Corporate integration: Chairman Hatch's straightforward approach to tax reform.

• Author: Minkovich, Alexandra
• Position: Sen. Orrin Hatch

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Want to have input on the proposal? There's no time like the present

There is consensus that business tax reform needs to occur, but disagreement over how best to achieve it. Earlier this year, Sen. Orrin Hatch (R-UT), chairman of the Senate Committee on Finance (Senate Finance), announced that he was developing a corporate integration proposal. Although Chairman Hatch has not yet issued a discussion draft or introduced legislative language, he and his staff have discussed corporate integration in various public fora. In addition, Senate Finance held two hearings on corporate integration in May 2016. (1)

Companies that want to affect the development of business tax reform should pay close attention to Chairman Hatch's forthcoming proposal. Now is the time for businesses to participate in discussions and raise important issues for the chairman and Senate Finance to consider.

"There is nothing new in the world except the history you do not know," President Harry S. Truman famously said. Policymakers have been debating the appropriate method for taxing corporate income since corporate profits were first subject to tax in 1894. (2) Initially, the corporate tax system did not assume two levels of tax would be imposed, and the two-tier system we have today that seeks a tax at both the corporate and shareholder levels was not enacted until 1936.

Since 1936, there have been several well-developed recommendations to integrate the corporate and shareholder levels of tax such that only one tax is imposed on corporate profits. Over the years, however, the rationale and the suggested method for achieving integration have changed.

In the 1970s, for example, the Treasury Department proposed corporate integration in part because other countries had integrated their individual and corporate tax systems, and the United States needed to keep pace with its peers. The 1970s proposals included integration methods that would have shifted the liability for the tax on business profits to the shareholder by, for example, expanding the subchapter S regime.

In the mid-1980s, the Treasury Department issued two reports on reforming the corporate tax system, Treasury I and Treasury II. (3) Treasury I recommended a dividends-paid deduction (DPD) but limited the deduction to 50 percent of dividends paid. Treasury II also recommended a DPD, but limited it to 10 percent of dividends paid. In each case, the deduction was limited due to revenue concerns. Despite the limitation, both Treasury I and II sought to move at least some of the liability for the tax on business profits to the shareholder.

In 1992, the Treasury Department went in a different direction to propose a comprehensive business income tax. The CBIT would have retained the entity-level tax on all business entities, denied interest deductions, and allowed shareholders to exclude dividends from their earnings when distributed. This 1992 approach had the advantage of being easier for the Internal Revenue Service to administer, in that there was a single corporate taxpayer to pursue rather than multiple shareholders.

Despite forty years of interest, however, proponents of full corporate integration have yet to successfully enact legislation. That said, partial integration was achieved with the enactment of the Jobs and Growth Tax Relief Reconciliation Act of 2003, which provided that most types of dividends would be taxed to shareholders at the lower capital gains rate. (4)

In December 2014, the Republican staff of the Senate Committee on Finance issued a white paper, Comprehensive Tax Reform for 2015 and Beyond. (5) The white paper, which was intended to provide background on the current state of the tax law and identify potential future reforms, included a discussion of corporate integration in excess of 100 pages. According to the white paper, in 2013 corporate tax revenues were the third largest source of federal revenues, raising $274 billion (or 10 percent of tax revenues) for the fisc. The white paper noted that corporate income tax revenues peaked at 39.8 percent of federal revenues in 1943 and have been steadily declining since.

The white paper proposed to broaden the corporate tax base and eliminate almost all corporate tax expenditures. It identified the following distortions that would be reduced or eliminated if there were only a single level of tax on corporate income:

the incentive to invest in noncorporate rather than corporate businesses, the incentive to finance corporations with debt rather than equity, the incentive to retain earnings or distribute earnings in a manner to avoid a second level of tax, and the incentive to distribute earnings in a manner to avoid a second level of tax. (6) The white paper also identified and described eight methods for achieving corporate integration (either partial or complete):

1. dividend exclusion

2. shareholder allocation

3. imputation (or shareholder) credit

4. comprehensive business income tax

5. business enterprise income tax (BEIT)

6. dividends-paid deduction

7. mark-to-market treatment for publicly traded stock and flow-through treatment for non publicly traded entities, and

8. split rates on undistributed and distributed income.

(This article discusses only the DPD, the method that Chairman Hatch is expected to propose. Companies interested in the details of the other methods for achieving corporate integration should consult the white paper.)

Chairman Hatch has stated publicly that he and his staff have met with companies since the white paper was released, and that those who came in for a meeting have expressed "near unanimous" support for corporate integration.

Taking Deductions for Dividends Paid to Shareholders

Although the specifics of Chairman Hatch's proposal are not yet available, based on statements he has made publicly and the discussions at Senate Finance hearings, the proposal is expected to permit companies to take a deduction for dividends paid to shareholders and will require companies to withhold taxes at a 35 percent rate on both dividend and interest payments made. Taxes that are withheld will not be refundable. Retained earnings will still be subject to the corporate income tax. The Joint Committee on Taxation (JCT) has apparently reviewed the proposal and determined that it would raise revenue, although Chairman Hatch has stated that he intends to revise the proposal so as to be revenue-neutral. When Chairman Hatch releases his proposal, he is expected to release a white paper describing the proposal, some legislative language, and JCT's analysis of the proposal. In addition, he will likely seek comments on the proposal from stakeholders.

Under the proposal, shareholders that are currently tax-exempt (including tax-exempt organizations and retirement plans) will be subject to the 35 percent withholding tax. The chairman has acknowledged the concerns these shareholders may have, but has stated that he intends to craft a proposal whereby they receive economic...