Dividend Tax Repeal: A Lot To Think About

The Bush Administration in its skimpy briefing paper on its dividend tax repeal proposal did not seriously address any of these questions.

The dividend tax repeal proposal by itself raises three distinct series of questions.

The first concerns macro effects:

The second series, for the investors and issuers, concerns the structural institutional consequences of the proposal:

The third set of questions, for the tax practitioner, concerns the mechanics:

Is It As Simple As It Sounds?

Many questions remain unanswered, and the potential answers may not be simple.

It sounds simple on its face. Dividends will be tax-free much as municipal bond interest is tax-free.

Will tax-free dividends be similarly included in the Alternative Minimum Tax (AMT) base after the proposal goes through the legislative mill? Will stockholders have to adjust their bases for their shares of stock of corporations, which pay tax-free dividends?

If this is the case, the effect of the proposal may not be to make dividends tax free, but simply defer the tax. Arguably, there should be no basis reduction because the corporate tax should act as a surrogate for the shareholder tax.

Presumably tax-free dividends will be taken into account by retirees in determining the taxability of social security, thereby lessening the benefit of dividend tax repeal to low and moderate- income retirees.

Another looming question is how will states respond to a reduction in the federal tax base?

The Treasury described a new concept of adjusted earnings and profits, which will be reflected on Form 1099, the so-called Excludable Dividend Account or EDA. EDAs will add another level of complexity to the tax system with questions about the treatments of losses and credits.

And will dividends from flow-through corporate entities be tax-free?

Changing Strategies For Corporations And Investors

It will be interesting to see how investors and corporations adjust their strategies to deal with this change. It seems intuitive that dividend-yielding investments will now be more attractive to investors than taxable debt.

However, interest is deductible by the payer while dividends are not; consequently, if preferred stocks are priced to achieve yields that are comparable to tax-exempt bonds, preferred stock financing will be more expensive than comparable debt financing. Senior equity may not be a good substitute for debt.

Although what was intuitive is not so obvious, it seems likely to encourage more equity financing if only to satisfy investor demand and improve balance sheets and to make the record keeping burden greater for both issuers and investors.

High bracket taxpayers should be attracted away from debt to equities. This should push down dividend yields and push up price/earnings ratios, which is good news for existing stockholders.

It may also encourage dividend payments, especially in companies dominated by a single large shareholder or a single family of shareholders, who were rich in shares and poor in greenbacks.

The market should reflect a dividend component of value for companies. As dividend yield becomes more significant in the pricing of equity securities, stock will become less attractive for tax-exempt investors, such as retirement plans and charities.

If the tax exemption reduces the yield on equities, equities will become less attractive for foreign investors. If foreign investors suffer a diminution in their U.S. yield, get no credit for U.S. tax, and continue to be taxable in their home countries, U.S. equities may be less advantageous. Should U.S. shareholders in foreign companies get a U.S. tax break? Exempting foreign dividends would deprive the U.S. of leverage to get a dividend exemption for U.S. taxpayers in tax treaties.

Dividend tax repeal will clearly call for a shift in portfolios for many, perhaps most, taxpayers away from tax exempt bonds to stock and to non-taxable fixed income securities, perhaps with equity conversion rights, and overall equity securities should have a one-time value stimulus. An increase in the supply of tax exempt securities could raise borrowing costs for states, municipalities other issuers.

Planning Opportunities

Dividend tax repeal may also present numerous planning opportunities. In the event of a sale of a business, there would be no need to liquidate and pay a shareholder level capital gains tax if one could simply operate the corporation as a personal investment portfolio, paying dividends on a tax-free basis, much as the Suez Canal company continued as a closed end investment company after its operating property was confiscated.

Repeal of the shareholder level income tax on dividends is likely to produce a revolution in tax planning which is every bit as far reaching as the revolution, which occurred in 1986 with the lowering of individual rates and the repeal of certain corporate tax benefits, resulting in the widespread disincorporation of America. It might, in fact, trigger a reincorporation of America.

A fair income tax starts with a base, which fairly measures each individual’s ability to pay. By excluding corporate income from shareholders’ incomes, this rationality is compromised. This can be rationalized by arguing that the corporate tax is not an income tax, but really a sales or franchise tax or as interest paid for the privilege of deferring individual income tax.

Franchise fees and sales taxes can take care of much of the revenue loss if the corporate tax were integrated with the individual income tax. The rest can be made up by the method of integration. The alternatives are: (1) exclusion of corporate dividends from the individual tax base, (2) a dividends paid deduction against corporate taxable income, (3) a credit against individual income tax for the corporate tax paid on dividends received by taxpayers and (4) inclusion of corporate income in shareholders’ incomes.

Dividend tax repeal or exclusion of corporate dividends is perhaps the clumsiest method. It is not simple.

The uncertainty of the tax status of dividends from a company from year to year may make it difficult for the market to reflect the tax free dividend return in the price of a security. Even if the tax-free status of the dividend were accurately reflected in the price of the security, the after tax cost of non-deductible dividend is likely to be greater than the cost of deductible interest. For these reasons, it faces an uphill battle even within the Bush Administration’s supporters.

If simplicity is the goal, a dividends paid deduction is probably the way to go, but that imposes a penalty on companies that want to reinvest earnings.

A dividends received credit may be more complicated, particularly if it were based on a calculation of the actual corporate tax imposed on the earnings which generated the dividend, and if it were not based on actual tax, the credit may be given for earnings which never bore any meaningful tax. This same issue permeates the current dividend exclusion proposal.

The subchapter S model is very complicated, but may produce the most satisfactory results. It promotes the goal of a uniform tax base; it reduces and largely eliminates tax considerations when choosing a form of entity in which to operate a business; it results in a single layer of tax; and it makes dividend payment policy tax neutral.

Shareholder liquidity is a problem unless companies are required to make a minimum distribution. A better solution would be to require the company to pay a withholding tax (reduced by appropriate credits) at or near the maximum individual rate. Losses and dividends in excess of earnings will require basis adjustment, but the current system also requires constant basis adjustments to reflect stock dividends, stock splits, warrants, mergers, spin-offs and return of capital dividends.

Economists seem to gaze into crystal balls when it comes to predicting macro effects. Integration of the corporate and individual taxes is a worthy goal, but it is unclear whether repeal of the tax on dividends is the way to do it. Because of the political nature of the debate, it may be extended to be a run-up to the 2004 presidential election.

Howard D. Medwed is a partner at Burns & Levinson in Boston and chairman of its tax group. He has over 30 years of experience as a tax lawyer in all fields of business, personal and estate tax planning with an emphasis on structuring transactions and ongoing business and personal arrangements to promote tax efficiency in combination with the attainment of non-tax goals.