 2...

University of Chicago Tax Conference

November 6, 2015

Corporate Tax Integration

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Agenda • Introduction – Why integration is especially

relevant today

• Summarize approaches that are available to achieve integration: – Four Approaches Covered:

• dividend exclusion • imputation • dividend paid deduction • shareholder mark-to-market regime

– We emphasize the impact each approach has on corporate management incentives

• Conclusion

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Introduction Prior Focus of Integration Debate (i.e., Treasury 1992 reports, ALI 1993 study, and Treasury 2002 Study): • Entity Neutrality

• Distortions in debt and equity finance • Preservation of shareholder treatment:

– exemption for charities – exemption for savings vehicles – general progressivity

• Preservation of corporate preferential treatments

– deductions for specific investments – credits for specific investments – exclusion of certain income, municipal bond interest

• Concern for windfall in transition

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What has changed since 1992-1993?

• More capital escapes classical regime entirely through private aggregation

• More corporate stock held by tax indifferent entities • Capital increasingly mobile

• Increased use of stock buy-backs

• Consumers are increasingly mobile (e.g., internet purchases

means there is no need for a company to have a physical presence in the U.S. to sell in to the U.S. market)

• Corporate managers are incentivized to achieve lowest tax rate,

and the costs of migrating offshore are low and getting lower

Introduction

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Introduction How Integration Can Help • Economic growth. Corporate integration lessens the tax

distortions between: a) Corporate and noncorporate investment, b) Debt and equity finance; and c) Distribution and retention of earnings (depending on

tax rates). Treasury's 2002 report on corporate integration includes estimates of the impact of corporate integration options on economic growth.

• Reduced base erosion. Academic research suggests that

dividend imputation systems can reduce base erosion by domestic companies (See Amiram-Bauer-Frank).

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Introduction How Integration Can Help (cont’d): • An integration system could be designed to:

a. favor investment in US companies; b. reduce pressure to enact corporate tax preferences; c. eliminate incentive for REIT conversions; d. increase progressivity as measured by JCT and

Treasury; e. increase policy options for dealing with deferral of foreign

profits; and f. discourage inversions (see next slide).

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Introduction • So long as tax liability is imposed on the corporation for tax and

accounting purposes, corporate managers are going to be compensated on an after corporate tax basis – This has ramifications for the tax system . . .

• Even if the overall scheme is designed to be revenue neutral or

comparable to complete pass-through, integration that imposes a corporate level tax, with relief to shareholders, will leave those incentives unchanged

• Integration that imposes a shareholder level tax, using the

corporation only as a collection mechanism, could affect those incentives

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How should each type of shareholder be impacted? Which relative treatments need to be preserved?

U.S. Corporation

Domestic Corporation

Domestic Exempt Entities

Foreign Corporation

U.S. Individual

Progressive Rate

Foreign Individual

Dom. Pass-

Through

Foreign Pass-

Through

Foreign Exempt Entities

Introduction

Different Types of Shareholders . . .

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U.S. Operating Income

Which treatments need to be preserved?

U.S. Corporation

Foreign Operating Income

US Source Preference

Income

Summary of Integration Approaches Sources of Corporate Income . . .

Dividends from Domestic

Corporations

Interest from Domestic

Corporations

Dividends from Foreign

Corporations

Interest from Foreign

Corporations

Foreign Source Preference

Income

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Summary of Integration Approaches • Most analyses have distinguished between “small”

companies and “large” companies based on some “criteria” with a pass-through or expanded Subchapter S applying to “small” companies.

• The criteria have varied: • sheer size • complex capital structures (Kwall, 1940s/1950s Literature) • access to capital markets (Rudnick, Dodge) • inability to allocate income accurately (Polito)

• Our focus is solely on “large” companies however defined . . ..

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Summary of Integration Approaches

• Although there are many integration approaches that have been analyzed over the years, we focus on four (4): • Corporate level tax, exclusion of dividends

• Corporate level tax, shareholder imputation credit when dividends are paid

• Corporate level tax, dividends paid deduction with complementary

withholding tax • Shareholder Mark-to-Market Regime

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Summary of Integration Approaches • Rather than analyze each approach against a laundry list of factors, we

summarize the impact each approach has on arguably the most important factor – i.e., Corporate Managers’ Incentives: 1. Debt rather than equity financing

2. Retention of corporate earnings

3. Form of distribution

4. Incentive for tax avoidance behavior (i.e., see Bank of New York Mellon

and related FTC cases)

5. Incentive for export of capital (i.e., transfer pricing and deferral)

6. Change of tax residence

7. Migration of activities to alternative capital structures • Publicly Traded Partnership for Natural Resource Companies • REIT Spin Offs

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1. Corporate Level Tax; Dividend Exclusion

ALL Shareholders

• Key Design Questions: • Are dividends excluded even if corporate tax not imposed (e.g.,

dividends out of earnings from municipal bond interest)? • Is exclusion passed through to recipients of distributions from

individual retirement accounts and qualified plans? • Are capital gains exempt or are they taxed with basis increase

provided for corporate earnings? • Treatment of transition? • See U.S. Department of Treasury. General Explanation of the

Administration’s Fiscal 2004 Revenue Proposal, Feb 2003, p. 11.

$100 earnings Less $ 25 tax $ 75 available to distribute $ 75 available for reinvestment by shareholder

ALL income sources

Corporation Pays Tax but Dividends, Shareholder Capital Gains and Shareholder Gains on Liquidation Exempt from Taxation

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1. Corporate Level Tax; Dividend Exclusion • Corporation pays tax, but dividends, and potentially shareholder capital gains and

shareholder gains on liquidation exempt from taxation:

– The effect of adoption of this scheme of integration depends importantly on how it is designed.

– Although the debt-equity disparity is lessened somewhat, the advantage of debt financing will remain without additional steps (disallowance of interest deductions; imputed deduction for capital, etc.).

– Does not remove managerial incentives with respect to observed net tax rate.

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Summary of Dividend Exclusion • Impact on Corporate Managers’ Incentives:

1. Debt rather than equity financing?

2. Retention of corporate earnings?

3. Form of distribution?

4. Incentive for tax avoidance behavior?

5. Incentive for export of capital?

6. Change of tax residence?

7. Migration of activities to alternative capital structures?

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$100 earnings Less $25 tax $75 available to distribute $75 actual distribution $25 deemed distribution $100 taxable to shareholder At 40% $40 tax due At 5% $5 tax due $25 credit $25 credit $15 net tax $20 net refund $60 available for reinvestment by sh $95 available for reinvestment by sh

2. Corporate Level Tax w/ Imputation Credit Shareholders Taxed on Grossed Up Earnings Distributed with Credit for Corporate Tax Paid


Individual Shareholders

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$100 earnings Less $25 corp tax $75 available to distribute $75 actual distribution $25 gross-up of distribution $100 taxable to shareholder At 40% sh $40 tax due $25 credit $15 net tax $60 available for reinvestment by shareholder

2. Corporate level tax with imputation credit Shareholders taxed on grossed up earnings distributed with credit for corporate tax paid

IF CREDIT BASED ONLY ON TAXES ACTUALLY PAID CORPORATE PREFERENCES LOST

$100 earnings Less $21 corp tax plus $4 tax credit $79 available to distribute $79 actual distribution $21 gross-up of distribution* $100 taxable to shareholder At 40% sh $40 tax due $21 credit $19 net tax $60 available for reinvestment by shareholder

Credit claimed at corporate level Gross-up by taxes actually paid, No incentive credit to shareholder No credit to corporate

No credit to shareholder

* Requires relatively complex method of tracing and reporting




Income

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• To preserve preferential treatments, gross-up and credit may be based on nominal rates of corporate tax, not taxes actually paid

• All dividends grossed up by same factor, resulting in simplicity for shareholders • Can produce negative tax if shareholder rate sufficiently low

• Compensatory tax on distributed earnings would avoid revenue loss while

preserving benefits for retained earnings





Income

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2. Corporate level tax with imputation credit Shareholders taxed on earnings distributed with credit for corporate tax paid

• How should tax exempts be treated? • Continue exemption with corresponding revenue loss?

• Treat dividends as UBIT akin to the approach proposed when

the House passed a partial dividends paid deduction in 1985?

Should we think about section 501(c) entities differently from Pension Funds and IRAs and section 401(k) plans?



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• Decision needs to be made about intercorporate dividends.

• Are all intercorporate U.S. dividends exempted from double-taxation, contrary to current U.S. law with respect to the dividends received deduction? Or is double-taxation only called off when ownership is substantial?

• If imputation credits are moved from one corporation to another:

• What to do about different fiscal years?


Dividends from Domestic Corporation




U.S. Individual

Progressive Rate

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2. Corporate level tax with imputation credit Shareholders taxed on earnings distributed with credit for corporate tax paid

SHOULD IMPUTATION CREDIT FOR FOREIGN TAXES PAID BE AVAILABLE TO US SHAREHOLDERS?

Foreign Source Income



SHOULD CREDIT BE AVAILABLE FOR FOREIGN SHAREHOLDERS?

Foreign Shareholders

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• If shareholders can use all imputation credits, and avoiding corporate tax is costly, overall after-tax return to shareholders is reduced by tax avoidance strategies

• See Amiram, Bauer, Frank, Tax Avoidance at Public Corporations Driven by Shareholder Demand: Evidence from Changes in Shareholder Dividend Tax Policy


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• Impact on Corporate Managers’ Incentives: 1. Debt rather than equity financing?






7. Migration of activities given tax preferences to alternative capital

structures?

Summary of Imputation Credit

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See 1984 Treasury study

$100 earnings-100 distributed Less $ 0 corporate tax 100 distributed At 40% sh $40 tax due $60 available for reinvestment by shareholder

$100 earnings-100 distributed Less $ 0 corporate tax 100 distributed At 5% sh $ 5 tax due $95 available for reinvestment by shareholder

3. Corporate level tax with dividend paid deduction Shareholders taxed on earnings as distributed

U.S. Individual

Progressive Rate

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• General design issues: – How is preference income treated? – Treatment of losses at corporate level? – Distinction between earnings and profits and taxable corporate

income?

• How do we preserve at least one level of tax when the shareholder is tax-exempt or foreign?

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Foreign Individual

• The U.S. has already substantially relinquished source-based taxation of dividends (completely in the case of 80% corporate shareholders with significant trading partners like UK / Netherlands). − Can Domestic Corporation withhold despite treaties? − What if Domestic Corporation pays equivalent amount of tax instead

of shareholder (i.e., it becomes a “corporate liability”)?

− Does this violate the nondiscrimination provisions of treaties? − What is the economic impact due to the application of corporate

law if U.S. and foreign shareholders own stock of the same class?

Foreign Corporation

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structures?

Summary of Dividends Paid Deduction

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4. Shareholder Mark to Market Regime

U.S. Corporation



Foreign Corporation

U.S. Individual

Progressive Rate

Foreign Individual Dom.

Pass-Through

Foreign Pass-

Through


Great from a management incentive perspective, but . . . • Chief political impediment is the liquidity concern

• Chief technical impediments are:

• collecting the tax from “foreign” shareholders; and

• companies that have at least one class of stock that is not actively traded

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U.S. Corporation

Foreign Corporation

Foreign Individual

Foreign Pass-

Through


FOREIGN SHAREHOLDER ISSUES • Dividends can be withheld upon:

• Same treaty override concern as dividends paid deduction.

• Capital Gains: • No practical way to collect on a mark to market basis

• Even if 100% of shares were only traded on a U.S. exchange through U.S. brokers, there is no cash for the U.S. brokers to withhold on

• Moreover, NOT all shares will be traded on a U.S. exchange through U.S. brokers • The House actually passed a bill attempting to tax gains on a realization basis in 1989

and 1990 (see “Foreign Tax Equity Bill of 1990”). • Unlike FIRPTA, one would likely need to impose a withholding obligation on

brokers, not “buyers”. • How do you deal with shares listed on a foreign exchange?

• NOTE: FATCA and 871(m) face the same administrative problem.

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U.S. Corporation

NON-TRADED CLASS OF STOCK • Although not typical, some U.S. corporations have at least one class of stock that

is not listed (i.e., held by a family).

• To be fair to the other shareholders, some form of PFIC-like interest-charge / QEF regime would have to be applied to those shareholders.



U.S. Individual

Progressive Rate

Dom. Pass-

Through

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structures?

Summary of Mark to Market

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Conclusions

• Pure pass through (subchapter S like) regime could likely be afforded to a larger group of companies than is currently permitted, provided their shares are not capable of being transferred without the knowledge of the issuer

• For actively traded companies, the dividends paid deduction approach comes closest to positively impacting corporate manager incentives while still being relatively administrable

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University of Chicago Tax Conference · Conference November 6, 2015 Corporate Tax Integration . 2...

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