Report of 

THE DEPARTMENT OF THE TREASURY 

on 

Integration 

of 

The Individual and Corporate 

Tax Systems 

Taxing Business Income Once 

January 1992 

For sale by the US. Govemment Printing Office 

Superintendent of Documents, Mail Stop: SSOP, Washington, DC 20402-9328 

ISBN 0-16-036045-5 
DEPARTMENT OF THE TREASURY 

WASHINGTON 

ASS ISTA NT SEC R ETA R Y January 1992 

The Honorable Dan Rostenkowski 

Chairman 

Committee on Ways and Means 

United States House of Representatives 

Washington, D.C. 20515 

Dear Mr. Chairman: 

Section 634 of Public Law 99-514, the Tax Reform Act of 1986 directed the 

Secretary of the Treasury or his delegate to study reforms of the taxation of corporate income 

under Subchapter C of the Internal Revenue Code. This mandate is quite broad. We concluded 

that a comprehensive study of the issues presented by integration of the corporate and individual 

income tax would address fundamental questions concerning how the corporate income tax might 

be restructured to reduce tax distortions of important corporate financial decisions and to achieve 

a more efficient system. Given the prevalence of integrated corporate income tax systems in the 

world today, we believe that an examination of these substantial issues should precede 

consideration of other, less fundamental, approaches to corporate income tax reform. 

Accordingly, this Report is submitted pursuant to the statutory directive cited above. 

I am sending a similar letter to Representative Bill Archer. 

Sincerely, 

kenneth W. Gideon 

Assistant Secretary 

(Tax Policy) 
DEPARTMENT OF THE TREASURY 

WASHINGTON 

January 1992 

ASSISTANT SECRETARY 

The Honorable Lloyd Bentsen 

Chairman 

Committee on Finance 

United States Senate 

Washington, D.C. 20515 

Dear Mr. Chairman: 

Section 634 of Public Law 99-514, the Tax Reform Act of 1986 directed the 

Secretary of the Treasury or his delegate to study reforms of the taxation of corporate income 

under Subchapter C of the Internal Revenue Code. This mandate is quite broad. We concluded 

that a comprehensive study of the issues presented by integration of the corporate and individual 

income tax would address fundamental questions concerning how the corporate income tax might 

be restructured to reduce tax distortions of important corporate financial decisions and to achieve 

a more efficient system. Given the prevalence of integrated corporate income tax systems in the 

world today, we believe that an examination of these substantial issues should precede 

consideration of other, less fundamental, approaches to corporate income tax reform. 

Accordingly, this Report is submitted pursuant to the statutory directive cited above. 

I am sending a similar letter to Senator Bob Packwood. 

Sincerely, 

.

Kenneth W. Gideon 

Assistant Secretary 

(Tax Policy) 
PREFACE 

The so-called classical system of current U.S. tax law treats corporations 

and their investors as separate entities and levies tax at both the corporate and 

shareholder levels on earnings from investments in corporate equity. Corporate 

earnings distributed to lenders as interest are generally deductible by the 

corporation and taxed, if at all, to the lender. Investors who conduct business 

activity in noncorporate form, such as a sole proprietorship or partnership, are 

taxed once on their earnings at the owners’ tax rate. 

As a result, despite the critical role played by corporations as a vehicle for 

economic growth, the United States tax law often perversely penalizes the 

corporate form of organization. The current system of taxation also distorts 

corporate financial decisions-in particular by encouraging debt and discouraging 

new equity financing of corporate investments. The tax system also prejudices 

corporate decisions about whether to retain earnings or pay dividends and 

encourages corporations to distribute earnings in a manner to avoid the doublelevel tax. 

Integration of the individual and corporate tax system would tax corporate 

income once and reduce or eliminate these economic distortions. Most trading 

partners of the United States have integrated their corporate tax systems. The 

potential economic gains from integration are substantial. 

This Report examines in detail several different integration prototypes, 

although it does not attempt an exhaustive discussion of all possible integration 

systems or of all the technical issues raised by the alternative prototypes. 

This Report does not contain legislative recommendations. Rather, it is 

intended to stimulate discussion of the various prototypes and issues they raise. 

By advancing the opportunity for such debate, this Report should encourage 

serious consideration of proposals for integrating the individual and corporate tax 

systems in the United States. 

V 
EXECUTIVE SUMMARY 

WHAT IS INTEGRATION AND WHY SHOULD IT BE BENEFICIAL? 

Currently, our tax system taxes corporate profits distributed to shareholders at least 

twice-once at the shareholder level and once at the corporate level. If the distribution is 

made through multiple unrelated corporations, profits may be taxed more than twice. If, on 

the other hand, the corporation succeeds in distributing profits in the form of interest on 

bonds to a tax-exempt or foreign lender, no U.S. tax at all is paid. 

The two-tier tax system (Le,, imposing tax on distributed profits in the hands of 

shareholders after taxation at the corporate level) is often referred to as a classical tax 

system. Over the past two decades, most of our trading partners have modified their 

corporate tax systems to "integrate" the corporate and shareholder taxes to mitigate the 

impact of imposing two levels of tax on distributed corporateprofits. Most typically, this has 

been accomplished by providing the shareholder with a full or partial credit for taxes paid 

at the corporate level. 

Integration would reduce three distortions inherent in the classical system: 

The incentive to invest in noncorporate rather than corporate 

businesses. Current law's double tax on corporations creates a 

higher effective tax rate on corporate equity than on noncorporate equity. The additional tax burden encourages "selfhelp" integration through disincorporation. 

The incentive to finance corporate investments with debt rather 

than new equity. Particularly in the 198Os, corporations issued 

substantial amounts of debt. By 1990, net interest expense 

reached a postwar high of 19 percent of corporate cash flow. 

The incentive to retain &f 

corporate Drofits in a manner to avoid the double tax. Between 

1970 and 1990, corporations' repurchases of their own shares 

grew from $1.2 billion (or 5.4 percent of dividends) to $47.9 

billion (or 34 percent of dividends). By 1990, over one-quarter 

of corporate interest payments were attributableto the substitution of debt for equity through share repurchases. 

These distortions raise the cost of capital for corporate investments; integration could 

be expected to reduce it. To the extent that an integrated system reduces incentives for 

highly-leveraged corporate capital structures, it would provide important non-tax benefits by 

encouraging the adoption of capital structures less vulnerable to instability in times of 

economic downturn. The Report contains estimates of substantial potential economic gains 

from integration. Depending on its form, the Report estimates that integration could increase 

the capital stock in the corporate sector by $125 billion to $500 billion, could decrease the 

vii 
Executive Summary viii 

debt-asset ratio in the corporate sector by 1 to 7 percentage points and could produce an 

annual gain to the U.S. economy as a whole from $2.5 billion to $25 billion. 

PROTOTYPES 

This Report defines four integration prototypes and provides specifications for how 

each would work. Three prototypes are described in Part 11: (1) the dividend exclusion 

prototype, (2) the shareholder allocation prototype, and (3) the Comprehensive Business 

Income Tax (CBIT) prototype. In addition, in Part IV,titled "Roads Not Taken," the Report 

describes the imputation credit prototype and a dividend deduction alternative. For 

administrative reasons that the Report details, we have not recommended the shareholder 

allocation prototype (a system in which all corporate income is allocated to shareholders and 

taxed in a manner similar to partnership income under current law). SimpWication concerns 

led us to prefer the dividend exclusion to any form of the imputation credit prototype. 

In the dividend exclusion prototype, shareholders exclude dividends from income 

because they have already been taxed at the corporate level. Dividend exclusion provides 

significant integration benefits and requires little structural change in the Internal Revenue 

Code. When fully phased in, dividend exclusion would cost approximately $13.1 billion per 

Y" 

CBIT is, as its name implies, a much more comprehensive and larger scale prototype 

and will require signifrcant statutory revision. CBIT represents a long-term, comprehensive 

option for equalizing the tax treatment of debt and equity. It is not expected that implementation of CBIT would begin in the short term, and full implementation would likely be phased 

in over a period of about 10 years. In CBIT, shareholders and bondholders exclude dividends 

and interest received from corporations from income, but neither type of payment is 

deductible by the corporation. Because debt and equity receive identical treatment in CBIT, 

CBIT better achieves tax neutrality goals than does the dividend exclusion prototype. CBIT 

is self-financing and would permit lowering the corporate rate to the maximum individual 

rate of 31 percent on a revenue neutral basis, even if capital gains on corporate stock were 

fully exempt from tax to shareholders. 

POLICY RECOMMENDATIONS 

In addition to describing prototypes, the Report makes several basic policy 

recommendations which we believe should apply to any integration proposal ultimately 

adopted: 

(a) Integration should not result in the extension of coqorate tax 

preferences to shareholders. This stricture is grounded in both 

policy and revenue concerns and has been adopted by every 

country with an integrated system. The mechanism for 

preventing passthrough of preferences varies; some countries 

utilize a compensatory tax mechanism and others simply tax 

preference-sheltered income when distributed (as we recommend in the dividend exclusion prototype). Both of these 

mechanisms are discussed in the Report. 
ix Executive Summary 

(b) Integration should not reduce the total tax collected on corporate income allocable to tax-exempt investors. Absent this 

restriction, business profits paid to tax-exempt entities could 

escape all taxation in an integrated system. This revenue loss 

would prove difficult to finance and would exacerbate distortions between taxable and tax-exempt investors, 

(c) 

through treaty negotiations. not bv statute. This is required to 

assure that U. S. shareholders receive reciprocal concessions 

from foreign tax jurisdictions. 

(d) Foreign taxes paid by U.S. corporations should not be treated, 

bv statute. identicallv to taxes paid to the U.S. Government. 

Absent this limitation, integration could eliminate all U.S. 

taxes on foreign source profits in many cases, 

A table summarizing the characteristics of each of the prototypes follows. 

OBJECTIVES OF THE REPORT 

This Report is not a legislative proposal but rather a source document to begin the 

debate on the desirability of integration. This Report concludes that integration is desirable 

and presents a variety of integration mechanisms. A major reform such as integration should 

be undertaken only after appropriate deliberation and consideration of public comments. In 

light of the increasing isolation of the United States as one of the few remaining countries 

with a classical tax system, serious consideration of integration is now appropriate. 
Executive Summary X 

Comparison of the four principal integration prototypes 

Prototype 

Issues 

Rates 

a) Distributed 

Income 

b) Retained 

Income' 

Treatment of 

non-corporate 

businesses 

Corporate tax 

preferences 

Tax-exempt 

investors 

Foreign source 

income 

Foreign 

investors 

Treatment of 

debt 

Dividend 

Exclusion 

Prototype 

Corporate rate 

Corporate rate 

(additional shareholder 

level tax depends on 

the treatment of capital gains; see Chapter 

8) 

Unaffected 

Does not extend preferences to shareholders. Preference income is subject to 

shareholder tax when 

distributed. 

Corporate equity income continues to 

bear one level of tax. 

Foreign taxes are 

creditable at the corporate level, but 

shielded income is 

subject to shareholder 

tax when distributed. 

Corporate equity income continues to 

bear tax at the corporate level and current withholding taxes 

(eligible for treaty 

reduction) continue to 

apply to distributions. 

Unaffected 

Shareholder 

Allocation 

Prototype 

Shareholder rate' 

Shareholder rate 

Unaffected 

Extends preferences to shareholders. 

Corporate equity 

income continues 

to bear one level 

of tax. 

Foreign taxes are 

creditable at the 

corporate level 

and at the shareholder level. 

Corporate equity 

income continues 

to bear tax at the 

corporate level 

and current withholding taxes 

(eligible for treaty 

reduction) continue to apply to 

distributions. 

Unaffected 

CBIT 

Prototype 

CBIT rate (31 percent) 

CBIT rate (additional 

investor level tax 

depends on the 

treatment of capital 

gains; see Chapter 8) 

CBIT applies to noncorporate businesses 

as well as corporations, except for very 

small businesses. 

Does not extend preferences to investors. 

Preference income is 

subject to compensatory tax or investor level 

tax when distributed. 

A CBIT entity's equity 

income and income 

used to pay interest 

bear one level of tax. 

Foreign taxes are 

creditable at the entity 

level, but shielded 

income is subject to 

compensatory tax or 

an investor level tax 

when distributed. 

A CBIT entity's equity 

income and income 

used to pay interest 

bear tax only at the 

entity level, and no 

withholding taxes are 

imposed on distributions to equity holders 

or on payments of 

interest. 

Equalizes treatment of 

debt and equity 

Imputation 

Credit 

Prototype 

Shareholder rate' 

Corporate rate 

(additional shareholder level tax 

depends on the 

treatment of capital 

gains; see Chapter 8) 

Unaffected 

Does not extend 

preferences to shareholders. Preference 

income is subject to 

shareholder tax when 

distributed. 

Corporate equity 

income continues to 

bear one level of tax. 

Foreign taxes are 

creditable at the 

corporate level, but 

shielded income is 

subject to shareholder 

tax when distributed. 

Corporate equity 

income continues to 

bear tax at the 

corporate level and 

current withholding 

taxes (eligible for 

treaty reduction) 

continue to apply to 

distributions. 

Unaffected (unless 

bondholder credit 

system adopted) 

'Plus 3 percentage points of corporate level tax not creditable because the prototype retains the 34 percent corporate 

rate but provides credits at the 3 1 percent shareholder rate. 

'Assuming no DRIP. See Chapter 9. 
Table of Contents 

PART I: THE CASE FOR INTEGRATION ................... 1 

Chapter 1: Introduction ............................. 1 

1.A The Corporate Tax: Need for Change ............. 1 

1.B The Corporate Tax and Economic Distortions ........ 3 

1.C Neutrality as the Goal of Integration .............. 12 

PARTI1:PROTOTYPES .............................. 15 

Introduction .................................... 15 

Chapter 2: Dividend Exclusion Prototype .................. 17 

2.A Introduction and Overview of Prototype ........... 17 

2.B The Need for a Limitation on Excludable Dividends .... 18 

2.C Foreign Source Income ...................... 21 

2.D Low-Bracket Shareholders .................... 22 

2.E Individual Alternative Minimum Tax ............. 23 

2.F Structural Issues .......................... 23 

2.G Pension Funds ........................... 24 

Chapter 3: Shareholder Allocation Prototype ............... 27 

3.A Introduction ............................. 27 

3.B Overview of the Shareholder Allocation Prototype ..... 27 

3.C Corporate Level Payment of Tax ................ 29 

3.D Passthrough of Corporate Losses to Shareholders ...... 30 

3.E Tax Treatment of Preferences .................. 30 

3.F Allocating Income Among Different Classes of Stock ... 32 

3.G Change of Stock Ownership During the Year ........ 33 

3.H Reporting and Auditing Considerations ............ 35 

3.1 Treatment of Tax-Exempt and Foreign Shareholders .... 36 

3.J Foreign Source Income ...................... 36 

Chapter 4: Comprehensive Business Income Tax Prototype ....... 39 

4.A Introduction ............................. 39 

4.B Overview of CBIT Prototype .................. 40 

4.C Entities Not Subject to CBIT .................. 41 

4.D Tax Preferences .......................... 43 

4.E International Considerations ................... 45 

4.F Impact of CBIT on Investment Behavior of Low-Bracket,

Tax-Exempt, and Foreign Investors .............. 49 

4.G Structural Issues .......................... 52 

4.H Conduits ............................... 56 

4.1 Financial Intermediaries Under CBIT ............. 58 

PART 111: PRINCIPAL ISSUES .......................... 61 

Introduction .................................... 61 

Chapter 5: Treatment of Tax Preferences .................. 63 

Xi 
Chapter 6: Tax-Exempt and Tax-Favored Investors ............ 67 

6.A Introduction ............................. 67 

6.B Distortions Under Current Law ................. 69 

6.C Neutrality Under an Integrated Tax System ......... 69 

6.D General Recommendations .................... 70 

Chapter 7: Treatment of Foreign Income and Shareholders ....... 73 

7.A Introduction ............................. 73 

7.B Overview of U.S. International Tax Policy .......... 74 

7.C International Tax Policy and Integration ........... 77 

Chapter 8: The Treatment of Capital Gains in an 

Integrated Tax System ........................... 81 

8.A Taxation of Capital Gains Attributable to 

Retained Taxable Earnings ................... 81 

8.B Sources of Capital Gains Other Than 

Taxable Retained Earnings ................... 82 

8.C Adjustments to Eliminate Double Taxation of 

RetainedCorporateEarnings .................. 82 

8.D Other Countries .......................... 84 

8.E Share Repurchases ........................ 84 

8.F Capital Losses ........................... 86 

Chapter 9: Dividend Reinvestment Plans .................. 87 

9.A Mechanics ............................. 87 

9.B Design Considerations ...................... 88 

Chapter 10: Transition Considerations .................... 89 

10.A Introduction. ............................ 89 

10.B Taxation of Transitional Gains and Losses .......... 89 

10.C Phase-In of Integration ...................... 90 

10.D Mechanics of a Phase-In ..................... 91 

PART1V:THEROADSNOTTAKEN ..................... 93 

Introduction .................................... 93 

Chapter 11: Imputation Credit System .................... 95 

11.A Overview of Imputation Credit Prototype ........... 95 

ll.B Choice Between a Credit Limitation System and a 

Compensatory Tax System .................... 97 

ll.C Role of the Corporate Alternative Minimum Tax ..... 101 

ll.D Foreign Source Income ..................... 102 

11.E Choices Required Because of Shareholders with 

Different Rates .......................... 103 

11.F Anti-Abuse Rules ........................ 103 

11.G Structural Issues ......................... 104 

ll.H Extending the Imputation Credit Prototype to Debt .... 105 

11.1 Dividend Reinvestment Plans (DRIPS) ........... 106 

xii 
Chapter 12: Other Proposals to Reduce the Bias Against 

Corporate Equity ............................ 107 

12.A Dividend Deduction ....................... 107 

12.B Institute for Fiscal Studies Proposal ............. 108 

12.C American Law Institute Reporter’s Study Draft ...... 108 

PART V: ECONOMIC ANALYSIS OF INTEGRATION .......... 111 

Chapter 13: Economic Effects of Integration ............... 111 

13.A Introduction and Summary ................... 111 

13.B Corporate Tax Distortions: Economic Issues ........ 112 

13.C Methodological Issues in Analyzing the 

Allocation Effects of Integration ............... 118 

13.D Overview of the Integration Prototypes ........... 120 

13.E Integration, Corporate Financial Policy. and the 

Cost of Capital .......................... 121 

13.F Integration and the Allocation of Resources ......... 128 

13.G Distributional Effects of Integration ............. 146 

13.H Revenue Estimates for Integration Prototypes ....... 150 

APPENDICES .................................... 153 

Appendix A: The Corporate Income Tax in the United States ....... 153 

A.1 Brief Description of the Corporate Income Tax ...... 153 

A.2 Overview of U.S. Corporate Tax Receipts ......... 156 

Appendix B: Experience of Other Countries with 

Distribution-Related Integration Systems .............. 159 

B.l Australia ............................. 159 

B.2 Canada .............................. 163 

B.3 France ............................... 167 

B.4 Germany ............................. 172 

B.5 New Zealand ........................... 177 

B.6 UnitedKingdom ......................... 181 

Appendix C: Equivalence of Distribution-Related Integration Systems 185 

C.1 Equivalence of Systems If Tax Rates Were Equal .... 185 

C.2 Effects of Rate Differences, Preference Income, and 

Exempt Shareholders ...................... 185 

NOTES ............................ . ........... 189 

GLOSSARY ..................................... 251 

BIBLIOGRAPHY .................................. 253 

ACKNOWLEDGEMENTS ............................ 267 

xiii 
List of Figures 

Figure 1.1 Distortions Under the Classical System . . . . . . . . . . . . 

Figure 1.2 Ratio of Corporate Investment Relative to 

Residential Investment in Four Countries, 1976-1989 . . . 

Figure 1.3 Ratio of Corporate Investment Relative to Noncorporate 

(including Household) Investment in 

Five Countries, 1976-1989 . . . . . . . . . . . . . . . . . . . 

Figure 1.4 Ratio of Credit Market Debt to the Book Value of 

Tangible Assets: Nonfinancial Corporations . . . . . . . . . 

Figure 1.5 Ratio of Market Value of Debt to Market Value of the 

Firm: Nonfinancial Corporations , . . . . . . . . . . . . . . . 

Figure 1.6 Changing Sources of Funds for the Corporate ‘Sector . . . 

Figure 1.7 Ratio of Net Interest to Cash Flow, 1948-1990: 

4 

5 

6 

7 

8 

8 

Nonfinancial Corporations , . . . . . . . . . . . . . . . . . . 10 

Figure 4.1 Comparison of CBIT and Current Law . , , . . . . . , . . . 39 

Figure 6.1 Pension Fund Holdings of Corporate Capital, 1950-1990 . 68 

Figure 13.1 Profits of Nonfinancial Corporations, 

Proprietors’ Income, and Net Interest as a 

Percentage of Net National Product, 1950-1990 . . , , , . 113 

Figure 13.2 Measures of Corporate Activity in the Economy, 

1950-1990.. . . . . . . , , . . . . . . . . . . . . . . . . . . . 114 

Figure A.l Corporate Receipts as a Percentage of Total Receipts and 

Gross National Product, 1940-1991 . . . , . . . . . , , . . 156 

xv 
List of Tables 

Table 1.1 

Table 1.2 

Table 1.3 

Table 2.1 

Table 3.1 

Table 4.1 

Table 6.1 

Table 8.1 

Table 11.1 

Table 13.1 

Table 13.2 

Table 13.3 

Table 13.4 

Table 13.5 

Table 13.6 

Table 13.7 

Corporate Tax Wedges for New Investments in 

Manufacturing, 1991 . . . . . . , . . . . . . . . , . , . , . . . 6 

Sources of Funds, Nonfinancial Corporations, 1946-1990 9 

Estimates of Maximum Amount of Interest Attributable to 

Increased Share Repurchases, 1980-1990 . . . . . . . . . 10 

Total U.S. Tax Rate on a Dollar of NonPreference, U.S. 

Source Income from a U.S. Business Under Current Law 

and the Dividend Exclusion Prototype . . . . . . . . . . . . 18 

Total U.S. Tax Rate on a Dollar of NonPreference, U.S. 

Source Income from a U.S. Business Under Current Law 

and the Shareholder Allocation Prototype . . . . . . . . . . 29 

Total U.S. Tax Rate on a Dollar of NonPreference, U.S. 

Source Income from a U.S. Business Under Current Law 

and the CBIT Prototype . . . . . . . . . . . . . . . . . . . . . 42 

Financial Assets of the Tax-Exempt Sector, 

End of Year 1990 , . . . . , . , , . . . . . . . . . . . . . . . 68 

Taxation of Individuals on Long-Term Gains on 

Securities: Select Foreign Countries . . , . . , . . . . . . . 85 

Total U.S. Tax Rate on a Dollar of NonPreference, U.S. 

Source Income from a U.S. Business Under Current Law 

and the Imputation Credit Prototype . . . . . . . , . . . . . 97 

Total U.S. Tax Rate on a Dollar of NonPreference, U.S. 

Source Income from a U.S. Business Under Current Law 

and the Integration Prototypes . . . . . . . . . . . . . , . . 122 

Effect of Integration on Corporate Financial Policy . . . 125 

Cost of Capital Under Current Law . . . , , . . . . . . . . 126 

The Cost of Capital Under Current Law and the 

Integration Prototypes: With Financial Distortions , . , . 128 

The Cost of Capital Under Current Law and the 

Integration Prototypes: No Financial Distortions . . . . . 129 

General Equilibrium Results, Augmented Harberger 

Model: With Financial Distortions , . . . . . . . . . . . . 130 

General Equilibrium Results, Augmented Harberger 

Model: No Financial Distortions . . . . . . . . . . . . . . 131 

xvii 
Table 13.8 General Equilibrium Results, Mutual Production Model: 

With Financial Distortions .................. 134 

Table 13.9 The Effect of Integration on the Allocation of 

Physical Capital, Wealth, and Corporate Financial Policy: 

Results from the Portfolio Allocation Model ........ 137 

Table 13.10 Summary of the Effects of Integration on 

Real and Financial Decisions: Results from the 

Portfolio Allocation Model (Lump Sum Replacement) . 138 

Table 13.11 General Equilibrium Results: International Model, 

Projected Long-Run Effects of 

Tax Integration Alternatives ................. 144 

Table 13.12 Effective Tax Rates on Individuals: Current Law and 

Integration Prototypes Standard Incidence Assumption . 148 

Table 13.13 Effective Tax Rates on Individuals: Current Law and 

Integration Prototypes Alternative Incidence Assumption 148 

xviii 
PART I: THE CASE FOR INTEGRATION 

CHAPTER1: INTRODUCTION 

l.A THE CORPORATE TAX: 

NEED FOR CHANGE 

Issues 

Current U.S. tax law treats corporations and 

their investors as separate taxable entities. Under 

this classical system of corporate income taxation, 

two levels of income tax are generally imposed on 

earnings from investments in corporate equity. 

First, corporate earnings are taxed at the corporate level. Second, if the corporation distributes 

earnings to shareholders, the earnings are taxed 

again at the shareholder level. In contrast, investors in business activities conducted in noncorporate form, such as sole proprietorships or 

partnerships, are generally taxed only once on the 

earnings, and this tax is imposed at the individual 

level. Corporate earnings distributed as interest to 

suppliers of debt capital also are taxed only once 

because interest is deductible by the corporation 

and generally taxed to lenders as ordinary income. 

Despite its long history, considerable debate 

surrounds the role of the corporate income tax in 

the Federal tax structure. The central issue is 

whether corporate earnings should be taxed once 

rather than taxed both when earned and when 

distributed to shareholders. Integration of the 

individual and corporate income tax refers to the 

taxation of corporate income once. This Report 

discusses and evaluates several integration 

alternatives. 

Despite their differences, the methods of 

integration studied in this Report reflect a common goal: where practical, fundamentaleconomic 

considerations, rather than tax considerations, 

should guide business investment, organization, 

and financial decisions. The Tax Reform Act of 

1986 (the 1986 Act)2made the tax system significantly more neutral in its impact on business 

decisions about capital investment by reducing tax 

rates and tax preferences. The 1986 Act, 

however, did not address tax-related distortions of 

business organizationaland financingdecisions. In 

fact, the 1986 reforms may have increased the 

pressure to select noncorporate organizational 

forms by imposing a higher marginal rate on 

corporations than on individuals and by repealing 

the General Utilitie? doctrine, which had protected corporations from corporate level tax on 

liquidating dispositions of corporate assets. Corporate integration can thus be regarded as a 

second phase of tax reform in the United States, 

extending the goal of neutral taxation to the 

choice of business organization and financial 

policy. 

The current two-tier system of corporate 

taxation discourages the use of the corporate form 

even when incorporation would provide nontax 

benefits, such as limited liability for the owners, 

centralized management, free transferability of 

interests, and continuity of life. The two-tier tax 

also discourages new equity financing of corporate 

investment, encourages debt financing of such 

investment, distorts decisions with respect to the 

payment of dividends, and encourages corporations to distribute earnings in a manner designed 

to avoid the double-level tax. 

These distortions have economic costs. The 

classical corporate tax system reduces the level of 

investment and interferes with the efficient allocation of resources. In addition, the tax bias against 

corporate equity can encourage corporations to 

increase debt financing beyond levels supported 

by nontax considerations, thereby increasing risks 

of financial distress and bankruptcy. 

Historically, the corporation has been an 

important vehicle for economic growth in the 

United States, but the classical corporate tax 

system often perversely penalizes the corporate 

form of organization. With the increasing integration of international markets for products and 

capital, one must consider effects of the corporate 

1 
The Case for Integration 2 

tax system on the competitiveness of U.S. fms. 

Most of the major trading partners of the United 

States have revised their tax systems to provide 

for some integration of the corporate and 

individual tax systems. 

This Report provides a comprehensive study 

of integration, including both the legal and economic foundations for implementing integration in 

the United States. We present three prototypes 

representing a range of integration systems and 

recommend two prototypes that implement our 

policy goals. One prototype, a dividend exclusion 

system, can be implemented with minimal changes to current law. The second, the Comprehensive 

Business Income Tax (CBIT), extends the dividend exclusion model to debt. CBIT achieves the 

important goal of equating the treatment of debt 

and equity, but because it represents a greater 

departure from current law, it would require a 

longer transition period. We have included, albeit 

with substantial reservations as to feasibility, a 

third prototypea shareholder allocation system, 

often referred to as full integration. We considered it necessary to examine such a prototype 

because this system is so frequently viewed as 

ideal by proponents of integration, although we 

ultimately reject it on both policy and 

administrative grounds. 

The Report also documents the substantial 

economic benefits of integration. We estimate that 

any of the three prototypes would increase the 

capital stock in the corporate sector by $125 to 

$500 billion and would decrease the debt to asset 

ratio in the corporate sector from 1 to 7 percentage points. Further, efficiency gains from integration would be equivalent to annual welfare gain 

for the U.S. economy as a whole of 0.07 to 0.7 

percent of annual consumption (or $2.5 to $25 

billion (in 1991 dollar^).^ See Chapter 13. 

Brief Description of Current Law 

Under current law, income earned by corporations is taxed at the corporate level, generally at 

a marginal rate of 34 per~ent.~When the corporation distributes earnings to shareholders in the 

form of dividends, the income is generally taxed 

again at the shareholder level.6 If corporations 

retain earnings, the value of their stock will 

generally increase to reflect those earnings. When 

shareholders sell their stock, gains from the sale 

are taxed also. Thus, like income distributed as 

dividends, retained corporate income generally is 

taxed twice. In contrast, investors who conduct 

business activity in noncorporate form, such as 

through a sole proprietorship or partnership, are 

taxed once on their earnings at their individual tax 

rate. 

Dividends distributed to individual U. S. citizens and residents are taxed generally at 

marginal rates of 15, 28, or 31 percent.' Dividends distributed to nonresident aliens and foreign 

corporations by U.S. corporations are generally 

subject to a nonrefundable "withholding" tax, 

currently set by statute at 30 percent. United 

States treaties with trading partners frequently 

reduce the rate to 15 or 5 percent on a reciprocal 

basis. Dividends received by U.S. corporate 

shareholders generally qualify for a dividends 

received deduction of 70, 80 or 100 percent, 

depending on the degree of afffiation between the 

corporations. Shareholders' gains from sales of 

corporate stock are taxed also, typically as capital 

gains, although capital gains of foreign shareholders generally are exempt from U.S. tax. 

Unlike dividends, interest is generally deductible by corporations. Interest income received by 

domestic lenders is generally taxed at their marginal tax rates. Interest income received by foreign lenders from U. S. corporations, however, 

generally is not subject to U.S. tax.* 

Tax-exempt entities supply a substantial 

portion of the corporate capital in the United 

States. These tax-exempt entities include pension 

funds and educational, religious and other charitable organizations. These entities are generally not 

taxed on interest, dividends or gains from the sale 

of their investments. However, the corporate level 

tax applies to corporate income attributableto the 

equity capital they supply. Tax-exempt entities 

may be subject to the unrelated business income 

tax (UBIT) on earnings from equity investments 

in partnerships. 
3 The Case for Integration 

l.B THE CORPORATE TAX AND 

ECONOMIC DISTORTIONS 

The classical corporate income tax system 

distorts three economic and financial decisions: 

(1) whether to invest in noncorporate rather than 

corporate form, (2) whether to finance investments with debt rather than equity, and (3) whether to retain rather than distribute earnings. Apart 

from corporate and investor level tax considerations, nontax benefits and costs also influence 

these decisions. To the extent that the classical tax 

system distorts the choice of organizational form, 

financial structure, and dividend policy, economic 

resources can be misallocated. 

The Cost of Capital As a Measure of 

Investment Incentives 

This Report examines distortions resulting 

from the corporate income tax in terms of effects 

on the cost of capital. In deciding whether to 

undertake an investment, fms require that the 

investment provide a sufficient after-tax return to 

compensate investors. The cost of capital is the 

pre-tax rate of return that is sufficient to cover 

operating expenses, taxes, economic depreciation, 

and the investor's required after-tax rate of return. 

Thus, the cost of capital depends in part on the 

return fms must pay to suppliers of debt or 

equity capital to attract funds. The cost of capital 

also depends on such factors as tax rates, the 

investment's economic depreciation rate, the 

capital cost recovery deductions allowed on the 

investment, the inflation rate, and the source of 

financing for the investment. Because a higher 

cost of capital makes certain investments unprofitable, corporate and individual income taxes 

reduce investment incentivesby raising the cost of 

capital. 

This section uses the cost of capital as a 

framework for analyzing the effects of the current 

classical corporate tax system on the business 

decisions described above (Le., form of business 

organization, form of financing, and retention of 

earnings). The final part of this section discusses 

the effect of the corporate income tax on savings 

and investment in the economy as a whole. 

Organizational Form 

The waste of economic resources from taxdistorted misallocation of capital between the 

noncorporate and corporate sectors was the 

original focus of criticism of the corporate income 

tax. Beginning with Harberger," economists 

have argued that a classical corporate tax system 

misallocates capital between the corporate and 

noncorporate sectors. Over the years, more 

sophisticated models have been developed to 

examine more carefully the efficiency costs of 

corporate taxation. Contemporary approaches 

suggest that these costs are significant. See 

Chapter 13. 

A simple example illustrates the effect of the 

current corporate tax system on investment decisions. Suppose that an investor requires an aftertax rate of return of 8 percent and the investor's 

effective tax rate is 20 percent. An equity investment in a noncorporate enterprise must earn a 

return high enough to pay tax at the investor's 

rate (20 percent) and still yield the required 8 

percent after-tax return." The noncorporate 

investment must therefore earn a 10 percent pretax rate of return (net of depreciation) in order to 

cover the investor's .income taxes and meet the 

required return (O.lOX(1-0.20) = 0.08). However, if the corporate tax rate is 34 percent and 

the corporation distributes all of its income, the 

cost of capital of an equity financed investment in 

the corporate sector in the above example is 15.2 

percent. This 15.2 percent pre-tax return yields an 

8 percent return after paying both the corporate 

tax and the investor level tax on dividends 

(0.152X(1-0.34)X(1-0.20) = 0.08). Since 

fewer investments can earn the higher required 

return (15.2 percent as opposed to 10 percent), 

the corporate tax discourages investment in the 

corporate sector by raising the cost of capital. 

More complex calculations support this result. 

For example, a Congressional Research Service 

report estimates, under realistic assumptions, the 

total effective Federal income tax rate on corporate equity (taking into account both corporate 

level and shareholder level taxes) to be 48 percent, compared to 28 percent for noncorporate 
The Case for Integration 

equity.'* Therefore, some corporations fail to 

undertake investments that would be profitable if 

the tax burden on corporate and noncorporate 

investments were the same. Moreover, for some 

business enterprises, the added corporate taxes 

exceed the nontax benefits of incorporation, 

causing such businesses to forego those benefits 

and to operate instead in noncorporate form. 

Figure 1.1illustrates the differences in taxation of 

equity investments in corporate and non-corporate 

businesses. 

The bias against corporate sector investments 

compared with investments in the noncorporate 

sector reduces the productivity of the nation's 

capital investments and reduces potential national 

income. See Chapter 13. This reduction in productivity is a hidden cost of the corporate tax. In 

addition, the classical system encourages corporations to convert to noncorporate form, thereby 

abandoning the benefits of inc~rporation.'~ 

Certain tax provisions mitigate this tax bias 

against corporate investment. First, by using debt 

to finance investments, corporations can reduce 

Figure 1.1 

Distortions Under the Classical System' 

4 

the relative tax advantage of noncorporate fms. 

Considering only tax costs, corporate and noncorporate entities face the same cost of debt 

financed capital, because interest paid is deductible. Thus, corporations can reduce the difference 

in tax burdens for total investment by financing 

new investment with debt. Increases in debt may, 

however, increase the risk of financial distress or 

bankruptcy. Second, accelerated cost recovery 

deductions provide, in effect, an interest-free 

government loan to finance new investment. 

These deductions lower the total cost of capital 

for both corporate and noncorporate firms,- but 

because corporate tax rates generally exceed 

individual tax rates, corporations realize greater 

tax benefits from accelerated depreciation. Thus, 

such deductions reduce, but do not eliminate, the 

additional tax burden on corporate equity 

investments. 

Corporations also can reduce the distortionbetween corporate and noncorporate investments by 

distributing corporate income to shareholders 

through share repurchases and other nondividend 

distributions. The advantage of a nondividend 

Equity Holders 

Corporation e Taxable

Foreign 

Return Ta-ExemPt 

Debt Holders 

(Investment ) Equity Holders 

Retum \ I Debt Holders 

\ l*U Ail 

Non-Corporate Form 

'The figure does not take into account tax preferences or taxes 

imposed by other countries. 

distribution is that it 

allows shareholders to 

recover the cost (or basis) 

of their shares, with any 

excess generally taxed as 

capital gains. Current law 

provides a slight rate 

preference for capital 

gains of individuals (a 

on other income). Capital 

gains also benefit from 

the deferral permitted 

under current law, because shareholders do not 

recognize gain until stock 

is sold, and capital assets 

receive a tax-free step-up 

in basis at death. The 

preferential tax treatment 

of capital gains reduces, 

but does not eliminate, 
5 The Case for Integration 

the distorting effect of the current corporate tax of relatively low corporate investment in the 

system on corporate level investment. United States is depicted in Figure 1.3, which 

presents the ratio of investment (net of depreciaInternational comparisons add perspective on tion) in the corporate sector relative to the total 

the effect of the corporate tax on the U.S. corpo- noncorpomte sector (households and unincorporatrate sector. One measure is the ratio of corporate ed businesses combined) during the same period 

investment to investment in housing, which for the same four countries plus France. By this 

provides a comparison of resource allocation in measure, the United States had the lowest ratio of 

different economies. Figure 1.2 presents the ratio corporate to noncorporate investment during the 

of corporate gross fixed investment relative to last 3 years for which data are available for any 

private residential investment in the United States of the five nations. 

and three other industrialized countries for which 

data are available since 1976. Throughout the Another useful internationalcomparison is the 

period, the United States had a lower ratio than spread between the pre-tax return on corporate 

the United Kingdom. Although the U.S. ratio investment and the cost of funds in the United 

exceeded that for Japan and Australia until the States and other countries. This spread, or corpoearly 1980s, corporate investment relative to rate "taxwedge," generally depends upon the type 

housing investment has tended upwards over the of asset acquired, the corporate tax rate, the 

whole period for Japan and Australia while the capital recovery allowances, the rate of inflation, 

ratio for the United States has remained fairly and various other country specific factors. Table 

stable, except for the 2 years following the Eco- 1.1 presents a listing of preliminary OECD 

nomic Recovery Tax Act of 1981. Indeed, for the calculations of the '1991 corporate tax wedge 

last 4 years for which data are available, the based on a standardized mix of assets and sources 

United States has had essentially the lowest of funding for a manufacturer located in several 

corporate investment per dollar of housing invest- OECD member countries. According to these 

ment of any of the four nations. A similar picture data, the corporate tax wedge in the United States 

Figure 1.2 

Ratio of Corporate Investment Relative to 

Residential Investment in Four Countries, 1976-1989 

/\ 31! 3 

2.5 -

2 -

1.5 -

1-

is higher than in France or 

Germany, is approximately the 

same as in the U.K., and is 

lower than the tax wedge in 

Canada and Japan. 

Corporate Capital

Structure 

Corporations have three 

alternatives for financing new 

investments: (1) issuing new 

equity, (2) using retained 

earnings, or (3) issuing debt. 

There can be important nontax 

benefits and costs of alternative corporate financing 

arrangements, and the tax 

system should avoid prejudic- 0.5 I

ing financial decisions. 

1976 1980 1984 1988 

Yeat The current classical cor- Sourax Organidon for Economic cooperation and Development, 

National Accounts (1976-1989). porate taxsystem discriminates
The Case for Integration 6 

Figure 1.3 

Ratio of Corporate Investment Relative to 

Noncorporate (mcluding Household) Investment 

in Five Countries, 1976-1989 

3'5 h 

3 )i'\, 

2.5 1 

1.5 -

1-

0.5 -

1976 1980 yeat 1984 1988 

Source: OrlJaniSationfor Economic Co-operatiOn and Development, National Accounts (19761989). 

Table 1.1 

Corporate Tax Wedges for 

New Investments in Manufacturing 1991 

Country Co orateTax 

%edge1 

Canada 1.2 

France 0.4 

Germany 0.6 

Japan 1.4 

United Kingdom 0.9 

United States 0.8 

Department of the Treasury 

Office of Tax Policy 

'The difference between the precorporate tax real rate of return and 5 

percent (the real interest rate). The calculations assume no personal taxes 

and an inflation rate of 4.5 percent for all countries. The weights for the 

proportion of investment in each type of asset and the proportion of 

finance from each source of funds are assumed to be the same for each 

country: 50 percent for machinery, 27 percent for buildings, and 23 

percent for inventories and 35 percent for debt, 10 percent for new 

equity, and 55 percent for retentions. 

Source: Organisation for Economic Co-operation and Development, 

preliminary unpublished estimates. 

against equity financing of 

new corporate investment. 

See Figure 1.1. Because of 

the two levels of taxation of 

corporate profits, the cost of 

equity capital generally exceeds the cost of debt capital. 

The Congressional Research 

Service estimates, under 

realistic assumptions, the 

total effective Federal income 

tax rate on corporate debt to 

be 20 percent, compared with 

48 percent for corporate equity,14 Moreover, the total 

effective tax rate on debt can 

be negative. The lower effective tax rate for debt financed 

corporate investment than for 

equity financed corporate 

&vestment encourages the 

use of debt by corporations, 

assuming nontax factors that 

affect financing decisions do 

not change. 

If a corporation borrows 

from an individual to finance 

an investment, the corporation deducts the interest 

payments from its taxable 

income and is therefore not 

taxed on the investment's 

pre-tax return to the extent of 

interest payments, although 

the lender is taxable on the 

interest at the individual tax 

rate.15 Consequently, to the 

extent that corporations finance investment with debt, 

current law does not distort 

the choice between investment in the corporate and 

noncorporate sectors. Using 

the assumptions in the numerical example set forth under 

"Organizational Form, 'I 

above, for a 100 percent 

debt financed corporate 
7 The Case for Integration 

investment, the cost of capital is 10 percent 

(O.lOx(1-0.2) = 0.08, the required rate of 

return). This cost is well below the 15.2 percent 

cost of capital for equity financed investments for 

corporations that distribute income as dividends, 

and is the same as the cost of capital for a noncorporate investment. 

Recent Trends in Corporate Debt 

Historical data show U. S. corporate debt to be 

at relatively high levels by postwar standards, 

with some, but not all, measures growing at an 

unusually rapid pace in the 1980s. Because there 

ratio of credit market debt to the book value of 

tangible assets for nonfinancial corporations, 

based on Federal Reserve Board data. This ratio 

grew from 43 percent in 1948 to 61 percent in 

1989. Although the ratio generally increased over 

the postwar period, it declined sharply beginning 

in 1975 and continuing through the mid 1980s. 

Following that decrease, the ratio began to rise 

again and by 1989 had reached a postwar high of 

61 percent. In 1989, this book-value debt to asset 

ratio was more than 17 percentage points higher 

than in 1980, but only 10percentage points higher 

than the pre-1980s peak of 51 percent reached in 

1973. 

percent in 1974, a year in 

which the stock market fell 

sharply. During the 1980s, the 

market-value ratio does not 

show a discernible upward 

trend because rising stock 

market prices largely offset the 

growth in the dollar amount of 

debt during this period. In 

contrast, the book-value measure described in the preceding 

paragraph shows a large increase during the 1980s, because stock market growth is 

0.7 -

0.65 -

0.6 -

0.55 -

0.5- d 

0.45-

0.4 -

0.35 -

0.3-1 I I , I 1 , I I I I I I I I I I I 8 1 I I I I I I I I 8 1 1 , I I I I I I I I I I I I I

does not offset the rising dollar 

volume of debt.16 
0.25 

The Case for Integration 8 

A second measure of Figure 1.5 

leverage focuses on the Ratio of Market Value of Debt to 

importance of debt in corpo- Market Value of the Firm 

rations' sources of additional Nonfinancial Corporations 

funds rather than corporations' total outstanding 0.45 -

debt. See Table 1.2. Over the 0.4 -

entire postwar period, equity 

finance was dominant. For 0.35-

nonfinancial corporations, 

retained 

equity issues 

earnings 

accounted 

and net new 

for 0 

Oa3j 

0.21 

4 

roughly 78 percent of funds A raised. Debt provided the 0.15 -

balance, divided about 

equally between private 0.1 -

issues (bank loans and private 0.05 -

placements) and public issues 

(bonds). Relative financing 

patterns changed during the 

1980s. While corporations 

continue to rely heavily on Source: Federal Reserve Board,unpublished estimates. 

retained earnings, they have 

sharply adjusted the composition of external finance. Most F'igure 1.6 

notably, corporations have Changing Sources of Funds for the Corporate Sector 

undertaken substantial repurchases of equity, financed Nonfinancial Corporate Nonfinancial Net Funds Raisec 

mainly with debt." In Debt and Equity Four Quarter Moving Average 

(current) dollar terms, this 300,

(billions of cment dollars) 

6, 

(percent of nominal GNP) 

pattern is illustrated in the 

left panel of Figure 1.6. The 

increase in nonfinancial 200 

corporate debt during the 

early and middle 1980s was 100 

largely matched by a reduction in outstanding equity. As 0

shown in the right panel of 

Figure 1.6, nonfinancial 

corporations relied significantly more on internal funds 

(retained eanzings) during the -200 -

1980s than was the case for 

the postwar period as a -300 -"'i"'i"'i"'l"1"'1"'1"'1"'1' whole. 

Recent evidence suggests Yeat 

0*

Yeat 

that share repurchases have 

contributed to the increase in Source: Strongin (1991). 
9 The Case for Integration 

Table 1.2 

Sources of Funds,Nonfinancial Corporations, 1946-1990 

Amount 

(millions of dollars) 

Internal New Debt Net New Total 

Year Funds Issues Equity Issues Funds 

1946 $8,503 $6,103 $1,018 $15,624 

1947 13,335 7,306 1,093 21,734 

1948 19,651 6,398 1,000 27,049 

1949 20,024 1,826 1,212 23,062 

1950 18,539 6,772 1,288 26,599 

1951 20,761 8,770 2,107 31,638 

1952 22,457 6,852 2,320 31,629 

1953 22,334 4,022 1,766 28,122 

1954 24,403 4,714 1,583 30,700 

1955 29,943 8,557 1,719 40,219 

1956 30,045 10,397 2,250 42,692 

1957 31,983 9,587 2,441 44,011 

1958 30,659 8,395 1,968 41,022 

1959 36,434 10,150 2,078 48,662 

1960 35,842 9,976 1,365 47,183 

1961 36,895 9,853 2,121 48,869 

1962 43,219 12,591 369 56,179 

1963 46,967 12,245 (341) 58,871 

1964 52,309 12,667 1,145 66,121 

1965 59,098 18,931 (28) 78,001 

1966 63,274 23,451 1,259 87,984 

1967 64,250 24,924 2,397 91,571 

1968 65,766 27,677 (159) 93,284 

1969 65,195 28,995 3,406 97,596 

1970 62,693 28,484 5,694 96,871 

1971 74,614 25,986 11,435 112,035 

1972 86,214 31,463 10,922 128,599 

1973 93,704 68,439 7,883 170,026 

1974 88,972 50,835 4,097 143,904 

1975 124,249 13,171 9,908 147,328 

1976 141,272 40,138 10,524 191,934 

1977 164,401 66,695 2,727 233,823 

1978 181,914 70,970 (101) 252,783 

1979 197,206 68,142 (7,836) 257,512 

1980 199,772 58,206 10,375 268,353 

1981 239,098 104,085 (13,450) 329,733 

1982 241,901 46,567 1,900 290,368 

1983 285,217 56,521 20,000 361,738 

1984 335,885 170,828 (78,975) 427,138 

1985 351,815 134,260 (84,500) 401,575 

1986 344,294 209,718 (84,975) 469,037 

1987 372,448 123,749 (75,500) 420,697 

1988 391,371 184,633 (1 29,500) 446,504 

1989 380,010 159,537 (124,150) 415,397 

1990 369,458 86,186 (63,000) 392,644 

Department of the Treasury 

Office of Tax Policy 

Source: Federal Reserve Board, Flow of Funds Accounts (various issues). 

Shares 

Intemal New Debt 

Funds Issues 

54.4% 39.1% 

61.4% 33.6% 

72.6% 23.7% 

86.8% 7.9% 

69.7% 25.5% 

65.6% 27.7% 

71.0% 21.7% 

79.4% 14.3% 

79.5% 15.4% 

74.4% 21.3% 

70.4% 24.4% 

72.7% 21.8% 

74.7% 20.5% 

74.9% 20.9% 

76.0% 21.1% 

75.5% 20.2% 

76.9% 22.4% 

79.8% 20.8% 

Net New 

Equity Issues 

6.5% 

5.0% 

3.7% 

5.3% 

4.8% 

6.7% 

7.3% 

6.3% 

5.2% 

4.3% 

5.3% 

5.5% 

4.8% 

4.3% 

2.9% 

4.3% 

0.7% 

-0.6% 

79.1% 19.2% 1.7% 

75.8% 24.3% -0.0% 

71.9% 26.7% 1.4% 

70.2% 27.2% 2.6% 

70.5% 29.7% -0.2% 

66.8% 29.7% 3.5% 

64.7% 29.4% 5.9% 

66.6% 23.2% 10.2% 

67.0% 24.5% 8.5% 

55.1% 40.3% 4.6% 

61.8% 35.3% 2.8% 

84.3% 8.9% 6.7% 

73.6% 20.9% 5.5% 

70.3% 28.5% 1.2% 

72.0% 28.1% -0.0% 

76.6% 26.5% -3.O % 

74.4% 21.7% 3.9% 

72.5% 31.6% -4.1% 

83.3% 16.0% 0.7% 

78.8% 15.6% 5.5% 

78.5% ,39.9% -18.5% 

87.6% 33.4% -21.0% 

73.4% 44.7% -18.1% 

88.5% 29.4% -17.9% 

87.7% 41.4% -29.O % 

91.5% 38.4% -29.9% 

94.1% 22.0% -16.0% 
The Case for Integration 

corporate debt. Rather than simply replacing 

dividends, repurchases have been financed primarily by debt, which results in higher interest 

costs.l8 Increased share repurchases, therefore, 

accounts for part of the recent increases in net 

interest payments, and may be viewed as one 

method that fms have used to reduce their 

corporate tax liabilities. Table 1.3 presents estimates of the portion of net interest payments of 

nonfinancial corporations that might be attributable to "excess" share repurchases of the 1980s, 

where the excess is the difference between actual 

repurchases and the levels that would have 

occurred if the ratio of repurchases to dividends 

had continued at its average for the 1970~'~ The 

table shows that, by 1990, over one quarter of the 

interest payments of nonfiiancial corporations was 

attributable to increased share repurchases.20 

A third measure of corporate debt focuses on 

the ability of corporations to service their debt. 

Corporations meet their interest payments out of 

the cash available after other payments, such as 

those for labor, materials, energy, and taxes. 

Cash flow, calculated as after-tax profits plus

depreciation, 

10 

Table 1.3 

Estimates of Maximum Amount of 

Interest Attributable to 

Increased Share Repurchases 1980-1990 

Year Percentage of Net Interest 

of Nonfinancial Corporations 

1980 1.o 

1981 0.9 

1982 1.3 

1983 1.8 

1984 5.4 

1985 11.2 

1986 12.4 

1987 18.2 

1988 23.6 

1989 23.4 

1990 25.5 

Department of the Treasury 

Office of Tax Policy 

Source: Office of Tax Policy calculations based on 

Standard and Poor's COMPUSTAT data and on information in Poterba (1987). 

serves as a 

measure of funds from which 

a corporation can cover its 

interest payments. Figure 1.7 

shows the ratio of net interest 

to cash flow for nonfinancial 

corporations from 1948 

through 1990. These data 

show a generally upward 

trend over time with substantial increases in the late 

1960s and early 1970s, again 

in the early 1980s, and in the 

last 2 years (1989 and 1990). 

After reaching 19 percent in 

1982, the ratio of net interest 

to cash flow showed little 

upward movement through 

1988 but has increased in 

1989 and 1990. By 1990, it 

reached a postwar high of 19 

percent. Firm level data 

document a similar 

pattern.*l 

Figure 1.7 

Ratio of Net Interest to Cash Flow, 1948-1990 

Nonfinancial Corporations 

0.2 -

0.15 -

3 0.1 -

d 

0.05 -

1948 1954 1960 1966 1972 1978 1984 1990 

Year 

Sources: Department of Commerce (1986) and Department of 

Commerce, Survey nf currentBusiness (July,va.t-iousyears). 
11 

Some economists also are concerned that high 

debt-service burdens (by postwar standards) 

during the 1980s have been associated with an 

increase in corporate bankruptcies. While bankruptcies followed a cyclical pattern over most of 

the postwar period, they remained high (relative 

to postwar standards) throughout the expansion

following the 1981-1982 recession.22 

Benefits and Costs of Corporate Debt 

Debt finance may have nontax benefits. 

Analysts most sanguine about high levels of 

corporate debt and debt-service burdens typically 

maintain that the discipline of debt is desirable 

because it gives lenders indirect means to monitor 

the activities of managers. This need for supervision owes to the separation between ownership 

and management that is characteristic of the 

traditional corporate structure.23 

A disadvantage of higher debt levels is that 

they can increase nontax costs of debt, including 

costs associated with financial distress. Even 

when corporations avoid formal bankruptcy 

proceedings, they incur costs when they cannot 

meet their interest obligations or when debt 

covenants restrict operating flexibility. The costs 

include extra demands on executives’time, supply 

disruptions, declines in customers’ confidence, 

and, frequently, significant legal fees. Corporations therefore must evaluate the tax and nontax 

benefits of additional debt relative to these costs. 

Tax-induced distortions in capital structure can 

entail significant efficiency costs.” 

Corporate Dividend Distributions 

The current system of corporate taxation also 

may distort a corporation’s choice between distributing or retaining earnings and, if amounts are 

distributed, whether they are paid in the form of 

a nondividend distribution, such as a share repurchase. Differences in effective tax rates on dividends and retained earnings are significant.25 

Assessing the efficiency costs of such tax 

differentials requires an analysis of motives for 

corporate dividend distributions in the presence of 

The Case for Integration 

relatively high taxes on such dividends compared 

to capital gains. This Report assumes that corporate dividends offer special nontax benefits to 

shareholders that offset their tax disadvantage,26 

and, accordingly, that corporations set dividend 

payments so that the incremental nontax benefit of 

dividends paid equals their incremental tax cost. 

Under this assumption, the amount of dividends 

paid out is expected to decrease as the tax burden 

on dividends relative to capital gains increases; 

empirical studies are consistent with this prediction.” Investor level taxes on dividends also 

raise the cost of capital (and thereby reduce 

investment) to the extent that corporations pay out 

earnings as dividends. Thus, under the assumptions used in this Report,dividend taxes reduce 

the payout ratio and real investment incentives. 

The growth in share repurchases in the last 

decade supports this view of the linkage between 

the corporate tax and corporate dividends. Share 

repurchases provide a means of distributing 

corporate earnings with, in many cases, more 

favorable shareholder level tax treatment than 

dividend distributions. While a shareholder pays 

tax on the full amount of a dividend at ordinary 

income rates, the shareholder generally pays tax 

on the proceeds of a share repurchase only to the 

extent they exceed share basis and, in some cases, 

at a preferential capital gains rate. Share repurchases increased substantially from 1970 to 1990, 

growing from $1.2 billion (or 5.4 percent of 

dividends) to $47.9 billion (or 34 percent of 

dividends), and peaking in 1989 at $65.8 billion 

(or 47 percent of dividends).28 

Savings and Investment 

The corporate tax increases the tax burden on 

the returns from saving and investing. The magnitudes of tax-induced distortions of investment and 

savings decisions depend on two factors: the size 

of the spread (or wedge) between pre-tax and 

after-tax returns and the responsiveness of savers 

and investors to changes in after-tax returns. The 

more responsive savers and investors are to 

changes in rates of return, the larger the effect of 

a tax wedge of a given size.29The Report documents significant wedges between pre-tax and 
The Case for Integration 12 

after-tax returns to saving and investment. While 

empirical evidence on the effect of changes in the 

after-tax return on savings is in conflict, there is 

substantialempiricalevidencedocumentingimportant effects of capital taxation on in~estment.~' 

See Chapter 13. 

In the presence of international capital flows, 

the U.S. corporate income tax can reduce incentives to invest in the United States, even if it has 

a relatively small effect on saving by U.S. 

citizens. 

l.C NEUTRALITY AS THE GOAL 

OF INTEGRATION 

Integration would reduce and in some cases 

eliminate the distortions of business decisions 

under the current tax system by coordinating the 

individual and corporate income tax systems so 

corporate income is taxed only once. Broadly 

speaking, corporate tax integration seeks to reduce 

tax-induced distortions in the allocation of capital 

by taxing corporate income once, rather than 

zero, once, or multiple times as under the current 

regime. Integration has attracted the attention of 

tax policymakers for many years. The Department 

of the Treasury and the Congress have considered 

integration on several occasions, most recently in 

1984 and 1985.31Many industrial countries have 

long had integrated systems; several others have 

recently adopted integrati~n.~' 

The classical system of corporate taxation is 

inefficient because it creates differences in the 

taxation of alternative sources of income from 

capital. Under the classical system, a taxpayer 

conducting business in corporate form faces a 

different tax burden on equity financing than a 

taxpayer conducting the same business in noncorporate form. A corporation that raises capital 

in the form of equity faces a different tax burden 

than a corporation that raises the same amount of 

capital from debt. A similar disparity exists in the 

treatment of corporations that finance with retained earnings and those that pay dividends and 

finance with new equity. This Report provides 

evidence that these distortions impose significant 

economic costs, including reduced fmancial 

flexibility of corporations and an inefficient 

allocation of capital. 

A traditional goal of integration proposals has 

been to tax corporate income only once at the tax 

rate of the shareholder to whom the income is 

attributed or di~tributed.~~ Under the traditional 

approach, corporate income ideally would be 

taken into account when earned in determining

each individual's economic income and would be 

taxed at each individual's marginal tax rate.34To 

illustrate, assume that a corporation has $100 of 

income on which it pays $34 in corporate tax. 

The corporation's shareholder has a marginal rate 

of 28 percent. Traditional proposals would typically treat the shareholder as having received 

income of $100, but credit the shareholder with a 

tax payment of $34. Since the shareholder owes 

only $28 in tax on $100 of income, traditional 

proposals typically provide that the shareholder is 

entitled to a $6 refund or credit against other 

taxes. 

Assuring that corporate income is taxed once, 

but only once, does not require that corporate 

income be taxed at individual rates, however. 

Attaining a single level of tax-with the most 

significant efficiency gains we project from any 

system of integration-can be achieved with a 

schedular system in which all corporate income is 

taxed at a uniform rate at the corporate level 

without regard to the tax rate of the corporate 

shareholder. Under the current rate structure, in 

which the corporate rate is slightly higher than the 

maximum individual rate, there seems littlereason 

to tax corporate income at shareholder rates. In 

contrast, an integration proposal developed in the 

late 1970s, when the maximum individual rate on 

capital income of 70 percent exceeded the corporate rate of 46 percent, might well have required 

taxation at shareholder rates in order to prevent 

avoidance of the higher shareholder rates.35 

Neutral taxation of capital income will reduce 

the distortions under the current system.36Economic efficiency suggests that all capital income 

should be taxed at the same rate. Accordingly, we 

place less emphasis than some advocates of 

integration on either trying to tax corporate 
The Case for Integration 

income at shareholder tax rates or on simply 

trying to eliminate one level of tax on distributed 

corporate income. 

The prototypes advanced in this Report use the 

corporation not as a withholding agent for individual shareholders (which implies ultimate taxation 

at shareholder rates), but rather as a means of 

collecting a single level of tax on capital income 

at a uniform rate. Nevertheless, Chapter 3 discusses a shareholder allocation prototype, which 

closely resembles the traditional passthrough 

methods of integration. We do not recommend 

adopting shareholder allocation, but it illustrates 

the problems presented by an integration mechanism that imputes corporate income to shareholders and taxes it at individual rates. 

A decision to adopt a schedular system for 

taxation of business capital is not irreversible. 

Future policymakers can, if they wish, add refund 

and crediting mechanisms to achieve the traditional objective of taxing corporate income at the 

individual shareholder’s marginal rate, or they can 

address the issue by adjusting the corporate rate to 

more precisely approximate individual rates.37 

Our judgment is that neither of these courses is 

necessary to achieve the principal benefits of an 

integrated tax system. They are options that can 

be added once the complexities of transition have 

been mastered. Deferring them makes the integration prototypes examined in this Report simpler to 

implement and conserves revenues. 

We approach integration primarily as a means 

of reducing the distortions of the classical system 

and improving economic efficiency. This Report’s 

emphasis on enhancing neutrality in the taxation 

of capital income can be summarized in four goals 

for the design of an integrated tax system: 

0 Integration should make more uniform the taxation 

of investment across sectors of the economv. The 

U.S. corporate system discourages investment in 

the corporate sector relative to investment in the 

noncorporate sector and owner-occupied housing. 

That is, current law results in too little capital in 

the corporate sector relative to that elsewhere in the 

economy. Integration seeks to reduce this 

distortion. 

Integration should make more uniform the taxation 

of returns eamed on alternative financial instruments. Darticularlv debt and euuitv. The U.S. 

corporate tax system discourages corporations from 

financing investments with equity as opposed to 

debt. Such a system violates the goal of neutral 

taxation. Although equalizing the tax treatment of 

debt and equity need not be the overriding goal of 

integration, equal treatment follows from the goal 

of attaining neutral taxation of capital income. 

Integration should distort as little as Dossible the 

choice between retaining and distributing earnings. 

The U.S.corporate system discourages the payment of dividends and encourages corporations to 

retain earnings or to make nondividend 

distributions. 

Integration should create a svstem that taxes capital 

income once. Imposing double or triple taxation on 

some forms of capital income while not taxing 

others violates the objective of achieving neutrality 

between corporate and noncorporate forms of 

investment. 

Integration is not a cure-all. Even an integrated system cannot attain complete neutrality with 

respect to the taxation of capital income. One 

reason is that integration fails to address an 

important category of tax distortions: distortions 

in allocating investment capital among assets. 

These inter-asset distortions are important, and 

reducing such distortions was an important impetus and goal of the 1986 Act. Because a corporate 

income tax per se does not cause inter-asset 

distortions, this Report does not directly address 

them.38 

The integration prototypes analyzed in this 

Report are income tax systems. The Report does 

not consider non-income tax refom of corporate 

taxation. For example, some economists have advocated a corporate cash-flow tax.39In 1984, the 

Department of the Treasury rejected substitution 

of a consumption-based tax for the income tax,4O 

and in the 1986 Act, Congress moved decisively 
The Case for Integration 14 

in the direction of strengthening the individual 

income tax. So long as the individual tax base is 

income, we do not beiieve a corporate cash-flow 

tax would enhance the neutral treatment of capital 

income relative to the reforms discussed here. 

Revenue concerns also may prevent integration 

from fully equalizing the taxation of alternative 

investments. Some integration proposals would 

reduce government revenue from income taxes. 

Lost tax revenue must be made up either by 

increasing other taxes or by reducing government 

spending. Replacement taxes may create distortions and alter the distribution of tax burdens. See 

Chapter 13. 

Finally, integration does not directly address 

the general question of whether the overall tax 

rate on capital income, and hence the overall cost 

of capital, is too high. If integration eliminates 

double taxation of corporate source income, the 

overall tax rate on capital income would fall, 

other things being the same. Integration must be 

financed, however, and taxes on other types of 

capital income might rise. Thus, integration primarily focuses on improving the allocation of the 

Nation’s capital stock, but not necessarily on 

reducing the overall tax rate on capital income. 

As Chapter 13 documents, the benefits associated 

with such improvements are nonetheless 

substantial. 
PART 11: PROTOTYPES 

INTRODUCTION 

This Part presents three prototypes for implementing integration in the United States: (1) a 

dividend exclusion prototype, (2) a shareholder 

allocation prototype, and (3) the Comprehensive 

Business Income Tax (CBIT) prototype. 

Our trading partners that have integrated their 

corporate tax systems, including most European 

countries, as well as Canada and Australia, have 

all adopted distribution-related integration systems. Such integrated systems retain a separate 

corporate level tax on undistributed earnings but 

eliminate part or all of the corporate level tax on 

corporate earnings distributed to shareholders as 

dividecds. Distribution-related integration can be 

accomplished by excluding dividends from shareholders’ income (a dividend exclusion system), by 

allowing shareholders a credit for corporate level 

taxes (an imputation credit system), or by allowing corporations a deduction for dividends (a 

dividend deduction system). 

After considering each of these three altematives, we determined that a dividend exclusion 

system would implement in a relatively simple 

and straightforward manner our policy recommendations. The flexibility of an imputation credit 

system in responding to important policy issues, 

such as the treatment of tax preferences, foreign 

taxes, and tax-exempt and foreign shareholders 

under integration, does not, in our view, outweigh 

its complexity in implementation. A dividend 

deduction system would produce results in many 

cases contrary to our policy recommendations. 

Chapter 2 outlines a dividend exclusion prototype, 

and Chapters 11 and 12 discuss the imputation 

credit and dividend deduction alternatives. Because an imputation credit system is the mechanism of corporate tax integration most frequently 

used abroad, we discuss an imputation credit 

prototype in considerable detail in Chapter 11.2 

The Report also examines two integration 

systems that are not distribution-related. 

Chapter 3 describes a shareholder allocation 

integration prototype, which would extend integration to retained earnings by taxing both distributed 

and retained corporate earnings at the shareholder’s tax rate. Chapter 4 describes the CBIT 

prototype, which, in effect, would extend a 

dividend exclusion system to payments of interest 

in order to equalize the treatment of debt and 

equity and would tax corporate and noncorporate 

businesses in the same manner. This Report 

recommends the dividend exclusion prototype and 

CBIT for further study. While we do not recommend adopting the shareholder allocation prototype, we include it here to illustrate how a traditional full integration or passthrough model might 

be implemented and the problems it presents. 

Each of these prototypes would move the U.S. 

tax system in the direction of more neutral taxation of corporate income and, in so doing, would 

reduce significantly tax-induced distortions in the 

allocation of capital. The prototypes generally are 

structured to implement our recommendations on 

four major issues: 

0 The benefit of coruorate level tax preferences 

should not be extended to shareholders. Tax preferences, e.g., exempt state and local bond interest 

and accelerated depreciation, may reduce the 

corporate level tax, but current law does not extend 

corporate level tax preferences to shareholders. 

When corporate earnings sheltered by preferences 

are distributed to shareholders, they are currently 

taxed. Integration of the corporate income tax need 

not become an occasion for expanding the benefits 

of tax preferences. Therefore, we do not recommend extending corporate level tax preferences to 

shareholders under integration, and we have attempted to develop administrable rules to reach this 

result whenever we could do so in a manner 

compatible with the prototype. See Chapter 5. 

0 Integration shouldnot reduce the total tax collected 

on coruorate income allocable to tax-exemut inves­

_. tors. Under current law, tax-exempt organizations 

holding corporate stock, in fact, are not exempt 

from the corporate level tax imposed on corporate 

equity investments. Because corporate income is 

15 
Prototypes 16 

subject to tax at the corporate level regardless of 

the exempt status of a shareholder, a tax-exempt 

organization is exempt only from the shareholder 

level tax. Integration presents the fundamental 

question whether under an integrated tax this 

treatment should continue, or whether integration 

should reduce the total taxes paid on corporate 

income allocable to tax-exempt entities. This 

Report recommends, in general, retaining the 

current level of taxation of corporate equity income 

allocable to tax-exempt shareholders. See Chapter 6. The CBIT prototype would introduce a 

corporate level tax on income allocable to taxexempt bondholders as well. See Chapter 4. 

0 Integration should be extended to foreign shareholders only through treatv negotiations. not bv 

statute. The United States generally imposes two 

levels of tax on foreign equity investment in U.S. 

corporations (inbound investment). Thus, the 

United States taxes the business profits of foreign 

owned domestic companies similarly to the profits 

of U.S. owned companies and also imposes significant withholdingtaxes on dividends paid to foreign 

investors. The basic issue that an integration 

proposal must resolve for inbound investment is 

whether, by statute, the United States should 

continue to collect two levels of tax on foreign 

owned corporate profits or whether foreign investors should receive benefits of integration similar to 

those received by domestic investors. This Report 

generally recommends that foreign shareholdersnot 

be granted integration benefits by statute, but 

instead that this issue be addressed through treaty 

negotiations in order to achieve reciprocity. Most 

of the major trading partners of the United States 

that have adopted integrated corporate tax regimes 

have followed this approach. See Chapter 7 and 

Appendix B. 

0 Foreign taxes paid bv U.S. comorations should not 

be treated, bv statute, identicallv to taxes Daid to 

the U.S. Government. The United States permits 

U.S. corporations to credit foreign taxes against 

U.S. taxes on foreign source income (outbound 

investment) but taxes shareholders on the distribution of such income without regard to the foreign 

taxes paid on that income. Treating foreign and 

U.S. corporate level taxes equally under an integrated system by statute would significantlyreduce 

the current U.S. tax claim against foreign source 

corporate profits and often would completely 

exempt such profits from U.S. taxation at both the 

corporate and shareholder levels. Such unilateral 

action would result in a significant departure from 

the current allocation of tax revenues between the 

source and residence country. We therefore recommend that foreign taxes not be treated, by statute, 

the same as U.S. taxes. As a consequence, the 

prototypes generally would retain the foreign tax 

credit at the corporate level but would continue to 

tax foreign source income when it is distributed to 

shareholders. Extending the benefits of integration 

to foreign source income is more properly accomplished in the context of bilateral treaty 

negotiations. See Chapter 7. 
CHAPTER 2: DMDENDEXCLUSIONPROTOTYPE 

2.A INTRODUCTION AND 

OVERVIEW OF PROTOTYPE 

The dividend exclusion prototype set forth in 

this chapter would, with few changes in current 

law, implement many of this Report’s key policy 

recommendations.’ The principal advantage of 

the dividend exclusion prototype is its simplicity 

and relative ease of implementation. We considered an imputation credit prototype that would 

achieve results similar to the dividend exclusion 

prototype but at the cost of additional complexity, 

including an entirely new regime for taxing 

corporate distributions. Although we do not 

recommend an imputation credit system, such a 

system is described in Chapter 11 because it 

provides useful background for understanding the 

dividend exclusion prototype. A summary of the 

prototype follows. 

Mechanics. Under the dividend exclusion 

prototype, corporations would continue to calculate their income under current law rules and pay 

tax at a 34 percent rate.2 Shareholders receiving 

corporate distributions treated as dividends under 

current law, however, generally would exclude 

the dividends from gross income. The prototype 

requires corporations to keep an Excludable 

Distributions Account (EDA) to measure the 

amount of dividends that can be excluded by 

shareholders-essentially an amount on which 

corporate taxes have been paid. Thus, the dividend exclusion prototype would apply the corporate tax rate of 34 percent to both distributed &d 

retained income but would eliminate the shareholder level tax on dividends paid from fullytaxed corporate incomeV3All other distributions, 

e.g., interest and returns of capital, would be 

taxed in the same manner as under current law. 

Tax-Exempt Shareholders. The dividend 

exclusion prototype would automatically retain the 

current level of taxation of corporate income 

earned on equity capital supplied by tax-exempt 

shareholders. Income from equity investments by 

tax-exempt organizations would be taxed at the 

corporate level under the current corporate tax 

rules but, when distributed, would be exempt 

from tax at the shareholder level.4 

Corporate Shareholders. A corporate shareholder would exclude from income excludable 

dividends received and would add the amount of 

such dividends to its EDA. The prototype retains 

the current dividends received deduction for 

taxable dividends. 

Tax Preferences.. The prototype retains the 

corporate tax preferences available under current 

law and the corporate alternative minimum tax. 

To avoid extending corporate tax preferences to 

shareholders, the prototype permits shareholders 

to exclude only those dividends deemed made out 

of income that has been taxed fully at the corporate level. Thus, corporate dividends paid to 

shareholders out of preference income would 

continue to be taxable as under current law. 

Mechanically, this is accomplished once the 

corporation’s supply of fully-taxed income (as 

reflected in the EDA) is exhausted, by making 

additional dividends taxable to shareholders. See 

Section 2.B. As under current law, preference 

income distributed to tax-exempt shareholders 

would escape taxation at both the corporate and 

shareholder levels. 

Foreign Source Income. The prototype retains 

the current foreign tax credit system, including 

the corporate level indirect foreign tax credit for 

taxes paid by foreign subsidiaries. The prototype, 

however, does not treat foreign taxes the same as 

U.S. taxes in determining the EDA, with the 

consequence that, as under current law, distributions of foreign earnings that have been shielded 

by the foreign tax credit at the corporate level are 

taxable to shareholders when distributeda6 

Foreign Shareholders. The prototype retains 

the current 30 percent statutory withholding tax 

on dividends. In addition, it retains the branch 

profits tax on earnings considered repatriated from 

U.S. branches of foreign corporations. Thus, as 

under current law, inbound investment is subject 

to two levels of U.S. tax, with reductions in the 

17 
~ 

Prototypes 18 

rate of withholding tax negotiated through tax 

treatie~.~ 

CaDital Gains and Share Repurchases. Chapter 8 discusses the treatment of capital gains on 

sales of corporate stock and the treatment of share 

repurchases. 

Structural Issues. The dividend exclusion 

prototype does not require any major changes to 

current rules concerning the tax treatment of 

corporate acquisitions. Adopting the prototype 

does, however, require consideration of rules for 

the carryover or separation of corporation EDA 

balances in liquidations and tax-free corporate 

reorganizations. 

ImDact on Tax Distortions. Table 2.1 illustrates the impact of the dividend exclusion prototype on the three distortions integration seeks to 

address: the current law biases in favor of corporate debt over equity finance, corporate retentions 

over distributions, and the noncorporate over the 

corporate form. The only difference between the 

current law treatment of nonpreference, U. S. source business income and its treatment under 

the dividend exclusion prototype is the taxation of 

corporate equity income distributed to individuals. 

Since exclusion of dividends by individuals would 

remove the individual level tax, the total tax rate 

on distributed earnings would be reduced to the 

corporate rate (tc, generally 34 percent), except 

for the influence of investor level taxes on foreign 

investors. This reduction would narrow (but not 

eliminate) the rate differential between distributed 

corporate and noncorporate equity income and 

between corporate equity income and interest. 

These reductions in differentials would help 

reduce the debt-over-corporate-equity-financeand 

noncorporate-over-corporateform distortions. The 

tax rate on undistributed corporate equity income 

would now be higher for individuals than the rate 

on distributed corporate equity income, so the tax 

bias against corporate distributions would likely 

be reversed, in the absence of a DRIP. See 

Chapter 9. For tax-exempt and foreign investors, 

there would be no change in the tax treatment of 

nonpreference, U.S. source business income. (The 

tax bias against distributed earnings thus would 

remain for foreign investors.)' 

2.B THE NEED FOR A 

LIMITATION ON 

EXCLUDABLE DIVIDENDS 

In General 

An exclusion from shareholder level taxfor all 

dividends received not only would eliminate the 

Table 2.1 

Total U.S. Tax Rate on a Dollar of 

NonPreference, U.S. Source Income from a 

U.S. Business Under Current Law and the 

Dividend Exclusion Prototype 

Dividend 

Exclusion 

Type of Income Current Law Prototype 

I. Individual Investor is Income Recipient 

Corporate Equity: 

Distributed 

Undistributed 

t,+(l-t&

t, +(1-t& 

tC 

t, +(1-t& 

Noncorporate Equity ti ti 

Interest ti ti 

Rents and Royalties ti ti 

II.Tax Exempt Entity is Income Recipient 

Corporate Equity: 

Distributed tC tc 

Undistributed tC tC 

Noncorporate Equity

Interest 

tC 

0 

tC 

0 

Rents and Royalties 0 0 

III. Foreign Investor is Income Recipient 

Corporate Equity: 

Distributed t,+ (1-tc)t, tc+(1-tdt, 

Undistributed t, tC 

Noncorporate Equity twN twN 

Interest twI twI 

Rents and Royalties twR twR 

Department of the Treasury 

Office of Tax Policy 

tc = U.S. corporateincome tax rate. 

ti = U.S. individual income tax rate. 

tg = U.S. effective individual tax rate on capital gains. 

twD,t, h,twR= U.S. withholding rates on payments 

to foreigners of dividends, noncorporate equity 

income, business interest, and rents and royalties, 

respectively. Generally varies by recipient, type of 

income, and eligibility for treaty benefits and may be 

zero. 
19 

double tax on distributed corporate income, but 

also would eliminate the current shareholder level 

tax that serves as the only U.S. tax on distributed 

income that has been sheltered from corporate 

level tax by preferences and on distributed foreign 

source income that has borne only foreign taxes. 

To prevent the dividend exclusion system from 

extending preferences to shareholders and to 

ensure that foreign source income that has not 

borne U.S. tax at the corporate level is subject to 

tax at the shareholder level when distributed, the 

dividend exclusion prototype limits the amount of 

dividends that can be excluded at the corporate 

level to an amount that has been subject to U.S. 

tax at the corporate level. Thus, as under current 

law, corporate preference income would generally 

remain free of tax until distributed and, when 

distributed, would be taxed at shareholder rates. 

Foreign source income sheltered by foreign tax 

credits at the corporate level also would continue 

to be taxed when distributed to shareholders. See 

Chapters 5 and 7. 

The prototype treats dividends as made first 

from a corporation's fully-taxed income, rather 

than from preference or foreign source income. 

Stacking dividends first against fully-taxed income 

should permit many corporations to continue their 

current dividend policy while paying excludable 

dividends. Even corporations with substantial 

preference or foreign source income can continue 

to pay dividends without incurring any additional 

corporate level tax, although the dividends would 

be taxable at the shareholder level. We considered, but rejected, the alternative of imposing a 

nonrefundable "compensatory tax" at the corporate level on distributions of preference or foreign 

source in~ome.~See Chapter 5. A nonrefundable 

compensatory tax not only reduces cash available 

to pay dividends but also increases the total tax 

burden on dividends paid to tax-exempt and 

foreign shareholders as well as to any shareholder 

taxed at less than a 34 percent rate; on the other 

hand, imposition of such a tax would permit 

uniform dividend exclusion. On balance, concern 

that a compensatorytax would distort the dividend 

decisions of corporations, particularly those with 

large numbers of tax-exempt or foreign shareholders, by requiring them to pay an extra tax to 

Prototypes 

maintain their current dividend policy, led us to 

the alternative described here. Section ll.B 

discusses a compensatory tax in more detail. 

The prototype retains the corporate alternative 

minimum tax (AMT), which functions, as under 

current law, to curb the excessive use of tax 

preferences at the corporate level. The prototype 

treats AMT as taxes paid for purposes of determining the corporation's supply of fully-taxed 

income, but effectively converts income taxed at 

the 20 percent corporate AMT rate to a smaller 

amount of income taxed at the regular 34 percent 

rate.lo 

Identifying Distributed Preference 

Income: the EDA 

To determine whether dividends are paid out 

of fully-taxed income or preference income, the 

prototype requires corporations to maintain an 

Excludable Distributions Account (EDA). Amounts included in the EDA are considered 

"fully-taxed income.'I Dividends paid are stacked 

first against fully-taxed income. 

As a mechanical matter, the EDA measures a 

corporation's supply of fully-taxed income based 

on the taxes actually paid by the corporation. The 

corporation simply tracks actual corporate taxes 

paid and then converts that amount into an equivalent amount of after-tax income taxed at a 34 

percent rate, using the following formula: 

Annual additions to EDA = 

+ excludable dividends received 

Thus, for each $34 of taxes paid (whether regular 

corporate tax or AMT),the corporation may pay 

$66 of excludable dividends, i.e., each $1 of 

corporate taxes paid supports $1.94 of excludable 

dividends or each dollar of excludable dividends 

must be supported by at least $0.52 of corporate 

taxes paid." The effect of calculating additions 

to the EDA at 34 percent is to ensure that distributed income has been taxed at the full corporate 

rate, even though, if taxable to shareholders, the 
Prototypes 20 

dividend would be taxed, at most, at the 31 

percent maximum individual rate. 

The EDA increases when a corporation pays 

taxes (including estimated taxes) or, as described 

under "Corporate Shareholders" below, receives 

an excludable dividend from another corporation. 

The EDA decreases when a corporation pays a 

dividend or receives a refund of taxes paid. 

Dividends paid when the EDA has been reduced 

to zero are treated as paid from preference income 

and are fully includable in shareholder's income. 

Examde. A corporation with a zero initial EDA 

balance earns $75 of taxable income and $25 of 

exempt income. The corporation pays $25.50 of 

corporate tax and has $74.50 available for distribution to shareholders. The $25.50 of tax supports 

the addition of $49.50 to the corporation's EDA 

($25.50/.34-$25.50). If the corporation actually 

distributes $74.50, only $49.50 of the dividend is 

excludable, because the EDA balance is $49.50. 

The remaining $25 represents a distribution of 

preference income that is fully subject to tax at the 

shareholder level. 

The prototype requires corporations to report 

annually to shareholders and the IRS the excludable and taxable portions of dividends. In the 

preceding example, the corporation would report 

the first $49.50 distributed as an excludable 

dividend and the next $25 distributed as a taxable 

dividend. Shareholders would include taxable 

dividends in income as under current law. Corporations also would report to the IRS annually the 

adjustments to and balance in the EDA. 

Adjustments to a corporation's tax liability for 

a prior year are reflected as adjustments to the 

corporation's EDA in the current year. Making 

audit adjustments to the EDA in the current year 

avoids the problem of recharacterizing dividends 

paid in prior years.'* An increase in a prior 

year's tax liability increases the EDA in the year 

the adjustment is made and the additional tax is 

paid, and a decrease in a prior year's tax liability, 

e.g., through carryback of a net operating loss, 

gives rise to a refund and requires a corresponding reduction in the EDA in the year the refund is 

received. Refunds would be limited to the balance 

in the corporation's EDA.13 Refunds in excess of 

the EDA balance would be carried forward to be 

applied against future corporate taxes. Similarly, 

an NOL carryback would not be permitted to 

reduce the EDA below zero; losses in excess of 

this amount would be carried for~ard.'~ 

Corporate Shareholders 

Current law limits the imposition of multiple 

levels of corporate taxation by permitting corporate shareholders to deduct some or all of their 

dividends received from domestic corporations, 

depending on the degree of affiliation with the 

distributing corporation. 

Under the prototype, distributions from an 

EDA are excludable from the income of any 

shareholder, including a corporate shareholder. 

The recipient corporation adds the amount of 

excludable dividends it receives to its EDA. This 

prevents the imposition of a second level of tax 

when excludable dividends are redistributed to the 

shareholders of the recipient corporation. 

The prototype retains current law for taxable 

dividends (dividends in excess of the distributing 

corporation's EDA) received by corporations. 

Thus, taxable dividends received from a U.S. 

Corporation (and a portion of dividends from 

certain foreign corporations engaged in business 

in the United States) would entitle the recipient to 

a dividends received deduction (DRD). A recipient corporation allowed only a 70 or 80 percent 

DRD would pay tax on the remainder of the 

dividend. Any taxes paid on the dividend would 

be added to the EDA, determined in accordance 

with the general formula for computing additions 

to the EDA set forth above. To the extent the 

recipient corporation qualifies for the DRD, the 

prototype defers the investor level tax on preference income until it is ultimately distributed to 

individual shareholders.l5 

Anti-abuse Rules 

We have considered whether special rules are 

necessary to limit a corporation's ability to target 

(or "stream") excludable dividends to taxable 
21 

shareholders and otherwise taxable dividends to 

tax-exempt shareholders. Streaming undercuts the 

prototype's preservation of the current level of 

taxation of corporate equity income paid to taxexempt and foreign shareholders by denying 

refunds of corporate taxes paid. On the other 

hand, tax-exempt and foreign investors may enter 

into a variety of ordinary business structures that 

enable them to receive income not taxed at the 

corporate level, e.g., by holding debt instead of 

equity.16 These arrangements are permitted under current law, and they are not limited under 

the prototype. The ability to arrange a capital 

structure to minimize taxes emphasizes the point 

that eliminating the double tax on dividends will 

not, by itself, eliminate the tax system's current 

bias in favor of debt financing. A more comprehensive approach such as CBIT (described in 

Chapter 4) is required to address this systemic 

bias. 

In the dividend exclusion prototype, concerns 

about streaming are balanced against the cost of 

complexity by restricting only a limited class of 

streaming transactions. In the prototype, current 

law rules that apply in analogous situations are 

extended." First, the prototype adopts a 45 day 

holding period requirement for dividends to be 

excludable to prevent tax-exempt shareholders 

from routinely selling stock to taxable shareholders just before payment of an excludable dividend 

and then repurchasing the stock.18 Second, depending on the treatment of capital gains, the 

prototype could extend application of the extraordinary dividend rules of IRC 9 1059 to excludable 

dividends in order to prevent taxable shareholders 

from Ifstripping" excludable dividends.l9 The 

existing rules of IRC 0 305 also may be useful in 

preventing other kinds of streaming.2o 

Rules like those of IRC $8 382 through 384, 

which limit the use of net operating losses and 

other corporate attributes after a change in ownership, are not included in the prototype. An EDA 

balance represents fully-taxed corporate income, 

and, in general, integration should prevent that 

income from being taxed again at the shareholder 

level. The issue is difficult, however, because 

allowing unlimited use of EDA balances may 

Prototypes 

permit an acquiror to use a target's EDA balance 

to defer or eliminate tax on the acquiror's preference income.21 On balance, we decided that 

extending the rules would create considerable 

complexity and may not provide any substantial 

benefit in addition to the rules discussed above.22 

If significant evidence of abuse develops, ownership change limitation rules could be adopted at 

that time.23 

Policymakers may wish to consider whether 

interest expense paid on debt incurred to purchase 

corporate stock should be disallowed under rules 

like those of IRC 9 265(a). In a dividend exclusion system, corporate earnings generally bear 

only one level of tax. See the example in Section 4.G.% While the potential for rate arbitrage 

exists under current law, it may be less of a 

problem where only one of two levels of tax is 

eliminated. The issue is a difficult one, however, 

because disallowing an interest deduction for 

interest paid to a taxable lender will result in the 

imposition of two levels of tax. Moreover, in 

CBIT, we recommend extending the interest 

disallowance rules with respect to CBIT debt and 

equity. See Section 4.G. There may be less 

pressure to adopt the same rule in the dividend 

exclusion prototype, however, because it does not 

equate the treatment of debt and equity.25 

2.C FOREIGN SOURCE INCOME 

Under the prototype, U.S. individual shareholders would continue to include in income 

dividends received from foreign corporations and 

to claim a foreign tax credit for any foreign 

withholding taxes imposed on the dividend. 

Similarly, U. S. corporate shareholders owning 

less than 10 percent of a foreign corporation's 

voting stock (the threshold requirement for the 

U.S. corporation being eligible to claim an indirect foreign tax credit under IRC 0 902) would 

include in income dividends from the foreign 

corporation and would claim a foreign tax credit 

for foreign withholding taxes. The corporate 

shareholder would not add any amount to its EDA 

to reflect foreign income taxes paid by the foreign 

corporation or foreign withholding taxes on 

dividends. 
Prototypes 22 

U.S. corporate shareholders owning at least 10 

percent of a foreign corporation's voting stock 

would continue to include in income dividends 

from the foreign corporation and to claim both a 

direct credit for foreign withholding taxes and an 

indirect foreign tax credit with respect to such 

dividends under the rules of IRC 0 902 of current 

law, subject to the foreign tax credit limitation in 

IRC 0 904. Under these provisions, the corporate 

shareholder receives a credit, subject to certain 

limitations, for foreign income taxes paid by the 

foreign corporation with respect to earnings out of 

which the dividends are paid. A U.S. corporation 

would increase its EDA only by an amount that 

reflects the residual U.S. tax (if any) imposed on 

the dividend income. Thus, absent any residual 

U.S. tax (and any EDA balance attributable to 

U.S. tax on U.S. source income), distributions 

out of foreign source income taxed abroad, in 

effect, would be taxed at the shareholder level as 

under present law. 

U.S. corporations with foreign branch operations, or which receive interest, rents, royalties, 

or other income from foreign sources, would 

continue to be subject to current U.S. tax on their 

foreign source income with a credit under IRC 8 

901 for foreign income taxes. As with earnings of 

foreign subsidiaries, the U.S. corporation would 

increase its EDA only to reflect the amount of 

any residual U.S. tax imposed on the foreign 

source income. 

Although we do not recommend a statutory 

rule permitting additions to an EDA based on 

payment of foreign taxes, consideration might be 

given to granting authority to enter into tax 

treaties that treat foreign taxes like U.S. taxes, 

where reciprocity exists.26Treating foreign taxes 

like U.S. taxes would allow a U.S. corporation 

doing business in a treaty jurisdiction to pay 

excludable dividends to its U. S. shareholderseven 

if its income was entirely shielded from U.S. tax 

by foreign tax credits." 

2.D LOW-BRACKET 

SHAREHOLDERS 

Taxing corporate income at a uniform rate at 

the corporate level significantly reduces the 

complexity of the dividend exclusion (and CBIT) 

prototypesand reduces the burdens of transition to 

a new system because refund and credit provisions 

are not required to deal with "overcollections" of 

tax from individual &payers with marginal rates 

lower than the 34 percent corporate rate. While 

this simplificationconcern has been a major factor 

in our decision to recommend a schedular system, 

inspection of the available data also suggests that 

the adoption of a schedular system will not result 

in significantly higher taxation of corporate 

income than the use of individual rates for most 

taxable shareholders. The data indicate that 

approximately two-thirds of corporate dividends 

paid to taxable individual shareholders, i.e. , shareholders who are U.S. citizens or residents, 

are paid to individuals with average marginal tax 

rates of more than 25 percent. 

It might at first appear that corporate income 

distributed to individuals with average marginal 

tax rates of less than 25 percent should be taxed 

at a lower rate, because a lower marginal rate 

indicates a lower income and, inferentially, less 

ability to pay. On the other hand, low-bracket 

shareholders who receive dividends clearly own 

some property, i.e., stock, and it is not clear 

whether their low taxable incomes accurately 

reflect their ability to pay.'* Accordingly, the 

dividend exclusion and CBIT prototypes do not 

contain provisions reducing the rate of taxcollected on corporate income distributedto low-bracket 

shareholders. 

If policymakers desired to tax distributed 

corporate income at shareholder rates, a dividend 

exclusion system could allow a tax credit that 

would refund all or part of the excess tax collected at the corporate level. To refund fully the 
23 

difference between 34 percent and the shareholder 

rate, the amount of the taxcredit would equal (1) 

the amount of the dividend received, grossed up 

at the 34 percent rate, multiplied by (2) the 

difference between 34 percent and the shareholder’s marginal tax rate. Each shareholder 

would calculate his own credit based on a formula 

(or a set of tables) and his marginal tax rate.29 

Examde. A corporation earns $100, pays tax of 

$34, and distributes $66 to a shareholder in the 15 

percent marginal tax bracket. The shareholder 

would owe no tax on the dividend and would be 

allowedataxcredit of$19 (($66/.66)X(.34-.15)), 

which could be used to offset other income. 

Such credits would be allowed only for 

excludable dividends.30 Allowing a shareholder 

tax credit for taxable dividends (dividends considered made out of preference income) would 

confer a shareholder level benefit for corporate 

level tax that had not been paid. 

2.E INDIVIDUAL ALTERNATIVE 

MINIMUM TAX 

Historically, individuals have been subject to 

a minimum tax to ensure that at least a small 

amount of tax is paid on an individual’s economic 

income and to respond to public perceptions that 

permitting high-income individuals to pay little or 

no income tax undermines the fairness of the tax 

system. The exclusion for dividends described 

here might result in some high-income individuals 

paying little or no tax at the individual level, thus 

raising issues of public perception. The EDA, 

however, operates to ensure that any dividends 

excludable from an individual’s gross income 

have already been subject to one level of tax at 

the corporate level. The investor’s income tax has 

been prepaid at the corporate level at the 34 

percent corporate rate, which exceeds the top 

individual rate. Including excludable dividends in 

the individual AMT would serve only to reinstitute a double tax on dividends and would 

Prototypes 

undermine to some extent the basic goals of this 

system of integration. 

2.F STRUCTURAL ISSUES 

This section discusses several areas of current 

law that should be modified to reflect adoption of 

the dividend exclusion prototype. This section 

does not provide a comprehensive analysis of the 

technical changes required but instead raises 

issues for further development. 

Corporate Acquisitions 

The dividend exclusion prototype retains the 

basic rules governing the treatment of taxable and 

tax-free corporate asset and stock acquisitions. 

The prototype permits taxable asset acquisitions to 

be made with only a single level of tax. Corporate 

tax paid on gain recognized on the sale of assets 

would be treated like any other corporate level tax 

payment and would support a corresponding 

addition to the EDA, thus generally allowing a 

tax-free distribution of proceeds to shareholders 

when the corporation liquidates. Upon liquidation, 

shareholders would, as under current law, generally recognize gain to the extent liquidation 

proceeds exceed share basis. A shareholder’s gain 

would be excludable, however, to the extent of a 

proportionate share of the liquidating corporation’s Stock acquisitions may face a 

higher tax burden than asset acquisitions if capital 

gains on corporate stock that are attributable to 

retained earnings are taxed in full at shareholder 

rates. See Chapter 8. 

The prototype retains current law rules that 

treat a qualifying corporate reorganization as taxfree at the corporate level (with the target’s tax 

attributes, including its asset bases, carrying over 

to the acquiror) and at the shareholder 

Additional rules would be needed to coordinate 

the reorganization provisions with the dividend 

exclusion prototype. For example, the EDA of a 

corporation acquired in a reorganization should 
Prototypes 24 

generally carry over to its successor. In a divisive 

reorganization, the EDA should be divided proportionately between the corporation^.^^ 

Earnings and Profits 

The prototype retains the current law rules 

that treat a distribution as a dividend only to the 

extent of current and accumulated earnings and 

profits.34Distributions that exceed earnings and 

profits are treated as a return of capital to the 

extent of a shareholder’s basis and then as gain on 

the disposition of the Under the 

prototype, only a distribution that is made out of 

the corporation’s EDA is eligible for exclusion at 

the shareholder level. If a distribution is made 

when a corporation has no EDA balance but has 

earnings and profits, it is a taxable dividend; if 

the corporation has no earnings and profits, the 

distribution is treated as a return of capital to the 

extent of the shareholder’s basis and then as gain. 

Some commentators have argued that the 

earnings and profits rules should be eliminated 

under current law, essentially arguing that the 

complexity of the earnings and profits rules 

outweigh any benefits that may result.36 In 

general, at least two alternatives to the earnings 

and profits rules are possible. All nonliquidating 

distributions to shareholders could be treated as 

dividends, except where a distribution results in a 

reduction in capital (stated or surplus) for 

corporate law purposes. Alternatively, all 

nonliquidating distributions to shareholders could 

be treated as dividends, subject generally to 

current rules allowing basis recovery with respect 

to transactions where a shareholder’s interest in 

the corporation is reduced or terminated. 

Under the dividend exclusion prototype, as 

under current law, replacing the earnings and 

profits rules with either of the alternative rules 

would simplify the determination of whether a 

corporate distribution is a dividend for tax 

purposes.37 However, although the simplification 

benefits of eliminating the earnings and profits 

rules are important, we conclude that adoption of 

the dividend exclusionprototype, by itself, neither 

compels the elimination of the rules nor demands 

their retenti~n.~’Thus, under the dividend exclusion prototype, earnings and profits would continue to provide a rough measure of whether, for 

purposes of determining the shareholder level tax, 

a distribution represents income from, or a return 

of, a shareholder’s in~estment.~~ 

Dividend Reinvestment Plans (DRIPS) 

Distributed earnings are subject to only one 

level of tax under the dividend exclusion prototype, but retained earnings may be subject to a 

greater tax burden to the extent that they increase 

the value of stock and are taxed as capital gains.

See Chapter 8. A dividend reinvestment plan, or 

DRIP, is one way for corporations to extend the 

benefits of integmtion to retained earnings. In a 

dividend exclusion system, a DRIP would allow 

a corporation to treat its shareholders as if they 

had received an excludable cash dividend and had 

reinvested it in the corporation. The shareholder’s 

basis would be increased to reflect the amount of 

the deemed dividend, ensuring that the shareholder would not be taxed on appreciation due to retained fully-taxed earnings when the stock is sold. 

Example. A corporation earns $100,pays $34 in 

tax, and adds $66 to its EDA. The corporation 

declares a deemed dividend of $66 and reduces the 

EDA by $66, and the shareholders increase their 

share basis by $66. 

Chapter 9 discusses DRIPS. 

2.6 PENSION FUNDS 

Under current law, contributions to qualified 

pension plans are generally deductible by the 

employer and are not currently includable by the 

employee. The employee is generally taxed only 

when distributions of benefits are made. The 

deduction provided to the employer combined 

with the deferral of income to the employee until 

benefits are paid effectively exempts the investment earnings on the contribution from tax.40 

Thus, pension fund income from investments in 

stock bear only one’level of tax-the corporate 

tax paid by the corporation. 
Prototypes 

The dividend exclusion prototype does not 

change this treatment. Under the prototype, most 

dividends are excludable by shareholders. Thus, 

if dividends were received directly by plan beneficiaries, they would be tax-free. The earnings of 

pension plans would be taxed when distributed, 

however, even if the distributions were attributable to excludable dividends received by the plan 

on its investments. Just as under current law, 

however, the combination of the employer’s 

deduction for contributions and the deferral of the 

beneficiary tax until earnings are distributed 

ensures that earnings on pension fund investments 

in stock are taxed only once. Although retaining 

the current treatment of pension funds in a dividend exclusion system perpetuates some bias 

against investments in stock by pension plans, the 

disincentive is no greater than under current law. 
CHAPTER 3: SHAREHOLDERALLOCATIONPROTOTYPE 

3.A INTRODUCTION 

The dividend exclusion prototype and other 

distribution-related systems of integration provide 

relief from double taxation only for distributed 

income. As a consequence, they may create an 

incentive for corporations to distribute, rather 

than retain, earnings at least to the extent that 

fully-taxed income can be distributed to taxable 

shareholders. In contrast, the shareholder allocation prototype would extend integration to retained 

earnings by allocating a corporation’s income 

among its shareholders as the income is earned. 

Shareholders would include allocated amounts in 

income, with a credit for corporate taxes paid, 

and would increase the basis in their shares by the 

amount of income allocated, less the amount of 

the credit. Distributions would be treated as a 

return of capital to the extent of a shareholder’s 

basis and, thereafter, as a capital gain.2 

Thus, the shareholder allocation prototype 

treats retained and distributed earnings equally. We 

do not favor adopting the shareholder allocation 

prototype, however, because of the policy results 

and administrative complexities it produces. As 

examples of policy problems, if it is to retain 

parity between retained and distributed earnings, 

the shareholder allocation prototype must extend 

tax preferences to shareholders and exempt from 

U.S. tax foreign source income that has borne no 

U.S. tax. While the shareholder allocation prototype reduces (but does not eliminate) current 

law’s bias in favor of debt financing, the same is 

true of the dividend exclusion prototype, which is 

a simpler regimee3Administratively, shareholder 

allocation integration would require corporations 

and shareholders to amend governing instruments 

for outstanding corporate stock to provide for 

income allocations, would require corporations to 

maintain capital accounts similar to those used 

under the partnership rules, and could create 

significant reporting difficulties for shareholders 

who sell stock during a year and for corporations 

that own stock. 

We nevertheless discuss the shareholder 

allocation prototype in some detail because it is 

the integration system advanced by advocates of 

traditional full integration proposals, which generally would treat a corporation as a conduit and 

allocate income to shareholders as earned. This 

chapter shows how a passthrough model of integration might be modified to conform as closely 

as possible with our policy recommendations and 

identifies some of the most difficult administrative 

issues. 

In contrast to a pure passthrough model of 

integration, the shareholder allocation prototype 

(1) does not pass through losses to shareholders, 

(2) retains the corporate level tax, which would 

assume a function similar to a withholding of 

shareholder level tax, (3) requires corporations to 

report to shareholders only an aggregate income 

amount, rather than separately report all items, 

and (4) does not extend integration benefits to taxexempt shareholders or to foreign shareholders 

except by treaty. 

3.B OVERVIEW OF THE 

SHAREHOLDER 

ALLOCATION PROTOTYPE 

The shareholder allocation prototype continues 

to treat the corporation as a separate entity for 

many reporting and auditing purposes. All tax 

items, including different types of income, deductions, losses and credits, are aggregated at the 

corporate level rather than being passed through 

to shareholders. To enhance compliance and 

mitigate shareholder cash flow problems, the 

prototype requires the corporation to pay income 

taxes at regular corporate rates as under current 

law. The corporation allocates its taxable income, 

as reported for regular tax purposes, among its 

shareholders. The shkeholders include the allocated amounts in income and credit corporate taxes 

paid and corporate tax credits claimed (including 

the foreign tax credit and other corporate tax 

credits) against their tax liability. Shareholders 

21 
Prototypes 28 

with marginal tax rates less than the corporate 

rate may use excess credits to offset tax liability 

on other income but may not obtain refund of the 

credit. 

Example. A corporation has $100 of taxable 

income and owes $31 of corporate level tax.’ The 

corporation also is entitled to a tax credit (e.g., a 

low-income housing credit) of $5. Thus, the corporation pays $26 in tax. The corporation allocates 

$100 of taxable income among its shareholders, 

together with $31 of tax credits ($26 tax actually 

paid plus $5 tax credit).6 

Shareholders would increase share basis by (1) 

the amount of taxable income allocated to them, 

after subtracting corporate taxes paid (including 

corporate tax credits),’ and (2) tax-exempt income. See Section 3.E. Thus, in the examples 

noted above, the shareholders’ collective basis 

increases by $69. Share basis would decrease by 

the amount of distributions. Distributions to 

shareholders are treated as a nontaxable return of 

capital to the extent of a shareholder’s basis in his 

stock. Distributions in excess of basis would be 

treated as gain recognized on the sale of the 

stock, which would generally be capital gain.8 

Corporate losses and excess corporate tax 

credits would not flow through to shareholders but 

could be carried forward at the corporate level. 

Losses or excess tax credits could not be carried 

back to claim a refund of corporate tax, because 

that tax would already have been made available 

to offset shareholder tax on allocated income.’ 

Current law limitations on the use and transfer of 

corporate losses and other tax attributes would 

continue to apply at the entity level. 

Mechanics. Corporations would allocate 

income and taxes paid to the holder of stock on a 

quarterly record date. A corporation with multiple 

classes of stock would allocate tax items in accordance with the terms of the stock certificate, 

which would designate the share of income to be 

allocated to each class of stock. See Section 3.F. 

A U.S. corporate shareholder would allocate to its 

own shareholders its share of the second 

corporation’s taxable income and tax credits. 

Intercorporate holdings may create difficult 

reporting issues. See Section 3.H. 

The mechanics of shareholder allocation 

integration can be illustrated with a simple 

example. 

Example. A corporation has three classes of common stock, the terms of which provide for the 

allocation of 30 percent of corporate income to 

Class A, 20 percent to Class B, and 50 percent to 

Class C. The corporation has taxable income of 

$100, pays $31 in corporate tax and pays a $10 

dividend with respect to Class C stock. The shareholder integration prototype allocates the income 

and the credit to each class of stock based on the 

respective percentages (so, for example, Class C 

would be allocated income of $50 and credits of 

$15.50). Within each class of stock, each share 

receives a pro rata amount.” Holders of Class A 

stock would collectively increase their basis by 

$20.70 (.30X($100-$31)), holders of Class B 

stock would increase their basis by $13.80 (0.20X 

($100-$31)), and holders of Class C stock would 

collectively increase their basis by $24.50 (.5X 

($100 -$3 1)-$lo). 

Tax-Exempt Shareholders. To preserve one 

level of tax on corporate income allocable to taxexempt shareholders; credits for corporate tax 

would not be refundable to tax-exempt shareholders. See Section 3.1. 

Tax Preferences. The shareholder allocation 

prototype would generally extend corporate level 

tax preferences to shareholders. See Section 3.E. 

Foreign Source Income and Foreign Shareholders. A U.S. corporation would pay corporate 

tax on its worldwide income and, where permitted 

under current law, could claim a foreign tax 

credit for foreign taxes paid directly and by a 

foreign subsidiary. The corporation would then 

allocate its taxable income to shareholders and the 

foreign tax credit would be creditable by shareholders. Section 3.1 discusses the difficulty of 

implementing appropriate shareholder level foreign tax credit limitation rules. Income of a 

foreign corporation would be includable in income 

of US. corporate shareholders only as under 
29 

current law, i.e., generally when distributed. The 

shareholder allocation prototype does not permit 

foreign shareholders, except pursuant to tax 

treaties, to claim a refund of the corporate tax or 

to use the credit for corporate tax to offset the 30 

percent (or lower) withholding tax levied on 

dividends (which would continue to apply). Such 

treaty benefits should be provided only in return 

for reciprocal benefits. 

Capital Gains and Share Repurchases. Chapter 8 discusses the treatment of capital gains on 

sales of corporate stock and the treatment of share 

repurchases. 

Structural Issues. Section 3.G discusses the 

problems of midyear sales of stock, and Section 3.H discusses the reporting difficulties that 

arise in the case of intercorporate stock ownership. We do not discuss further the treatment of 

corporate taxable and tax-free acquisitions under 

the shareholder allocation prototype. 

Impact on Tax Distortions. Table 3.1 illustrates the impact of the shareholder allocation 

prototype on the three distortions integration seeks 

to address: the current law biases in favor of 

corporate debt over equity finance, corporate 

retentions over distributions, and the noncorporate 

over the corporate form. For nonpreference, U.S. 

source income received by individuals, the shareholder allocation prototype is fully successful. All 

forms of income are taxed at the individual rate 

(ti, which can range from zero to 31 percent). 

Equalization of the tax rate across all sources of 

income for individuals means that shareholder 

allocation reduces all three current law distortions. For tax-exempt and foreign investors, 

however, the shareholder allocation prototype 

makes no change in the current taxation of nonpreference, U.S. source income. 

3.C CORPORATE LEVEL 

PAYMENT OF TAX 

In theory, corporate level payment of tax is 

not an essential feature of shareholder allocation 

integration.l1 Shareholders could have the sole 

responsibility for payment of taxes on corporate 

Prototypes 

level earnings, including retained earnings. Under 

such a system, corporations would report income 

to shareholders, who would include their allocable 

share of corporate income with other income on 

their returns and pay tax on their total income. 

Partnerships and S corporations follow this approach under current law. However, because tax 

is more likely to be collected if paid at the corporate level, the shareholder allocation prototype 

retains the current system requiring payment at 

the corporate level and then allocates to shareholders the corporation’staxable income and taxes 

paid. 

Table 3.1 

Total U.S. Tax Rate on a Dollar of 

NonPreference, U.S. Source Income from a 

U.S. Business Under Current Law and the 

Shareholder Allocation Prototype 

Shareholder 

Allocation 

Type of Income Current Law Integration 

I. Individual Investor is Income Recipient 

Corporate Equity: 

Distributed tc+(l-t& ti 

Undistributed tc+(l -tc)tg ti 

Noncorporate Equity ti ti 

Interest ti ti 

Rents and Royalties ti ti 

II. Tax Exempt Entity is Income Recipient 

Corporate Equity: 

Distributed tC tC 

Undistributed tc tC 

Noncorporate Equity

Interest tC 

0 

tC 

0 

Rents and Royalties 0 0 

III. Foreign Investor is Income Recipient 

Corporate Equity: 

Distributed tc+ (1 -tJtw tc+ (1 -tJtw 

Undistributed tC tC 

Noncorporate Equity 

Interest 

twN 

twI b 1 twI 

Rents and Royalties twR twR 

Department of the Treasury 

Office of Tax Policy 

tc = U.S. corporate income tax rate. 

ti = U.S. individual income tax rate. 

tg = U.S. effective individual tax rate on capital gains. 

tw, twN,t,, twR = U.S. withholding rates on payments to 

foreigners of dividends, noncorporateequity income, 

business interest, and rents and royalties, respectively. 

Generally varies by recipient, type of income, and 

eligibility for treaty benefits and may be zero. 
Prototypes 30 

In addition to increasing compliance, retaining 

corporate level payment of tax provides a mechanism for imposing tax on corporate income allocable to tax-exempt and foreign shareholders. 

Denying refundability of credits for corporate 

level tax to tax-exempt shareholders, in effect, 

preserves current law, which taxes corporate 

equity income allocable to tax-exempt shareholders at the corporate level. Nonrefundability of 

credits also preserves current law for foreign 

shareholders. See Section 3.1. 

3.D PASSTHROUGH OF 

CORPORATE LOSSES TO 

SHAREHOLDERS 

While it would be possible to pass through to 

shareholders aggregate net losses incurred at the 

corporate level, the prototype does not do so.12 

Passthrough of corporate losses would raise a host 

of fundamental policy, technical, and administrative issues. For example, one issue is whether, as 

for partnerships (but generally not S corporations), shareholders would be permitted to include 

entity level debt in their basis to determine the 

extent to which losses could be passed through. A 

second issue is whether the current at-risk and 

passive activity rules would apply at the shareholder level to limit the use of losses incurred by 

corporations. Failure to apply these rules could 

allow taxpayers to use corporations as tax shelters 

and to circumvent current restrictions applicable 

to partnerships and S corporations. Passthrough of 

corporate losses also would create significant 

administrative complexity. Even small shareholders would have to track losses allocated to them, 

including losses in excess of basis carried forward 

from previous years, and would have to apply the 

at-risk rules and the passive activity loss rules. 

To avoid the complexity created by applying 

additional loss limitations at the shareholder level 

and the need for anti-abuse rules, the shareholder 

allocation prototype denies passthrough of corporate losses to shareholders. Instead, corporate 

losses may be carried forward and used to offset 

corporate income in later years. This allows a 

reasonable degree of accuracy in measuring 

corporate income over time while minimizing 

complexity and opportunities for abuse. 

3.E TAX TREATMENT OF 

PREFERENCES 

Integration generally does not require extending the benefits of corporate level tax preferences 

to shareholders. Extending preferences to shareholders under integration would increase the value 

of corporate preferences relative to current law 

and would raise the revenue cost of integration. 

See Chapter 5. Accordingly, the dividend exclusion and CBIT prototypes are structured not to 

extend preferences to shareholders. See 

Section 2.B and Section 4.D. 

In contrast, the shareholder allocation prototype generally extends preferences to shareholders. While we considered modifying the 

shareholder allocation prototype in order not to 

extend preferences to shareholders, we found such 

modifications to be difficult and inconsistent with 

the passthrough nature of the prototype. Eliminating preferences by including preference income in 

shareholder income as earned would treat corporate preference income more harshly than under 

current 1aw.l3Current law generally taxes corporate preference income at the shareholder level 

only when the income is distributed or stock is 

sold. While shareholder allocation could be 

modified to tax preference income only when 

distributed, doing so would effectively convert 

shareholder allocation into distribution-related 

integration, for which less cumbersome structures 

can be used.14 

For these reasons, the shareholder allocation 

prototype generally passes through preferences to 

shareholders, but that feature is a major reason 

we do not favor the adoption of shareholder 

allocation. If policymakers were to adopt the 

shareholder allocationprototype, serious consideration should be given to restricting the preference 

items available to corporations. 

The extent to which the shareholder allocation 

prototype extends preferences to shareholders 
31 

depends on the type of preference. An exclusion 

preference, e.g., tax-exempt interest on state and 

local bonds, allows a corporation to earneconomic income that is not included in taxable income 

and, thus, is not allocated to shareholders. The 

prototype provides a shareholder basis increase 

for tax-exempt income, similar to the basis increase provided under current partnership rules, 

which ensures that such income is not taxed to a 

shareholder who sells his stock or receives a 

di~tribution.’~If such a special basis increase 

were not provided, then preference income attributable to an exclusion preference would be taxable 

upon distribution or sale of stock. 

A credit preference, e.g., the credit for increasing research activities, reduces corporate 

level taxes payable. The shareholder allocation 

prototype passes through a credit preference to 

shareholders (to the extent it is claimed by the 

corporation) by treating it as corporate taxes paid, 

which are creditable by shareholders. A basis reduction for the amounts of taxable income shielded from tax by credit preferences would make 

these amounts taxable either upon the sale of 

stock or receipt of distributions in excess of basis. 

A deferral preference, e.g., accelerated depreciation, initially reduces corporate taxable income 

relative to corporate economic income. In later 

years, however, as the deferral preference turns 

around, the corporation’s taxable income exceeds 

its economic income. Thus, because the shareholder allocation prototype allocates only taxable 

income to shareholders, a shareholder who holds 

stock throughout the deferral period generally 

benefits from a deferral preference to the same 

extent as the corporation. As under the partnership rules, however, a shareholder’s basis increases only by the amount of taxable income (and taxexempt income) allocated to him.Thus, a shareholder who sells stock or receives a distribution 

from the corporation may realize taxable gain 

because the shareholder’s basis does not reflect 

the economic income that has been sheltered at 

the corporate level by a deferral preference.16 

On the other hand, a distribution that does not 

Prototypes 

exceed basis before the deferral preference reverses will be treated as a return of basis. In such a 

case, the deferral preference will not be taxed to 

the shareholder until the stock is sold. 

Certain features of shareholder allocation 

integration indirectly limit the flowthrough of 

preferences. Because the shareholder allocation 

prototype does not allow losses to flow through to 

shareholders, preferences are not passed through 

to the extent they create corporate losses. In 

addition, because corporate debt is not included in 

shareholder basis and inside basis in assets is not 

stepped up to reflect the price paid for corporate 

shares, there could be disparities between inside 

and outside basis that could limit the benefit to 

shareholders of corporate level preferences, 

A final issue involving preferences is the 

treatment of the corporate alternative minimum 

tax (AMT).In general, the corporate AMT would 

be retained under integration to limit use of 

preferences at the corporate level. Accordingly, 

the dividend exclusion prototype and the CBIT 

prototype retain the corporate AMT. The shareholder allocation prototype does not retain the 

corporate AMT because we found no simple and 

administrable mechanism for doing so in the 

context of a passthrough system. 

For example, the approach most consistent 

with the passthrough nature of the shareholder 

allocation prototype would continue to collect 

AMT at the corporate level, include corporate 

alternative minimum taxable income (AMTI)in 

shareholder AMTI, and credit corporate AMT 

against an individual’s liability for regular tax and 

AMT.” This approach would treat the corporate 

AMT as equivalent to a mechanism for withholding shareholder level AMT.” However, the 

inclusion of corporate AMTI in shareholder 

AMTI would increase unacceptably the complexity of information reporting to shareholders and 

the calculation of shareholder tax. We considered 

but rejected as unworkable other solutions designed to confine the complexity of the AMT 

calculation to the corporate level.” 
Prototypes 32 

3.F ALLOCATING INCOME 

AMONG DIFFERENT 

CLASSES OF STOCK 

Under the shareholder allocation prototype, 

once the corporation determines its taxable income and taxes paid, additional rules are needed 

to allocate that amount among different classes of 

shares. Both S corporations and partnerships must 

make such allocations under current law. However, neither of these models is appropriate for 

shareholder allocation integration. The S corporation rules, which are designed for corporations 

with a single class of stock and a limited number 

of shareholders, cannot readily be adapted to 

more complex capital structures.2oThe partnership allocation rules are sufficiently flexible, but 

generally are too complex, to apply to widely held 

corporations, Therefore, the shareholder allocation prototype adopts a modified version of the 

partnership approach. 

Under current law, a partnership may allocate 

its income in any manner that has "substantial 

economic effect."21Subject to this limitation, a 

partnership has great flexibility to allocate income 

and loss or particular items of income or deduction to particular partners. In general, an allocation of partnership taxable income or loss can 

have substantial economic effect only if such 

income or loss is allocated to the partner or 

partners that will receive the benefit or bear the 

burden of the economic consequences corresponding to the taxable income or loss. The economic 

consequences of partnership allocations are reflected in capital accounts maintained by the 

partnership in accordance with detailed 

regulations.22 

The shareholder allocation prototype approximates the basic approach of the partnership 

allocation method while reducing its complexity. 

It retains the principal economic advantage of the 

partnership system by permitting allocations of 

income to reflect varying economic rights among 

different classes of stock. 

Under the shareholder allocation prototype, a 

corporation can allocate varying amounts of 

income to different classes of stock, in accordance 

with the terms of the corporation's governing 

instruments. Within &ch class of stock, a corporation allocates every share a pro rata portion of 

the income and tax credits allocable to that class. 

A corporation could not allocate income separately from credits for taxes paid. Thus, while the 

corporation and shareholders may agree on the 

amount of income allocated to each class of stock, 

all income allocated carries a proportionate share 

of credits for corporate taxes paid. Allowing 

corporations to allocate income and credits disproportionately would allow corporations to 

allocate credits to taxable shareholders and income without credits to tax-exempt shareholders. 

The shareholderallocationprototype simplifies 

the partnership model by (1) imputing to shareholders only a single amount of taxable income, 

(2) requiring that tax credits be allocated in 

proportion to income, and (3) not allocating 

corporate losses to .shareholders. As a consequence, the prototype permits considerable flexibility in corporate capital arrangements but does 

not allow corporations to adopt the complex 

allocations possible under the partnership rules 

(which permit special allocations of items of 

income, deduction, and loss). 

A substantial disadvantage is that this approach requires corporations to maintain capital 

accounts for each class of shares. Although, as 

discussed below, these capital accounts are simpler than the capital accounts required to be 

maintained for each partner in a partnership under 

the regulations under IRC 8 704(b),they still add 

complexity to the shareholder allocation system. 

Capital accounts are needed, however, to help 

ensure that allocations of tax consequences follow 

allocations of economic income. As the following 

simplified example demonstrates, without tax 

rules requiring capital accounts, the corporation 

could allocate tax liability without regard to the 

economic substance of the capital structure. 

Examde. Two shareholders each contribute $1 ,OOO 

to a new corporation. One shareholder has a 15 

percent marginal rate and enough other tax liability 

to absorb excess credits, and the other has a 31 

percent marginal rate. The corporation issues Class 
33 

A stock, which is allocated 100 percent of the 

corporation’s taxable income, to the low-bracket 

shareholder. The corporation issues Class B stock 

to the high-bracket shareholder and provides that 

no taxable income will be allocated to the Class B 

stock. Cash distributions,however, are to be made 

pro rata between the Class A stock and the Class B 

stock. If these allocations are respected, all the 

corporation’staxable income and credits for corporate taxes paid will be allocated to the 15 percent 

shareholder. The Class A shareholder’s share basis 

will increase accordingly, but the Class B shareholder’s basis will remain $l,OOO.Thus, when the 

corporation is liquidated, the low-bracket shareholder will realize a loss and the high-bracket 

shareholder will realize a gain. In the meantime, 

however, the shareholders have arranged for 

substantial deferral of tax by having the corporation’s income taxed currently at 15 percent 

(rather than having half taxed at 15 percent and 

half taxed at 31 percent, in accordance with the 

economic bargain between the parties). 

This strategy would fail if the allocations were 

subject to the “substantial economic effect” requirement of IRC $704(b). The rules under IRC 

$ 704(b) would require the allocation of equal 

amounts of income to the two shareholders in 

order to establish capital accounts that would 

permit an equal division of liquidation proceeds. 

Thus, some capital account mechanism is 

needed in the shareholder allocation prototype. 

The remainder of this discussion outlines generally the mechanics of maintaining capital accounts. 

Because we do not recommend adoption of shareholder allocation, however, we have not 

developed the additional technical analysis needed 

for a workable capital account regime.23 

, 

Capital accounts should be easier to maintain 

under shareholder allocation than under the 

partnership rules because the shareholder allocation prototype passes through only a single item 

(net taxable income) and a proportionate amount 

of credits for taxes paid. As a consequence, 

capital accounts increase by the amount of income 

allocated, net of credits for corporate taxes paid, 

and decrease by the amount of distributions. 

Further, because each share of stock within a 

class of stock receives a pro rata share of the 

income and taxes allocated, it is not necessary to 

keep detailed capital accounts for each 

Prototypes 

shareholder. Instead, capital accounts can be 

maintained for each class of stock. Rules also 

would be needed to govern the allocation of losses 

to capital accounts. Although losses are not passed 

through to shareholders, losses reduce corporate 

assets available for distribution and should be 

reflected in capital accounts. Special allocations of 

losses among classes of stock are permitted, if 

appropriately reflected in capital accounts. While 

special allocations of losses create additional 

complexity, relative to a system in which losses 

are required to be allocated in proportion to 

income allocations, they seem necessary to preserve corporations’ ability to issue preferred 

stock.24It may be difficult, however, to fashion 

practical rules that allow special allocations of 

losses to capital accounts that are liberal enough 

to preserve typical corporate capital structures but 

are restrictive enough to prevent abuse. 

Existing corporations would have to seek 

shareholder approval to modify the terms of 

outstanding stock to provide for allocations of 

corporate income and the maintenance of capital 

accounts. This is likely to be a lengthy and 

difficult process that would substantially complicate the transition to a shareholder allocation 

system of integration. Accordingly, while we do 

not recommend shareholder allocation, if it were 

adopted, we would recommend a delayed implementation. See Chapter 10. Additional transitional 

rules may be needed to provide relief where a 

corporation cannot obtain the necessary 

shareholder approvals, for example, because of 

state law or contractual supermajority 

requirements. 

3.6 CHANGEOF 

STOCK OWNERSHIP 

DURING THE YEAR 

Allocating both a corporation’s retained and 

distributed income to shareholders requires a 

mechanism to reflect changes in stock ownership 

during the period to which such income relates 

and thereby apportion income tax consequences 

among the corporation’s various owners. The 

current rules are straightforward: corporations pay 

dividends to the shareholder who owns the stock 
Prototypes 34 

on the dividend record date and the Code taxes 

the person who receives the dividend. 

The shareholder allocation prototype requires 

that corporate taxable income and corresponding 

credits for corporate taxes paid be allocated to 

shareholders of record as of the end of each 

quarter of the corporation’s taxable year.25Corporations would not close their books and file tax 

returns and information returns quarterly, but 

rather would close their books at year end and 

allocate net income ratably to the record holder of 

the stock at the end of the four quarters.26 

Closing corporate books at year end and 

allocating income pro rata among shareholders of 

record unavoidably creates problems in the treatment of shareholders that sell shares before 

corporate income and corporate taxes are known 

at the end of the year. As long as there is uncertainty concerning a given quarter’s income, the 

buyer and seller of stock will not be able to price 

the stock accurately. 

ExamDle. At the beginning of the year, a corporation has assets of $100.Shareholder A owns 100 

percent of the single class of stock and has a basis 

in the stock of $100. The corporation’s taxable 

year is the calendar year. On July 1, when the 

corporation has earned $25 of taxable income, A 

sells all her stock to Shareholder B for $117.25.If 

the corporation’s books closed on June 30, it would 

pay $7.75of corporate tax and would allocate $25 

of income and $7.75 of tax credits to A. If A has 

a marginal tax rate of 31 percent, the taxable 

income allocated to her will be exactly offset by 

the allocated credits. A’s basis in her stock would 

increase to $117.25,and A would report no gain 

on the sale. Because the shareholder allocation 

prototype does not determine taxable income until 

year end, A’s final basis will be determined based 

on her pro rata share of the actual earnings and 

taxes paid for the year, which will turn on events 

subsequent to A’s sale of stock and may differ 

from estimated earnings as of the date of sale. For 

example, if the corporation’s taxable income for 

the full year is $80, A will be allocated $40 of 

income and $12.40of tax credits and her basis will 

increase to $127.60.She will report a capital loss 

of $10.35.n 

Thus, while a shareholder can tentatively 

calculate gain on a sale at the time the sale is 

made, that estimate may need to be revised based 

on more precise or differing information available 

only later and may even require the fhg of an 

amended return.28 The problem of amended 

returns may be particularly acute for shareholders 

that hold stock in corporations with taxable years 

other than the calendar year. The uncertainty of 

income allocations may result in some inefficiency 

in pricing sales of stock, although sellers of large 

blocks of stock may be able to limit uncertainty 

by effectively shifting the tax burden through 

contractual mechanisms. 

This uncertainty could be reduced by requiring 

a quarterly closing of corporate books.29 We 

rejected such a requirement, however, as imposing too great a reporting burden at the corporate 

level. Requiring quarterly filings of Form 1120 

and quarterly information reports to shareholders 

would significantly increase the tax reporting 

burden on corporations. Although many large 

corporations must file quarterly financial statements (10-Qs) with the Securities and Exchange 

Commission (SEC), and most Corporations must 

make quarterly estimated tax payments, ref~g 

that information to the degree of precision needed 

for tax return purposes can be a time-consuming 

process. Requiring a true quarterly closing of 

books would in effect abandon the taxable year 

concept and substitute a “taxable quarter” 

regime,30 

Some intermediate solution may be possible. 

For example, capital gains and extraordinary 

dispositions could be allocated to the quarter in 

which they occurred. Large corporations might be 

required to provide estimates of each quarter’s 

income, based on 10-Q filings (if any) and the 

kinds of calculations used for estimated taxes. 

Shareholders could be permitted to report the 

estimated income and tax amounts and make 

corrections when final reports were issued after 

year end. Such a system would, however, allow 

a significant degree of latitude to corporations 

unless there were rules governing the quarterly 

estimating and annual correction process. Such 

rules would likely be complex. 

This problem would not exist in a pure passthrough integration system with no corporate level 
35 Prototypes 

tax, no differences in the treatment of capital 

gains and losses and ordinary income and full 

flow through of corporate losses to shareholder~.~’ For the policy reasons stated above, however, the shareholder allocation system retains the 

corporate level tax and does not require a quarterly closing of books. Accordingly, unless a satisfactory intermediate solution can be devised, the 

uncertainty of tax consequences for midyear sales 

of stock is unavoidable and is one of the significant obstacles to adoption of the shareholder 

allocation prototype. 

3.H REPORTING AND AUDITING 

CONSIDERATIONS 

As the preceding discussion makes clear, any 

passthrough integration system would increase the 

administrative burden on corporations and their 

shareholders. Although the shareholder allocation 

prototype includes simplified reporting provisions, 

it does require corporations to provide information 

reports (not now required) to shareholders showing each shareholder’s portion of corporate taxable income and credits for corporate taxes paid 

(including other tax credits claimed by the corporation). The information returns also would have 

to provide information on appropriate basis 

adjustments. Because basis will increase for taxexempt income, the basis adjustment will not 

necessarily be the same as the allocated income 

less the allocated tax credits. Shareholders, in 

turn, must take into account both corporate income and credits for corporate taxes paid in 

calculating their own tax liability and will need to 

keep detailed records to determine share basis 

when stock is sold. 

Another administrative problem is the timing 

of income reporting. For example, U.S. corporations cannot report taxable income and corporate 

level taxes to shareholders until they receive 

reports of the taxable income and credits of other 

U.S. corporations in which they own stock. We 

have been unable to devise a precise solution for 

these timing issues. The taxable years of members 

of a consolidated group or other closely held and 

closely afffiated corporations can be conformed 

so that income is calculated at the same time. For 

corporate portfolio shareholders, however, timing 

difficulties may be severe. Before shareholder 

allocation could be .implemented, it would be 

necessary to design a reporting system capable of 

accommodating corporate cro~s-ownership.~~ 

The shareholder allocation system also requires substantial changes in the way corporations 

and shareholders are audited. In theory, under a 

shareholder allocation system, any increase or 

decrease in tax as a result of an adjustment to a 

tax return, resulting from an IRS audit or an 

amended return, should be reflected in the tax 

liability of the shareholders. The current system 

for partnerships carries an adjustment back to the 

partners’ taxable year in which the understatement 

arose. Thus, if in 1990, it were determined that a 

partnership’s income for 1988 had been understated by $1,000, the increase of $1,000 would be 

allocated to those who were partners in 1988. 

Extending this regime to corporations under 

integration would require the IRS to track and 

adjust the returns of shareholders holding stock in 

prior years. Furthermore, under such a system an 

adjustment irj one year may require related 

adjustments in other years. 

To avoid these problems, the shareholder 

allocation integration prototype would treat any 

audit or other adjustment to corporate income as 

a taxable event in the year of the adjustment. 

Under the prototype, it is unnecessary to adjust 

returns of prior year shareholders because 

adjustments to corporate income would be treated 

as an increase or decrease in the corporation’s 

current year taxes and income. The adjustments 

would be passed through to current year shareholder~.~~ The IRS would collect deficiencies 

directly from the corporation, and the corporation 

would pass through the credits for corporate taxes 

paid along with the additional income. Shareholders’ bases would be adjusted to reflect the 

additional income. 
Prototypes 36 

3.1 TREATMENT OF TAXEXEMPT AND FOREIGN 

SHAREHOLDERS 

Tax-Exempt Shareholders 

The shareholder allocationprototype maintains 

the current taxation of corporate equity income 

allocated to tax-exempt shareholders by making 

shareholder credits for corporate level taxes 

nonrefundable to tax-exempt shareholders. Thus, 

tax on corporate income allocable to a tax-exempt 

shareholder would be taxed at the corporate level 

at the corporate rate. Tax-exempt shareholders 

would not be subject to UBIT on corporate 

income allocated to them and would not be 

allowed to use credits for corporate taxes paid to 

offset UBIT liability on other income. 

Foreign Shareholders 

We believe that foreign shareholders making 

investments in the United States should not 

receive, by statute, the benefits of integration 

received by U.S. shareholders. Thus, the shareholder allocation prototype denies refunds of 

corporate level taxes to foreign shareholders and 

continues to impose U.S. withholding tax on 

dividends. As under current law, corporate tax 

would be paid at the corporate level and withholding tax would be imposed at the investor level. 

The branch profits tax would continue to apply to 

U.S. branches of foreign corporations. Although 

in principle, the shareholder level withholding tax 

might be imposed on income allocated annually, 

the prototype continues to impose withholding tax 

only when distributions are made. Annual imposition of both the corporate and the investor level 

taxes would increase the tax burden on foreign 

investments in U.S. corporations as well as the 

disparity in the treatment of debt and equity 

owned by foreign investors. Denying integration 

benefits to foreign shareholders under the shareholder allocation prototype does not violate U.s. 

tax treaty obligations. Refundability of all or a 

part of the credit could be considered in treaty 

negotiations in exchange for reciprocal benefits. 

See Chapter 7. 

3.5 FOREIGN SOURCE INCOME 

We do not believe that an integrated tax 

system should, by statute, treat foreign taxes like 

taxes paid to the U.S. Government. Extending the 

benefits of integration to foreign taxed income, if 

appropriate, is more properly achieved through 

bilateral tax treaty negotiations. See Chapter 7. 

Accordingly, the dividend exclusion and CBIT 

prototypes are designed to collect at least one full 

level of U.S. tax on foreign source income earned 

by U.S. corporations. 

In contrast, the shareholder allocation prototype treats foreign taxes paid like U.S. taxes paid. 

As a consequence, depending on foreign tax rates, 

the United States may collect only a residual U. S. 

tax or no tax at all on corporate foreign source 

income. We considered modifying the shareholder 

allocation prototype to account separately for 

foreign taxes and deny foreign tax credits to 

shareholders, but such modifications are complex 

and fundamentally inconsistent with the passthrough nature of the prototype.34 Denying a 

foreign tax credit would be harsher than current 

law, which generally allows a foreign tax credit at 

the corporate level and defers the shareholder 

level tax on foreign source income until it is 

distributed. Modifying the shareholder allocation 

prototype to tax foreign source income to shareholders only when distributed would effectively 

convert shareholder allocation into distributionrelated integration. 

Accordingly, the shareholder allocation prototype allows a foreign tax credit, computed under 

current law rules, to offset corporate level tax. 

The foreign tax credit, like other corporate tax 

credits, is passed through to shareholders. One 

issue this approach raises is how, if at all, the 

foreign tax credit limitation rules should be 

applied at the shareholder level. Although the 

foreign tax credit limitation is computed initially 

at the corporate level, additional restrictions 

would be necessary to prevent individuals with 

marginal tax rates of less than 31 percent from 

using foreign tax credits to offset liability for 

U.S. tax on other income.35 
37 Prototypes 

As under current law, the shareholder 

allocation prototype allows an individual U.S. 

shareholder holding stock directly in a foreign 

corporation to claim a foreign tax credit for 

withholding taxes paid on dividends. The prototype does not extend the indirect foreign tax credit 

of IRC 5 902 to individual shareholders of a 

foreign corporation. The indirect credit was 

originally intended to prevent multiple taxation of 

corporate income earned through a foreign subsidiary. Because the shareholder allocation regime 

extends integration to foreign taxes, however, 

permitting individuals owning more than 10 

percent of the stock of a foreign corporation to 

claim an indirect credit may merit consideration. 

Extending the indirect credit to U.S.individual 

shareholders would remove the disparity that 

would otherwise exist between foreign corporate 

stock held directly and foreign corporate stock 

held through a U.S.corporation. Such a change, 

however, would be a significant departure from 

current law and would exacerbate the problem of 

fashioning an appropriate limitation rule at the 

shareholder level. 

Another issue for outbound investment in 

structuring the shareholder allocation integration 

prototype is whether to retain or eliminate the 

deferral allowed for profits earned through foreign 

subsidiaries. As Chapter 7 explains, the deferral 

rule provides that profits of a U.S. investor 

earned through a foreign corporation are generally 

not subject to U.S. tax until the profits are repatriated. Although theoretical consistency in implementing a shareholder allocation integration 

system would require eliminating the deferral 

rule, taxing foreign income currently is not 

essential to shareholder allocation. As a practical 

matter, it would be difficult to end deferral for 

U.S. portfolio shareholders, because sufficient 

information would not be available from the 

foreign corporation to determine the domestic 

shareholder’s tax liability on undistributed 

income. Even for large shareholders, requiring 

annual reporting of income and foreign taxes paid 

by foreign subsidiaries would compound the 

reporting problems discussed in Section 3.H. A 

corporation with foreign subsidiaries could not 

accurately report to its shareholders its own 

income for the year until its subsidiaries had paid 

their own taxes in foreign jurisdictions. Accordingly, the shareholder allocation prototype permits 

U.S. shareholders in foreign corporations to 

continue to take income into account only when 

dividends are received. The same rule applies to 

U. S.corporate shareholders, subject to the current 

Subpart F and other current inclusion rules. 
Tax-Exempt 

4.A INTRODUCTION 

The Comprehensive Business Income Tax 

(CBIT) is the most comprehensive of the integration prototypes developed in this Report.' It is 

not expected that implementation of CBIT would 

begin in the short term, and full implementation 

would likely be phased in over a period of about 

10 years.2The CBIT prototype represents a very 

long-term, comprehensive option for equalizing 

individual rate of 31 percent rate, regardless of 

the lender's actual marginal tax rate and regardless of the lender's status as a tax-exempt or 

foreign entity.3 

Without any overall revenue loss, the CBIT 

prototype permits a reduction in the rate of tax on 

corporations from 34 percent to the top individual 

rate of 31 per~ent.~A lower rate of tax on capital 

supplied by tax-exempt, foreign or low-income 

the tax treatment of debt and equity. 

CBIT would equate the treatment of 

debt and equity, would tax corporate and 

noncorporate businesses alike, and would 

significantly reduce the tax distortions 

between retained and distributed earnings. 

CBIT would accomplish these results by 

not allowing deductions for dividends or 

interest paid by the corporation, while 

excluding from income any dividends or 

interest received by shareholders and 

debtholders. To ensure consistent treatment of corporate and noncorporate entities, CBIT would apply to all but the 

smallest businesses, whether conducted in 

corporate form or as partnerships or sole 

proprietorships. The result is that 

one-but only one-level of tax would be 

collected on capital income earned by 

businesses. An illustration of taxation 

under the current classical corporate tax 

and CBIT is depicted in Figure 4.1. 

Under current law, income distributed 

on corporate equity generally bears two 

levels of tax, while interest paid to suppliers of debt capital bears at most one level 

of tax. CBIT not only eliminates the double taxation of corporate equity income, 

but also provides equal treatment for debt 

income. By denying a deduction for interest, the CBIT prototype subjects interest 

income, like dividend income, to a single 

level of U.S. tax equal to the top 

Figure 4.1 

Comparison of CBIT and Current Law' 

Current Law 

Corporation Euuity Holders 

-4 

-1 NoTax ) 

Nm-Corporate 

CBIT 

Corvoration 

( 

1

Investment ) 

Non-Corporate Form 

Debt Holders 

Debt Holders 

Taxable 

Equity Holders 

Debt Holders 

Ecluitv Holders 

Debt Holders 

ae)No Tax TaxableNoTax Foreign 

'The figures do not take into account tax preferences or taxes 

imposed by other countries. 

39 
Prototypes 40 

investors could be incorporated into a CBIT 

regime, but we have chosen not to include these 

complicatingprovisions in the prototype described 

in this ~hapter.~Taxing income from business 

capital at a 31 percent rate enhances economic 

efficiency and advances the policy goals set forth 

in Chapter 1.6 CBIT taxes corporate and noncorporate businesses (other than very small businesses) under identical rules, thus eliminating the 

current tax bias against the corporate form. CBIT 

also makes significant progress toward the removal of incentives to retain earnings, although a 

compensatory tax on distributions of preference 

income, if included in CBIT, would provide some 

incentive to retain such income. 

Like the other prototypes, the CBIT prototype 

is structured to conform as closely as possible to 

the policy decisions summarized in the introduction to this part with respect to the treatment of 

preferences and tax-exempt and foreign investors. 

Since CBIT would be a greater change from 

current law than either distribution-related integration or shareholder allocation integration-both of 

which would apply only to corporate equity-a 

very gradual phase-in of CBIT over a long period 

will be necessary in order to reduce the economic 

dislocations and the gains and losses that might 

result during the transition. See Chapter 10.' 

4.B OVERVIEW OF CBIT 

PROTOTYPE 

General Mechanics. Under CBIT, distributions 

of business income as dividends or interest are not 

generally taxed when received by investors (see 

the discussion of tax preferences below). The 

income of all business entities, including corporations and unincorporated businesses, is measured 

and taxed at the entity level at a 31 percent rate.' 

The CBIT tax base is generally the corporate 

income tax base under current law, except that no 

deduction is allowed for interest expense, and 

dividends and interest received from CBIT entities 

are excluded. Losses incurred at the entity level 

do not pass through to the equity holders. Unused 

losses can be carried over at the entity level, 

however, generally in the same manner as under 

the current law rules applicable to corporations. 

Small Business Exception. Because it is 

difficult to separate returns to capital from returns 

to labor in the case of very small businesses, 

taxing all capital income from those businesses at 

the 31 percent CBIT rate might overtax some 

labor income that otherwise would be taxable to 

an individual in a lower bracket. The CBIT 

prototype includes an exception for very small 

businesses. See Section 4.C. 

Tax Preferences. Tax preferences available to 

corporations generally would be available to CBIT 

entities. To implement this Report's general 

recommendation that preferences not be extended 

to shareholders, a flat rate nonrefundable tax of 

31 percent (a compensatory tax) could be imposed 

at the entity level on dividends and interest 

deemed paid from preference income. Alternatively, investors could be required to include in 

income any interest or dividends considered to be 

paid out of preference income. The choice 

between these two methods is discussed in 

Section 4.D. In either case, businesses would 

determine which distributions are made out of 

preference income by maintaining an Excludable 

Distributions Account (EDA), which is similar to 

the EDA described in Chapter 2 under the dividend exclusion prototype. The EDA would reflect 

taxes paid and the prototype would stack interest 

and dividend payments first against fully-taxed 

income.'' See Section 4.D. 

CBIT Entities as .Investors. CBIT entities are 

governed by the rules applicable to nonCBIT 

investors. Income from investments (other than 

dividends and interest from CBIT entities) is taxed 

to the CBIT entity as under current law. Dividends and interest from CBIT entities are not 

taxed in the hands of the recipient CBIT entity 

and would result in an appropriate addition to the 

recipient entity's EDA (thereby enabling the 

recipient CBIT entity to distribute such receipts 

without paying additional tax). Additional rules 

would be needed for taxable dividends and interest paid by CBIT entities if a compensatory tax 

were not adopted. See Section 4.D. 

Foreign Source Income. CBIT entities would 

be entitled to a foreign tax credit computed as 
41 

under current law, with modifications to reflect 

the nondeductibility of interest under CBIT. 

Foreign source income shielded from U.S. tax by 

foreign tax credits would be treated in a manner 

similar to preference income when distributed and 

either would be subject to a compensatory tax or 

would be taxable at the investor level at that time. 

As with distributions from preference income, 

stacking distributions first against fully-taxed 

income will limit somewhat application of these 

rules. 

Low-Bracket Investors. While the CBIT 

prototype does not include explicit relief for lowbracket equity holders and debtholders, it is 

possible to reduce the effective rate of tax on 

CBIT investments from 31 percent to the investor 

rate with an investor credit for entity level taxes 

paid. See Section 4.F. 

Tax-Exempt and Foreign Investors. Interest 

and dividends paid to tax-exempt and foreign 

investors by a CBIT entity are net of the 31 

percent entity level tax; however, in general 

neither tax-exempt nor foreign investors are 

subject to additional U.S. tax on interest or 

dividends received from CBIT entities. If a 

compensatory tax is adopted, all dividends and 

interest would be excludable. As Section 4.D 

discusses, however, the alternative to a compensatory tax is to tax preference and foreign source 

income at the investor level. 

We recognize that, in imposing one level of 

source-based taxation on interest paid to foreign 

investors, CBIT would represent a departure from 

current policy on inbound debt investment. Any 

such departure would have to be the result of 

extensive international discussions with tax authorities and market participants. l1 

CaDital Gains and Share Repurchases. Chapter 8 discusses the treatment of capital gains on 

CBIT equity and debt and the treatment of share 

repurchases. 

NonCBIT Interest and Other Capital Income. 

CBIT does not require any change in the current 

taxation of interest paid on debt issued by a 

Prototypes 

borrower other than an entity subject to CBIT. 

Thus, for example, home mortgage interest would 

continue to be deductible by an individual borrower and includable in the income of the recipient. 

State and local bond interest would remain excludable from gross income to the same extent as 

under current law. Interest on Treasury debt 

would, as under current law, be includable in 

income by the recipient.12 See "Interest Not 

Subject to CBIT" in Section 4.G. 

ImDact on tax distortions. Table 4.1 illustrates 

the impact of the CBIT prototype on the three 

distortions integration seeks address: the current 

law biases in favor of corporate debt over equity 

finance, corporate retentions over distributions, 

and the noncorporate over the corporate form. In 

general, CBIT is very successful in achieving the 

goals of integration because it removes most 

differentials in the tax rates on alternative income 

sources for domestic and foreign investors and 

tax-exempt entities. The near-uniform tax rate on 

all nonpreference, U. S. source business income is 

the maximum individual income tax rate (Gm, 31 

percent under current law). For individual investors, the only exceptions to this uniform rate are 

for undistributed corporate equity income (if 

capital gains on corporate stock continue to be 

taxed) and for rent and royalties, which would 

continue to be taxed at regular individual rates. 

For tax-exempt entities and foreign investors, the 

only exception to the uniform rate on nonpreference, U.S. source business income is the rate on 

rents and royalties, for which current law rates 

would be retained. 

4.C ENTITIES NOT SUBJECT TO 

CBIT 

In theory, CBIT would apply to all businesses, 

without regard to size or legal form of organization. Thus, all sole proprietorships, partnerships,

S corporations and other business entities would 

be subject to an entity level tax. After the 

phase-in of CBIT, current law distortions between 

the corporate and noncorporate business sectors 

would thus be eliminated, and taxpayers' choice 

of business entity would depend entirely upon 

nontax considerations. To preserve these 
Prototypes 42 

Table 4.1 

Total U.S. Tax Rate on a Dollar of 

NonPreference, U.S.Source Income from a 

U.S. Business Under Current Law and the 

CBIT Prototype 

Type of Income Current Law CBIT 

I. Individual Investor is Income Recipient 

Corporate Equity: 

Distributed t,+ (1-t& ti" 

Undistributed t,+(l -t,)tg ti"+(l -ti">$ 

Noncorporate Equity ti ti" 

Interest ti ti" 

Rents and Royalties ti ti 

II. Tax Exempt Entity is Income Recipient 

Corporate Equity: 

Distributed t, tim 

Undistributed t, ti" 

Noncorporate Equity t, ti" 

Interest 0 ti" 

Rents and Royalties 0 0 

III. Foreign Investor is Income Recipient 

Corporate Equity: 

Distributed t,+(l-t.Jtm ti" 

Undistributed t, ti" 

Noncorporate Equity tulN ti" 

Interest tw ti" 

Rents and Royalties twR twR 

Department of the Treasury 

Office of Tax Policy 

t, = U.S. corporate income tax rate. 

4 = U.S.individual income tax rate. 

= Maximum US.individual income tax rate. 

tg = U.S.effective individual tax rate on capital gains; is 

zero in one version of the prototype. 

twn,tW, tw, twR= U.S. withholding rates on payments 

to foreignersof dividends, noncorporate equity 

income, business interest, and rents and royalties, 

respectively. Generally varies by recipient, type of 

income, and eligibility for treaty benefits and may be 

zero. 

neutrality benefits, we believe that any small 

business exception to CBIT should be limited to 

very small entities. 

The CBIT prototype includes an exception for 

small businesses with gross receipts of less than 

$100,000. Such businesses would continue to 

deduct their interest expense, and the interest they 

pay would be taxable to the recipients. Any wages 

or profits distributed by an exempt small business 

would be taxable to the recipients at the 

recipients' marginal tax rates. CBIT interest and 

dividends received by a small business would be 

excludable. We concluded that such an exception 

was desirable because of complexities that might 

otherwise arise in the transition from current law 

to CBIT and difficulties in separating capital 

income from labor income for very small businesses (proprietorships, in particular). Although 

CBIT generally taxes the income shares of creditors and equityholders at a uniform 31 percent 

rate, it does not alter the current progressive 

individual rate structure (with graduated rates 

from 15 to 31 percent) for taxing wages or other 

labor income and nonCBIT capital income. While 

all CBIT taxpayers would be allowed to deduct 

reasonable compensation paid for services to the 

same extent as under current law, these rules may 

be inadequate for small businesses. In many small 

businesses, income received by an owner-manager, in fact, may be a mixture of returns on both 

physical and human capital. Ignoring the distinction and subjecting all the owner-manager's 

income to the uniform CBIT rate, might overtax 

the labor component of the owner-manager's 

income. In addition, not allowing losses to flow 

through currently might create significant hardship 

where the owner-manager draws a salary. With a 

small business exception, however defined, all 

returns on capital in such nonCBIT small businesses would be taxed at the investors' separate 

rates instead of at the uniform CBIT rate.13 

We concluded that an exclusion based on 

annual gross receipts would be the simplest to 

structure and estimate at the current conceptual 

phase of the prototype's development. For purposes of determining an entity's eligibility for the 

exception, dividends and interest received from 

CBIT entities would be included (although they 

would not be taxable to the receiving entity). Such 

a definition of the exclusion has several advantages. A gross receipts criterion is objective and 

easier to apply from a compliance and enforcement standpoint than the alternatives discussed 

below. It can be determined readily from documents currently generated for tax compliance

purpose^.'^ So long as the lower bound of gross 

receipts determining CBIT status is low, we 
43 

believe that aggregation rules for nonCBIT entities should be unneces~ary.'~ 

Other criteria are possible. Ideally, the criteria 

should be related to the potential "blurring" of 

owners' capital and labor incomes. For example, 

businesses with substantial equity held by individuals who also supply substantial labor to the 

enterprise might qualify. Other definitions currently used in the Code or elsewhere include 

criteria such as whether the business is closely 

held (as measured by the number of shareholders), the value of the business (as measured by the 

value of stock, net worth, or the value or adjusted 

basis of assets), the annual amount (or average 

annual amount) of net income, and the number of 

employees. The correlation between blurring of 

labor and capital income of owner-managers and 

some of these characteristics may depend on the 

nature of the business, industry characteristics, 

and other factors. We believe the more practical 

course, however, is simply to exempt certain 

"small businesses" based on size.16 

4.D TAX PREFERENCES 

Introduction 

We have made a general recommendation in 

this Report that integration should not become an 

occasion for extending corporate level tax preferences to shareholders. Future policymakers seem 

likely, however, to retain many of the preferences 

currently available to corporations under the 

Code. Absent special rules, CBIT's general 

exclusion of dividends and interest from income 

would automatically extend those preferences to 

shareholders, 

There are two general mechanisms which 

could be used to ensure that one level of tax is 

imposed on preference income when it is distributed. First, CBIT entities could be required to 

report to shareholders and debtholders the 

amount, if any, of each dividend or interest 

payment that is made out of preference income. 

The investor would then include that amount in 

income and pay tax at the investor's tax rate. This 

is the mechanism we recommend in the dividend 

Prototypes 

exclusion prototype. '* The alternative approach 

is to impose a 31 percent compensatory tax at the 

entity level on all distributions from preference 

income. Such a compensatory tax would not be 

refundable to tax-exempt or foreign investors. 

Although both systems have advantages) the 

dividend exclusion prototype (and the imputation 

credit prototype described in Chapter 11)reject a 

compensatory tax in favor of shareholder level 

taxation of distributed preference income and 

foreign source income shielded from US.tax by 

foreign tax credits. As Section ll.B discusses, in 

those prototypes, which are limited to corporate 

equity, this Report would tax preference income 

and foreign source income at the shareholder level 

in order to preserve current tax and dividend 

policy for corporations with substantial amounts 

of such income. 

Under CBIT, however, a compensatory tax 

has considerable conceptual and practical appeal. 

Adopting a compensatory taxwould permit investors to exclude all dividends and interest received 

from any CBIT entity. Thus, CBIT would consistently collect tax on capital income, whether 

interest or dividends, at the entity level at a 31 

percent rate. 

A compensatory tax would be simpler at the 

investor level. Because all distributions with 

respect to CBIT investments would be excludable 

by investors, no information reporting to shareholders or debtholders would be required. On the 

other hand, if preference income distributed as 

interest or dividends were subject to investor level 

tax,CBIT entities would have to provide infonnation reports to the IRS and to investors, indicating 

the extent to which a distribution is excludable. A 

compensatory tax under CBIT also would permit 

the complete repeal of the withholding tax on 

dividends and interest paid to foreign investors. 

See Section 4.E. 

The principal disadvantage of a compensatory 

tax under CBIT is that our economic analysis 

suggests that it would create significant inefficiencies in corporate payout decisions. Our data 

indicate that even if distributions were stacked 
Prototypes 44 

first against fully-taxed income, a compensatory 

tax would impose a significant entity level tax 

burden on distributions. Our models of corporate 

behavior predict that, to avoid this additional tax, 

CBIT entities would increase their reliance on 

retained earnings as a source of fmance and would 

rely less on both new equity and debt. Under the 

assumptions of our models, this effect is strong 

enough to distort corporate payout decisions as 

much as under current law. See Section 13.D. 

Accordingly, the remainder of this chapter 

describes the differences in treatment necessary 

under the CBIT prototype if no compensatory tax 

is imposed and distributed preference income and 

foreign source income are taxed at the investor 

level.l9 

Excludable Distributions Account 

The prototype identifies distributions out of 

preference income and foreign source income 

shielded from tax by foreign tax credits by requiring CBIT entities to maintain an Excludable 

Distributions Account (EDA). (The EDA is 

similar to the EDA described in Chapter 2, except 

that interest payments as well as dividend payments are charged against the account.) For each 

$1.00 of U.S. tax paid, approximately $2.23 

would be credited to the EDA. The annual addition to the EDA is referred to as fully-taxed 

income and is calculated using the following 

formula: 

Annual additions to EDA = 

+ equity distributions and interest received from CBlT entities 

The EDA is reduced by the amount of all dividend and interest payments, in the order in which 

payments are made. The EDA is also reduced by 

approximately $2.23 per $1.00 of tax refunded. 

Positive EDA balances may be carried forward 

without limitation. 

The prototype stacks payments first against 

fully-taxed income. Distributions of interest or 

dividends reduce the EDA. When the EDA is 

reduced to zero, distributions would be subject to 

compensatory tax or, alternatively, would be 

taxable to the investor.20 As in the dividend 

exclusion prototype, refunds of entity level tax 

would not reduce the EDA below zero. Refunds 

in excess of the taxes reflected by the EDA 

balance would be applied to reduce future entity 

level tax payments. Similarly, net operating losses 

in excess of the EDA would be carried forward. 

To illustrate, assume that a corporation subject 

to CBIT earns $100 in taxable income and $100 

of preference income, and pays $31 in regular 

CBIT taxes but neither pays nor receives dividends or interest. Its EDA is thus $69 [$31/.31-

$311. If it then pays $75 in interest and dividends, 

it will pay a compensatory tax of $1.86 [.31 x 

($75-$69)] or, alternatively, the $6 of distributions that is attributable to preference income will 

be taxable to investors.21 

If a compensatory tax is adopted, all distributions on equity and debt of CBIT entities will be 

excludable. A CBIT entity receiving a distribution 

would add the amount received to its own EDA. 

If, alternatively, distributions of preference income were taxable to investors, the prototype 

could either (1) tax CBIT entities currently on 

such distributions” or (2) provide a deduction, 

similar to the current dividends received deduction, for such receipts to defer tax until the income is redistributed to a nonCBIT entity.23 

Alternative Minimum Tax 

Consequences of CBIT 

The CBIT system retains an entity level 

alternative minimum tax (AMT) similar to the 

corporate AMT under current law. As under 

current law, the entity level minimum tax would 

ensure that some entity level tax is imposed 

currently on a profitable business. In a CBIT 

AMT, however, neither interest expense nor 

dividends would be deductible and dividends and 

interest from CBIT entities would be excluded. 

Because the CBIT tax base provides no deduction 

for interest paid, it is likely that relatively few 

nonfinancial businesses would have regular tax 

liabilities low enough to trigger a CBIT AMT 

imposed at the current 20 percent rate. As in the 
45 

dividend exclusion prototype, AMT would be 

treated as taxes paid in the same manner as the 

regular CBIT tax; however, the divisor in the 

EDA formula would still be the regular CBIT tax 

rate, 31 percent. Thus, a CBIT entity could not 

distribute all of its alternative minimum taxable 

income (AMTI)without triggering a compensatory tax or an investor level tax. 

Adopting CBIT might permit significant 

simplifying modifications to the current individual 

AMT. If CBIT applied to all but small business 

entities, the individual AMT base would apply 

principally to two items: (1) excess itemized 

deductions and (2) State and local tax-exempt 

bond income treated as a preference under current 

law.” It would be inappropriate, however, to 

include excludable CBIT interest or equity income 

in an investor’s AMTI because any such tax 

imposed would be a second level of tax on income 

that had already been subjected to tax at the 

highest individual rate.25 

4.E INTERNATIONAL 

CONSIDERATIONS 

Taxation of Income from 

Outbound Investment 

This Report recommends that the tax burden 

imposed by any integration prototype on income 

from U.S. investment in foreign businesses 

(outbound investment) be roughly equivalent to 

the tax burden imposed on such income under 

current law. The shift from two-tier taxation of 

corporate foreign source income to a single-tier 

tax should not result in the collection of a significantly greater or lesser amount of tax revenue 

from such income than under current law. See 

Chapter 7. 

Under current law, foreign source income 

earned through a domestic corporation is potentially subject to U.S. tax at both the corporate and 

the shareholder levels. At the corporate level, 

foreign source income is subject to a 34 percent 

tax, which may be reduced substantially or eliminated by foreign tax credits. If the U.S. corporate 

Prototypes 

tax liability on foreign source income is less than 

the foreign tax imposed on the income, excess 

foreign tax credits may arise. Upon distribution, 

the income generally is subject to full taxation at 

the shareholder’s marginal tax rate, without a 

foreign tax credit. This approach is consistent 

with U.S. income tax treaty commitments. No 

U.S. treaties require that investors in a U.S. 

corporation receive tax relief from foreign taxes 

paid by the corporation. 

Foreign Source Income of CBIT Entities and 

Other Business Entities 

Under the CBIT prototype, results comparable 

to those under current law are achieved by allowing the foreign tax credit (with a modified limitation, as described below) to offset the regular 

CBIT tax in full, but adding no amount to the 

EDA to reflect foreign source income sheltered 

from U.S. tax by foreign tax credits.26 

The EDA mechanism does not distinguish 

between foreign source income shielded from the 

regular CBIT tax by the foreign tax credit and 

U. S.source preference income. Both benefit from 

the stacking rule that treats distributions as arising 

frrst from income subject to the regular CBIT tax. 

Accordingly, as with preference income, so long 

as foreign source income shielded from CBIT by 

the foreign tax credit is not distributed, it will 

bear no further tax burden. The CBIT compensatory tax or an investor level tax will be triggered 

only when such income is distributed-the same 

circumstance that would result in imposition of a 

shareholder level tax under current law. 

If a compensatory tax is not adopted, this 

stacking rule ensures that the total Federal tax 

burden on outbound investment by corporations 

should not vary sigriificantly from that imposed 

under current law, apart from the effect of the 

expanded tax base for foreign branch income 

resulting from the nondeductibility of interest. 

Imposition of a compensatory tax could increase 

the tax revenue collected from outbound investment. In either case, the tax burden on outbound 

investment by corporations may actually be less 
Prototypes 46 

for foreign source income subject to foreign tax at 

a rate less than the CBIT rate, which will be 

subject to only a single level of residual U.S. tax. 

CBIT will, however, require modification of 

the current rules for computing the foreign tax 

credit. Under current law, the foreign tax credit 

limitation is equal to the product of (1) the taxpayer’s pre-credit U.S. tax liability on worldwide 

taxable income and (2) the ratio of the taxpayer’s 

foreign source taxable income to its worldwide 

taxable income. This usually reduces to the 

product of the U.S. tax rate and the foreign 

source income. The foreign source income of a 

U.S. taxpayer is currently computed under U.S. 

tax principles for this purpose.27In the case of a 

foreign subsidiary, the amount of foreign taxes 

that are deemed paid by a 10 percent U.S. corporate shareholder in respect of a particular dividend 

distribution is equal to the total foreign taxes paid 

by the subsidiary, multiplied by the ratio of the 

dividend to the total earnings of the subsidiary. 

(This amount is subject to the limitation just 

described.) 

If foreign source income were computed under 

CBIT principles, Le., with no deduction for 

interest, problems would arise. In the case of 

foreign branch operations of CBIT entities, the 

amount of foreign source income in the limitation 

formula could increase dramatically. Such an 

increase would seriously mismatch the computation of taxable income and tax liability by a 

foreign jurisdiction that allowed a deduction for 

interest. Assuming that foreign tax rates were 

high enough to provide an adequate supply of 

credits, no U.S. tax would be collected currently 

on foreign source income used to pay interest. 

Instead, U.S. tax would be collected only when 

such income was deemed to have been distributed 

by the entity and a compensatory tax (or an 

investor level tax) was imposed. In the case of a 

foreign subsidiary, the amount of earnings in the 

denominator of the indirect credit fraction could 

increase dramatically, seriously diluting the 

amount of foreign taxes attributed to a particular 

distribution of earnings. 

Accordingly, the CBIT prototype assumes 

that, in computing the foreign tax credit limitation, foreign source income of a branch will be 

reduced by interest expense claimed with respect 

to the foreign operations.28 Similarly, in 

computing the indirect foreign taxcredit, earnings 

of the foreign subsidiary will be reduced by 

interest expense claimed by the ~ubsidiary.~~ 

Under this approach, CBIT entities will continue 

to enjoy approximately the same level of direct 

and indirect foreign tax credits as under current 

law. Some reduction will occur, however, by 

reason of lowering the regular CBIT tax rate to 

31 percent from the current 34 percent. 

Several additional effects of CBIT on the 

taxation of foreign source income should be 

noted. As explained above, CBIT would subject 

all business organizations to an entity level tax. 

This has at least two possible implications for the 

foreign tax credit. First, it suggests that an indirect credit for foreign taxes deemed paid by a 

foreign subsidiary should be available to noncorporate domestic shareholders, such as partnerships, that are CBIT entities. Under CBIT, the 

purpose of the indirect credit would defer the 

additional level of CBIT tax until the time of 

distribution (when a compensatory tax or an 

investor level tax would be imposed) to avoid the 

burden of an immediate tax on foreign source 

profits. If the indirect credit were not extended to 

partnerships and other noncorporate CBIT entities, there would continue to be a strong bias in 

favor of the corporate vehicle for multinational 

enterprises. 

Second, the equal treatment of all business 

entities under CBIT means that foreign tax credits 

will not fully relieve CBIT tax in circumstances 

where U.S. tax is fully relieved under current 

law. If a domestic partnership or S corporation 

receives a dividend, interest, or royalty payment 

from a foreign corporation (or other foreign 

payor) under current law, and the payment has 

been subject to a foreign withholding tax, the 

recipient is eligible for a foreign tax credit, and 

no further U.S. tax is imposed to the extent that 
41 Prototypes 

the partners or shareholders are individuals. 

Under CBIT, however, the credit would only 

relieve the regular CBIT tax. A compensatory tax 

or an investor level tax would be imposed when 

the foreign profits are redistributed to the partner 

or shareholder. 

Finally, CBIT requires some consideration of 

the treatment of foreign business entities. Under 

current law, deferral of U.S. tax on foreign 

profits is available when the profits are earned 

through a foreign corporation. When such profits 

are earned through a foreignpartnership, the U.S. 

tax is not deferred, and the results are essentially 

the same as for a foreign branch office of a U.S. 

taxpayer. Under the CBIT prototype, foreign 

entities would generally be treated as nonCBIT 

entities. Thus, interest paid by a foreign entity 

would continue to be taxable to a U.S. lender, 

and would continue to be deductible by the foreign entity.3oIn addition, deferral would continue to be permitted for profits earned through a 

foreign corporation. 

Foreign branches of CBIT entities. In the case 

of a foreign branch of a U.S. CBIT entity, the 

expanded CBIT income base of the branch would 

be included in the U.S. CBIT entity’s income 

currently. Foreign source income earned by a 

CBIT entity through a foreign branch would be 

subject to residual regular CBIT tax prior to 

distribution. As discussed above, there will 

always be a residual regular CBIT tax on the 

portion of the foreign source income base that is 

excluded from the computation of the foreign tax 

credit. Where the foreign jurisdiction’s tax is 

computed with an interest deduction, such income 

will bear, in effect, the same tax that it would 

have borne if earned from domestic sources. With 

respect to the remaining portion of the foreign 

source income base, a residual regular CBIT tax 

will be imposed if the foreign income tax liability 

is less than the regular CBIT liability, with the 

effect that such income also will bear the same 

pre-distribution aggregate tax (foreign tax plus 

CBIT tax) that it would have borne if it were 

earned from domestic sources.31If the foreign 

income tax liability on the remaining portion of 

the foreign source income base is higher than the 

regular CBIT liability, such income will bear a 

pre-distribution tax rate that is higher than the 

CBIT rate applicable to domestic source income. 

This disparity, which also exists under current 

law, is entirely attributable to higher foreign tax 

rates. 

Foreign portfolio equity investment (less than 

10 Dercent of total equity) bv a CBIT entity. 

Foreign source portfolio dividends received by a 

CBIT entity would be subject to source country 

income taxation at the level of the foreign corporation and to a second level source country withholding tax upon distribution. Regular CBIT 

would apply to the foreign source dividend when 

received by a CBIT entity, subject to offset by a 

foreign tax credit for the source country withholding tax. In most cases, some regular CBIT would 

be collected, because regular CBIT liability would 

generally exceed the foreign withholding tax by 

virtue of treaty rate reductions and by virtue of 

the expansion of the CBIT income base to include 

income paid out as interest. While such income is 

subject to an additional level of taxation (the 

foreign corporate level tax) relative to income 

earned through investment in a U.S. subsidiary, 

the disparity should be approximatelythe same as 

under current law. If distributed by the CBIT 

entity, such income, to the extent shielded from 

regular CBIT by the foreign tax credit, would be 

subject to the CBIT compensatory tax or an 

investor level tax. If the CBIT entity is a corporation, this result generally will be comparable to 

the result under current law. To the extent residual regular CBIT is paid, the result will be better 

than under current law for shareholders now 

taxable on dividend income. A CBIT entity that is 

a partnership with individual shareholders or an S 

corporation may be treated less favorably than 

under current law in certain circumstances. 

Foreign direct equitv investment (10 Dercent 

or more of total equity). Foreign source income 

earned by a CBIT entity through a direct equity 

investment would be subject to full source country 

corporate level tax and to a second level source 

country withholding tax upon distribution of a 

dividend from the foreign subsidiary. The CBIT 

entity (whether a corporation or partnership) 
Prototypes 48 

would receive a credit both for the source country 

withholding tax and for the source country corporate level tax under IRC 0 902. Thus, regular 

CBIT would be imposed only to the extent that 

the regular CBIT liability exceeded the total 

amount of foreign taxes paid or deemed paid. 

Given the opportunity to defer the CBIT 

compensatory tax or investor level tax by 

retention of foreign subsidiary profits at the CBIT 

entity level, the disparity between direct equity 

investment in a foreign subsidiary and investment 

in a domestic subsidiary under CBIT should not 

vary significantly from current law, If distributed 

by the CBIT entity, such income would be subject 

to the CBIT compensatory tax or an investor level 

tax to the extent it was shielded from regular 

CBIT by foreign tax credits. However, as with 

portfolio investment, the result will generally be 

similar to the result under current law in cases 

where such dividends would be taxed fully. To 

the extent subject to residual regular CBIT, such 

income will be taxed less heavily than under 

current law. A CBIT entity that is a partnership 

or an S corporation may be treated less favorably 

than under current law (depending on whether the 

IRC 8 902 credit is extended to such 

shareholders). 

Foreinn debt investment. Foreign source 

income earned by a CBIT entity through a debt 

investment in a foreign entity or subsidiary would 

escape source country income taxation to the 

extent that interest is deductible for foreign income tax purposes. While such incomepotentially 

would be subject to a foreign withholding tax 

upon distribution as interest, the CBIT entity 

would receive a foreign tax credit for the 

withholding tax (subject to the foreign tax credit 

limitation).Thus, regular CBIT would be imposed 

only to the extent that regular CBIT liability 

exceeds the foreign withholding tax. Interest 

income received from a domestic subsidiary also 

would be subject to CBIT, in this case imposed 

on the subsidiary. Thus, outbound debt investment 

should not be subject to greater entity level tax 

than domestic debt investment until such income 

is distributed. The CBIT compensatory tax or an 

investor level tax then would apply to the extent 

the income had been shielded from U.S. tax by 

foreign tax credits. The impact of the CBIT 

compensatory tax or an investor level tax,if and 

to the extent imposed, will be similar to the 

consequencesdescribed for the imposition of such 

tax on foreign portfolio equity investment. 

Foreign Source Income 

Earned Directly by Individuals 

Under CBIT, foreign corporations and other 

foreign entities would be treated as nonCBIT 

entities. Accordingly, as under current law, 

interest and dividend income received directly by 

a U.S. resident individualfrom a foreign corporation would be subject to tax at the individual’s 

marginal tax rate. CBIT does not require the 

modification of the foreign tax credit allowed to 

individuals under current law. 

Taxation of Income from 

Inbound Investment 

As noted in Section 4.A, we view CBIT as a 

very long-range option for equalizing the treatment of debt and equity. We anticipate that 

adoption of CBIT would be preceded by a lengthy 

period of consideration and, when implemented, 

CBIT would be phased-in over a period of about 

10 years. See Chapter 10. 

Both the dividend exclusionprototype and the 

shareholderallocationprototype retain the current 

U.S. withholding tax on dividends paid to foreign 

shareholders and the branch profits tax on U.S. 

branches of foreign corporations. Retaining the 

second level of tax on equity income in those 

prototypes simply replicates current law and 

permits reduction of the second level of tax 

through tax treaty negotiations. 

We make a different recommendation in 

CBIT, however. Retaining current law in the context of CBIT would require collecting two levels 

of tax on dividends and zero or one level of tax 

on interest. (Chapter 7 discusses the current law 

taxation of foreign investors.) Such treatment 

would violate the equality between debt and equity 

that is one of the principal goals of CBIT. To 

maintain parity between debt and equity, the 
49 Prototypes 

CBIT prototype removes the remaining withholding taxes on both interest and dividends paid by 

CBIT entities.32The result is to subject both debt 

and equity income to CBIT taxation once at the 

entity level. 

Elimination of the remaining withholding taxes 

on both dividends and nonportfolio interest under 

CBIT would clearly affect U.S. income tax treaty 

negotiations. While existing U. S.treaties provide 

for reciprocal reductions of source country tax 

rates on interest and dividends, CBIT might 

reduce U.S. treaty partners’ incentive to grant a 

reciprocal exemption in future negotiation^.^^ In 

order to obtain a reciprocal exemption, it might 

be necessary for the United States to make concessions either with respect to entity level tax 

collected on dividends and interest or CBIT 

compensatory taxes (if any) imposed on dividends 

and interest. For example, a tax credit for CBIT 

taxes paid could be made available only on a 

bilateral basis. Any such treaty concessions should 

be made in a manner to protect CBIT’s basic goal 

of equating the taxation of debt and equity. 

If a compensatory tax were not adopted, 

distributed preference income and shielded foreign 

source income will be taxable to investors. 

We recognize that adoption of CBIT would 

represent a departure from current policy on 

inbound debt investment and that any such departure would require extensive international discussions with tax authorities and market participants. 

Conduct of a U.S.Trade or Business 

As under current law, income earned by a 

foreign investor through the conduct of a U.S. 

trade or business would be taxed in the same 

manner as income earned by US. residents. CBIT 

rules would apply to foreign business activities in 

the United States. Thus, interest expense attributable to a U.S. trade or business would be nondeductible, and the current law provisions governing 

the allocation of interest expense to effectively 

c0nnecte.l income would be ~nnecessary.~~ 

Small Business Erception 

The small business exception would apply to 

inbound investment. See Section 4.C. Distributions from small, nonCBIT corporations to foreigners would remain subject to current statutory 

withholding at 30 percent, unless that rate is 

reduced by treaty provision.35In the case of a 

U.S. branch of a foreign corporation, the size 

criteria would be applied on the basis of the gross 

effectively connected receipts of the branch. 

4.F IMPACT OF CBIT ON 

INVESTMENT BEHAVIOR 

OF LOW-BRACKET,

TAX-EXEMPT, AND 

FOREIGN INVESTORS 

Overview 

Because substantial nontax factors influence 

investment behavior, we cannot predict with 

certainty CBIT’s impact on the manner in which 

investors allocate their portfolios. Indeed, if tax 

considerations were paramount, there would be a 

strong bias under current law against any 

investment by low-bracket taxpayers and domestic 

tax-exempts in domestic corporate equities (as 

opposed to debt). Current experience indicates, 

however, that both of these groups invest in 

corporate equity. While special statutory withholding provisions, the statutory exemption for 

capital gains realized by foreign investors on 

property investments other than in real property, 

and treaty mitigation provisions make it hard to 

generalize in the case of foreign investors, the tax 

provisions of current law, if given paramount 

effect, would direct their investment toward 

domestic debt rather than corporate equity in most 

instances. Other nontax factors are important, 

however, and foreign investment in domestic 

equity occurs despite higher tax rates than for 

domestic debt. 

The United States’ stable economic and political climate attracts investment. The size of our 

consumer market attracts foreign sellers and 
Prototypes 50 

investors. Opportunities for diversification not 

available through alternative investments can 

override tax disadvantages. These nontax factors 

will temper portfolio shifts by these classes of 

taxpayers, Considering these countervailing 

forces, we believe that the best approach is to 

adopt a gradual phase-in of CBIT, rather than 

specific measures for low-bracket, tax-exempt and 

foreign investors although we discuss such 

measures below. To preserve CBIT’s neutrality 

between debt and equity, the discussion contemplates identical treatment of debt and equity. The 

reductions of tax due to these mechanisms, of 

course, will have revenue consequences. 

Interest Rate Impact of CBIT 

The interest rate on CBIT debt will be less 

than the interest rate on nonCBIT debt, potentially 

by an amount up to the 31 percent entity level 

tax, because interest received on CBIT debt 

represents an after-tax return.36For example, if 

market interest rates on nonCBIT debt were 10 

percent, a debt instrument issued by a CBIT entity 

might bear interest at a rate as low as 6.9 percent. 

If this were the case, the after-tax return on the 

two instruments would be the same for a taxable 

investor with a 31 percent marginal rate. While 

predicting the actual rate relationship between 

CBIT and nonCBIT debt is impossible, experience 

with the ratio of interest on tax-exempt state and 

local bonds to that on taxable corporate bonds 

suggests that the CBIT interest rate may not 

reflect a 31 percent tax rate, because there may be 

insufficient demand for CBIT debt by investors 

with a marginal rate of 31 percent. Thus, for 

example, if a nonCBIT bond bore interest at a 10 

percent pre-tax rate, a CBIT bond might bear 

interest at 8 percent if it were necessary to attract 

lower-bracket investors to CBIT debt. In such a 

case, the 8 percent (after-tax) CBIT return would 

be more attractive to an investor in the 31 percent 

bracket than the 10 percent (pre-tax) nonCBIT 

return. 

Because interest rates on CBIT debt should be 

lower than the rates on nonCBIT debt, low-bracket, tax-exempt, or foreign investors (collectively, 

tax-favored investors) can be expected to increase 

their holdings of nonCBIT debt and decrease their 

holdings of CBIT debt. (Overall, these portfolio 

shifts may be offset by increased demand for 

CBIT debt and equity by taxable investors.) 

Depending on their tax rates, tax-favored investors, for example, might prefer a 10 percent 

nonCBIT bond to an 8 percent CBIT bond. For 

any investor with a marginal rate of less than 20 

percent, a 10 percent nonCBIT return is worth 

more than an 8 percent CBIT (after-tax) return. 

While a rate differential of less than 15 percent 

between CBIT and nonCBIT bond rates should 

not affect the portfolio choices of low-bracket 

individual taxpayers, any rate differential could 

affect investment choices by tax-exempt and 

foreign investors since, as under current law, all 

nonCBIT interest paid to tax-exempt investors 

(and portfolio interest paid to foreign investors) is 

tax-free at the investor level. Domestic tax-exempt 

entities might be expected to decrease holdings of 

CBIT debt and increase holdings of governmental 

or other nonCBIT debt and CBIT equity.37 

The treatment of preference income under 

CBIT further complicates the analysis of the 

expected rate differential between CBIT and 

nonCBIT investments. If a compensatory tax were 

imposed, all CBIT investments would pay an 

after-tax return, and .one would generally expect 

the risk adjusted return on CBIT investments to 

be the same. On the other hand, if payments of 

dividends and interest out of preference and 

foreign source income are taxable to investors, 

issuers with substantial preference and foreign 

source income may pay a higher return than 

issuers with substantial fully-taxed income. 

If CBIT were adopted, special attention would 

have to be given to its impact on international 

capital flows. 

Low-Bracket Investors 

As discussed in Chapter 1, we have structured 

the CBIT prototype to impose a uniform 31 

percent tax on earnings on capital invested in 

CBIT entities. However, the impact of CBIT on 

taxable equity holders and bondholders with 

marginal rates of less than 31 percent could be 
51 

lessened by providing those investors with a tax 

credit. This credit could be designed to give those 

investors a tax benefit equal to all or a portion of 

the difference between their marginal rate and the 

31 percent CBIT rate. While the credit would not 

be refundable, it could offset tax on other income. 

The effect would be similar to full refundability 

for any investor with enough other tax liability to 

absorb the credit.38If a compensatory tax were 

not imposed, the credit would be available only 

for excludable payments. 

The credit is essentially the same as the 

shareholder credit for low-bracket investors 

described in Section 2.D in the context of the 

dividend exclusion prototype. Because CBIT 

extends to both dividends and interest, the credit 

would be available to both equity holders and 

bondholders. 

Example. Assume that a CBIT entity earns $100of 

income and pays $3 1 in tax. It then distributes $69 

as interest to a bondholder with a marginal tax rate 

of 15 percent. Applying the formula set forth in 

Section 2.D (adjusted to reflect the 31 percent 

CBIT rate), a bondholder credit of $16 (Le., 

$69/.69 x (.3 1-.15)) would produce a tax benefit 

equal to the difference between the bondholder rate 

and the CBIT rate. 

Tax-Exempt Investors 

Under the other prototypes described in this 

Report, denying refundability of corporate level 

taxes preserves the current law treatment of 

corporate equity owned by tax-exemptand foreign 

investors. Under CBIT, however, some offset for 

corporate level taxes would tend to move CBIT 

closer to current law by mitigating the additional 

tax burden the prototype places on interest earned 

by tax-exempt investors. As with low-bracket 

shareholders, the credit could be set at a rate that 

would refund either all or a portion of the tax 

imposed at the 31 percent CBIT rate. If a compensatory tax is not imposed, the credit would be 

available only for excludable payments. 

Because tax-exempt investors have little or no 

tax liability, they would be unable to benefit from 

the nonrefundable investor credit described in the 

Prototypes 

preceding section. One possibility would make the 

investor credit described above refundable. An 

alternative approach would combine an investor 

level credit with a tax on investment income of 

tax-exempt entities. Under this approach, taxexempt and foreign investors would be liable for 

tax on all investment income (interest, dividends, 

capital gains, rents, royalties, and other investment income). The rate of this tax could be set to 

produce overall revenues (taking into account the 

investor credit) equivalent to those currently borne 

by equity supplied by the tax-exempt sector. A 

tax-exempt entity could then use the investor level 

credit to offset the tax due on other investment 

income. See Section 6.D.39 

Imposing a tax on investment income and 

allowing a credit would treat CBIT and nonCBIT 

debt instruments alike (although it probably would 

not fully compensate for the interest rate differential between CBIT and nonCBIT debt). It generally would encourage tax-exempt entities to hold a 

mixture of CBIT and nonCBIT debt and equity, 

because the nonrefundableinvestor credit associated with CBIT debt and equity could be used to 

offset the tax due on other kinds of investment 

income. This approach would minimize differences between CBIT and nonCBIT investments, just 

as it could minimize differences between debt and 

equity under distribution-related integrati~n.~' 

Foreign Investors 

The absence of special relief for foreign debt 

investors in the CBIT prototype reflects our 

judgment that elimination of the withholding tax 

on CBIT dividends and interest and eliminationof 

the branch tax may balance the CBIT change as to 

debt, recognizing that, under CBIT, foreign 

investors may prefer nonCBIT debt to CBIT debt 

and CBIT equity to equity under current law. 

Nevertheless, either of the mechanisms described for tax-exempt investors-a refundable 

credit or the investment tax and credit mechanism 

described in the preceding section-could be used 

to provide relief for foreign investors. A gradual 

phase-in of CBIT also would allow assessment of 
Prototypes 52 

the need for such mechanisms based on 

experience. 

Impact of Relief Measures for 

Low-Bracket, Tax-Exempt and Foreign

Investors on the CBIT Prototype 

Our recommended CBIT prototype contains 

none of the relief mechanisms discussed in the 

preceding sections. Adoption of any of these 

mechanisms would result in a revenue loss which 

would have to be recovered elsewhere in the 

prototype or in other offsetting revenues not now 

required by the prototype. For example, a compensatory tax could be imposed. (The estimates 

for the CBIT prototype in Section 13.Hdo not 

include a compensatory tax.) In addition, the decisions to eliminate the branch tax and withholding 

taxes for foreign investors could be re-examined 

(although such a modification would be contrary 

to the goal of imposing a single level of U.S. 

tax). 

4.6 STRUCTURAL ISSUES 

Current Law Interest Deduction 

Limitations Under CBIT 

Under current law, interest paid or incurred 

by businesses generally is deductible. In special 

circumstances, however, the Code limits business 

interest deductions. These limitations serve several purposes, such as treating debt instruments with 

equity characteristics as equity, preventing mismatches in the timing of income and expense, and 

preventing tax arbitrage by borrowing to purchase 

tax-favored investments. 

CBIT's elimination of the deduction for 

business interest by all but the smallest businesses 

could allow a major simplification in the Code by 

eliminating (or substantially reducing) the need 

for several provisions designed to prevent excessive and mismatched interest deductions. Thin 

capitalization will no longer be a tax concern. We 

believe the following Code sections could be 

repealed or substantially reduced in scope: 

0 IRC $ 385 (granting Treasury the authority to 

define the distinction between debt and equity) and 

IRC $279(denying deductionsfor equity-like debt) 

would be repealed, 

0 IRC 0 163(e)(5) and (i) (deferring interest deductions on high-yield discount obligations) and IRC $ 

1630) (deferring excessive interest deductions on 

certain related-party debt-the anti-earnings stripping provision) would be repealed, 

0 IRC 0 267(a)(2) (relating to matching of interest 

income and deductions between related parties) 

would no longer apply to interest paid by CBIT 

entities, 

0 IRC $ 469 (the passive loss rules) and IRC 9 465 

(the at risk rules) would have no application to 

interest paid by a CBIT entity, 

0 IRC $ 263A(f) (relating to capitalization of interest 

with respect to self-constructed assets and inventory) could be repealed, and IRC $ 266 (the election 

to capitalize interest generally) could be repealed 

with respect to CBIT entities:' 

0 IRC $ 1277 (restricting interest deductions allocable to accrued market discount) and IRC $ 1282 

(restricting interest deductions allocable to accrued 

discount) might no longer apply to interest paid by 

CBIT entities, 

0 IRC $ 263(g) (requiring capitalization of interest 

and other costs of carxying a straddle) might no 

longer apply to interest paid by a CBIT entity, 

0 IRC 5 265(a)(2) (disallowingdeductionsfor interest 

inc~~ed to purchaseobligationsbearing tax-exempt 

interest) might no longer apply to interest paid by 

a CBIT entity, 

0 IRC $ 265(b) (relating to disallowance of interest 

deductions of financial institutions allocable to taxexempt obligations) and IRC $ 291(e)(l)(B)(ii) (an 

earlier version of IRC $ 265(b) applicable for taxexempt obligationsacquiredby financial institutions 

between 1982 and 1986) could be repealed,42and 

0 IRC $ 264(a)(2), (3), and (4) (denying interest 

deductions on certain debts relating to life insurance policies) might not apply to interest paid by 

CBIT entities. 

CBIT will expand the scope of provisions, 

such as IRC 6 265(a)(2) (which currently disallows deductions for interest on indebtedness 
53 Prototypes 

incurred or continued to purchase or carry obligations bearing tax-exempt interest) and IRC 6 

265(a)(1) (which currently disallows expense 

allocable to tax-exempt income other than interest), to apply to taxpayers who receive CBIT 

interest and dividends. While the expanded interest disallowance rules would not apply to CBIT 

entities, it would apply to individuals and small 

business entities to disallow interest on debt 

incurred or continued to purchase or carry equity 

or debt of CBIT entities.43Absent such expansion, much of the CBIT tax base would erode in 

tax arbitrage transactions illustrated by the following hypothetical example: 

Examde. Assume that, for each year of its operation, CBIT entity X m s $1 million, pays 

$310,000 in regular CBIT tax and pays the remaining $690,000 as a dividend to individual A, its sole 

shareholder. The $690,000 is not taxable to A. 

Assume that A borrowed $6,900,000 from taxexempt entity C at 10 percent interest per year to 

purchase the X stock. If A is allowed a deduction 

of $690,000 for interest paid, he can shelter up to 

$690,000 in income from other sources while using 

his excludable CBIT dividends to pay the interest 

to C. C will pay no tax on the $690,000 in interest 

it receives each year. If the $690,000 deduction 

allowed to A shelters income otherwise taxable at 

31 percent, $213,900 of the tax paid by X will in 

effect be refunded to A. While the interest paid and 

dividend received in this example are equal, they 

need not be. If C is willing to loan A $10 million 

against his X stock on the same terms, A's interest 

deduction, if used against other income, would 

fully offset the CBIT tax X paid with respect to the 

distribution to A.44 

Under current law, this is simply one of many 

opportunities for rate arbitrage through the issuance of debt by taxable issuers to tax-exempt and 

foreign lenders. CBIT, however, generally eliminates businesses' ability to pay interest to taxexempt and foreign lenders without the payment 

of one level of tax.Thus, to prevent the erosion 

of the CBIT base, it is also necessary to prevent 

investor level rate arbitrage through borrowing. 

Application of modified IRC 6 265 would be 

equally appropriate if a compensatory tax is not 

adopted and interest and dividends paid by CBIT 

entities out of preference income are taxable to 

investors. In either case, the potential for arbitrage is the same. See "Anti-abuse Rules" in 

Section 2.B. 

Finally, some of the interest deduction limitations CBIT might eliminate may serve policies 

that would continue to be important but would 

require new mechanisms under CBIT. One example is current law's requirement that debt obligations be issued in registered form. Currently IRC 

6 163(f) denies a deduction for interest on unregistered obligations for which registration is required. This sanction would have no deterrent 

effect for CBIT entities because CBIT eliminates 

interest deductions. Because interest received 

from CBIT entities will not be taxed to the investor, the need for registration of debt instruments 

of CBIT entities for tax enforcement purposes will 

be greatly reduced. However, registration may be 

desirable for nontax law enforcement purposes, 

and replacement sanctions may be needed.45 

Identifying Disguised Interest 

CBIT entities and their investors will be 

indifferent to the characterization of payments to 

investors as either interest or dividends, because 

neither will be deductible by the CBIT entity and 

nei.ther will be taxable to the investor. However, 

tax tensions will remain and may be exacerbated 

by CBIT with respect to rent and royalty payments and allocations between principal and 

interest on the purchase of capital assets. 

If the market rate of interest on CBIT debt 

does not fully reflect the nondeductibility of 

interest payments, it will generally be advantageous to a CBIT entity to restructure such payments, where possible, into deductible rental and 

royalty payments. Such a restructuring will 

generally be disadvantageous to taxable recipients 

since it will convert interest that is not taxed into 

taxable rents or royalties. No such tension will 

exist, however, if the recipient is a tax-exempt 

entity or a CBIT entity that is in a net operating 
Prototypes 54 

loss position. Similarly, CBIT entities can be 

expected to maximize principal and minimize 

interest payments on capital purchases, since asset 

basis will give rise to deductible cost recovery 

while interest payments are nondeductible. Again, 

taxable sellers may have opposing interests depending on how gains on asset sales are taxed.46 

As with rents and royalties, these tensions will not 

exist where the seller is tax-exempt or is a CBIT 

entity with a net operating loss. 

CBIT therefore will put increased pressure on 

standards, such as those the Internal Revenue 

Service has developed, distinguishing finance 

leases (which are treated for tax purposes as loans 

and hence generate nondeductible interest for a 

CBIT entity) from true leases (which are 

respected as such for tax purposes and hence give 

rise to deductible rentals for CBIT en ti tie^).^' 

We believe that it would be prudent in a CBIT 

regime to include standards for distinguishing 

interest from rents and royalties in the Code, 

modeling them on existing standards, such as 

those the Service has developed for leases, or on 

IRC fj 467, which imputes interest to prevent 

uneconomic accruals of rent.48 

Purchase price allocations are inherently 

factual and governed by the standards of the 

market. While CBIT may change the tax stakes in 

such allocations, the problem presented is no 

different from that confronting the Internal 

Revenue Service in making fair market value 

determinations under current law. We do not 

contemplate that statutory change will be needed 

in this connection to implement CBIT. 

The current original issue discount (OID) and 

imputed interest rules may be needed in order to 

distinguish interest from principal. For example, 

in the case of sales of property in exchange for 

debt, these rules are needed to determine the 

buyer’s basis and the seller’s amount realized.49 

Similarly, in the case of debt issued for cash, 

these rules are needed to distinguish payments of 

interest (which reduce the EDA and, when the 

EDA is exhausted, are subject to compensatory 

tax or investor level tax) from payments of 

principal.50 

Interest Not Subject to CBIT 

CBIT does not dictate any change in the 

current taxation of interest paid on debt issued by 

a nonCBIT borrower. Thus, for example, home 

mortgage interest and personal investment interest 

incurred to carry nonCBIT assets would continue 

to be deductible by an individual borrower to the 

same extent as under current law and includable 

in the income of the recipient. Nonmortgage, 

personal interest would continue to be nondeductible by the borrower and includable by the lender, 

State and local bond interest would generally 

remain excludable from gross income to the same 

extent as under current law. Interest on Treasury 

debt would, as under current law, be includable in 

income by the recipient.51 

One administrative issue raised by nonCBIT 

debt is tracking income and deductions related to 

such debt. For example, maintaining the current 

law treatment for home mortgage interest, interest 

on Federal debt, and debt issued by foreign and 

tax-exempt entities under CBIT will require 

special reporting rules to identify such interest as 

includable in income and to permit it to retain its 

special character when it is collected and distributed by a REMIC, REIT, or other passthrough 

entity. 

Under CBIT, interest earned on bonds issued 

by State and local governments would retain its 

current exemption from tax,52 but interest income on debt issued by CBIT entities generally 

would be exempt. Under CBIT, the rate of interest on exempt state and local obligations may 

approximate the interest rate on corporate debt of 

similar risk and maturity. Thus, State and local 

governments might view CBIT as eliminating the 

borrowing advantage they currently enjoy relative 

to corporate issuers. State and local debt would, 

however, retain its advantage over Treasury and 

other nonCBIT debt such as home mortgages. 

Pension Funds 

As Section 2.G discusses, the immediate 

deduction for employer contributions to pension 

plans, combined with the deferral of income to 
55 

the employee until benefits are paid, effectively 

exempts the investment earnings on the contribution from tax. As a consequence, under current 

law pension fund investment earnings from investments in corporate stock bear only one level of 

tax-the corporate tax paid by the corporation. 

Investment earnings on pension fund investments 

in corporate debt, however, bear no tax at all 

under current law, because corporate income used 

to pay interest is not taxed at the corporate level.53Under CBIT, however, investment earnings 

from both CBIT debt and equity will be taxed at 

the payor level, with the consequencethat pension 

plans will earn an after-tax return on such investments. The introduction of CBIT thus eliminates 

the deferral of tax on inside buildup. 

The position of pension plan trusts under 

current law could be replicated in CBIT only by 

refunding the CBIT entity level tax on interest 

paid to pension trusts. This step would eliminate 

the need to revise pension tax rules, but would 

undermine CBIT’s fundamental goals of treating 

debt and equity alike and collecting a uniform tax 

on business capital income regardless of the 

identity of the investor. 

To equate the treatment of CBIT debt and 

equity investments by pension funds, we recommend requiring pension trusts to maintain separate 

accounts for CBIT income and other amounts, 

e.g., contributions and nonCBIT income,54 to 

treat all distributions made each year as made 

proportionately from the income of each account, 

and to notify pension payees of the amount from 

each account included in their pension payments. 

Payees would be entitled to exclude from income 

pension distributions from the CBIT income 

account, thereby reducing the tax burden on corporate equity investments relative to current law. 

Because pension trusts will enjoy no inside 

build-up advantage over other investors with 

respect to the CBIT assets they hold, CBIT might 

induce such trusts to alter their portfolio mix 

toward nonCBIT assets. The degree to which this 

occurs depends on the relationship of CBIT to 

nonCBIT yields and the portfolio and diversification advantages of particular investments. 

Prototypes 

If a compensatory tax were not adopted, 

pension funds would add only excludable CBIT 

income to the CBIT income account. In general, 

taxing distributed preference income at the investor level, rather than imposing a compensatory 

tax, would lessen the extent to which adoption of 

CBIT removes the tax-free inside build-up on 

CBIT investments. 

Subchapter C Recognition and Reorganization Rules 

As in the dividend exclusion prototype, the 

CBIT prototype retains the basic rules of Subchapter C governing the treatment of taxable and 

tax-free corporate asset and stock acquisitions. 

CBIT entity gain on asset sales would be taxable 

to the CBIT entity and payment of tax on the 

gains would give rise to additions to the EDA, 

thereby permitting distribution of the after tax 

proceeds of such asset sales to investors without 

further tax. As in the dividend exclusion prototype, the Subchapter C reorganization rules would 

be retained, and no special limitations analogous 

to IRC $0 382 and 383 would apply to the EDA. 

See Section 2.F. As in the dividend exclusion 

prototype, EDAs would be combined in acquisitive reorganizations and allocated in divisive 

transactions. Liquidations would generally be 

treated as in the dividend exclusion prototype. A 

liquidating entity’s EDA would generally be 

allocated among equity holders in proportion to 

the amount of other assets distributed to them, 

and any gain would be excludable to the extent of 

the allocable EDA.” 

In CBIT, however, partnerships are treated as 

CBIT entities. Imposing Subchapter C structural 

rules on partnerships would change current law 

significantly by eliminating the partnership rules 

found in IRC $0 731-732 which permit tax-free 

distribution of partnership property to partners.56 

While the CBIT prototype contemplates that the 

existing Subchapter C recognition rules for distributions ultimately should be applied to all CBIT 

entities, policymakers concerned about the 

implications of such a rule on changes in the 

organization form of smaller CBIT enterprises 

could create carryover basis exceptions to the 
Prototypes 56 

Subchapter C recognition rules for smaller CBIT 

entities.57 

Capital Gains, Dividend Reinvestment 

Plans, and Share Repurchases 

If a compensatory tax were adopted, a full 

exemption of investor level gains and losses on 

equity and debt could be viewed as consistent with 

CBIT’s exemption of investor level tax on dividends and interest. However, the fundamental 

problem of capital gains taxation in CBIT is 

similar to that encountered in other integration 

prototypes and either resolution (to tax or to 

exempt capital gains) will be controversial. See 

Chapter 8. If capital gains are taxed under CBIT, 

corporations might implement a dividend-reinvestment plan (see Chapter 9) to reduce the incidence 

of double taxation on retained earnings. The 

appropriate treatment of share repurchases under 

CBIT also depends on treatment of capital gains. 

See Section 8.E. 

4.H CONDUITS 

Treatment of Conduits under CBIT 

Current law exempts certain organizations 

from entity level tax. These entities function as 

tax conduits; they either are granted complete 

passthrough status or are taxed only on their 

undistributed income. Partnerships generally are 

granted passthrough status if they meet certain 

classification tests that distinguish them from 

corporation^.^^ Certain publicly traded partnerships are always treated as corporation^.^^ Regulated investment companies (RICs) are taxable 

corporations but are allowed a deduction for 

dividends paid out of both ordinary income and 

capital gains.6oA typical RIC is a mutual fund 

that makes diversified investments for its shareholders. Real estate investment trusts (REITs) are 

taxed similarly to RICs but are restricted to 

investing predominately in real estate.61 Real 

estate mortgage investment conduits (REMICs) 

are entities that hold fmed pools of mortgages and 

have both regular interests, providing for fixed, 

unconditional payments and taxed as debt, and a 

single class of residual interests, taxed essentially 

like equity interests in a partnership.62Holders 

of REMIC residual interests are taxed on their pro 

rata share of the REMIC’s net income. 

A cooperative, generally, is an organization 

that transacts business with and for its patrons 

(owners). Some cooperatives enjoy a limited 

exemption from tax.’ Subchapter T cooperatives 

are treated as corporations under current law but 

are allowed a special deduction for patronage 

dividends and per unit returns allocated to patrons 

based on business activity. While this results in 

effective conduit treatment of patronage distributions and allocations, other earnings of a cooperative are subjected to corporate taxation.63Typical 

cooperatives include farmers’ cooperatives that 

purchase farmers’ crops, sell them, and remit the 

proceeds to the farmers or purchase feed and seed 

for resale to farmers. Other cooperatives include 

grocery, hardware, drug, book, and clothing 

stores that operate on a cooperative basis. 

Conduits that are not taxable entities under 

current law could continue as such under CBIT or 

could be treated as CBIT entities. To the extent 

that a conduit holds only CBIT equity or debt, its 

status as a conduit is irrelevant. A RIC, for 

example, that holds only CBIT bonds would pay 

no entity level tax even if it were treated as a 

CBIT entity, because all of its interest income and 

capital gains would be exempt from tax. Any 

dividends paid to shareholders also would be 

exempt from tax. Conduit status would be equally 

irrelevant, whether CBIT included a compensatory 

tax or instead imposed tax at the investor level on 

distributions out of preference income. See 

Section 4.D. 

Thus, the treatment of nonCBIT income 

earned by conduits is the principal issue in deciding whether conduits should retain their passthrough status. One of the principal purposes for 

conduit status under current law is to provide 

relief from the double tax applicable to corporations. Because CBIT subjects corporate income 

only to a single level of tax, CBIT might replace 

the need for conduits. In addition, retaining 

conduit status for some entities would provide a 
57 

means for avoiding the CBIT regime. Conduit 

status permits income to be taxed at shareholders’ 

rates (which, for tax-exempt shareholders, may be 

zero), rather than at the CBIT rate. Thus, there 

would be an incentive to have nonCBIT assets 

held through a conduit rather than through a CBIT 

entity. 

Partnerships 

The CBIT prototype treats partnerships as 

CBIT entities in order to avoid perpetuating the 

bias against doing business in the corporate form. 

Exempting partnerships from CBIT would create 

incentives for investors to choose the partnership 

form whenever the tax benefits of passthrough 

treatment outweighed the business costs of operating in partnership rather than corporate form. 

Examde. A group of investors (including some 

tax-exempt organizations) is considering undertaking a business venture. The investors decide to 

conduct business through a partnership rather than 

a CBIT entity so business income will be taxed at 

the investors’ rates rather than at the CBIT rate. 

By removing taxes from the determinants of 

organizational form, CBIT enhances neutrality. 

In general, under CBIT, partnerships that do 

not qualify for the small business exception 

described in Section 4.C would be taxed like 

other CBIT entities. Thus, a partnership would be 

subject to entity level tax each year on its earnings (computed under the normal corporate tax 

rules but without a deduction for interest), but 

would not allocate earnings to equity holders. 

Like other CBIT entities, a partnership would 

maintain an EDA and would track actual distributions (rather than allocations of income) to partners and interest payments on debt. Distributions 

and payments in excess of the EDA would be 

subject to compensatory tax (or investor level 

tax)? 

Subjecting partnerships to CBIT may treat 

certain types of partnership income less favorably 

than under current law. For example, partnership 

income would be subject to tax at the CBIT rate, 

rather than at the partners’ individual rates. 

Prototypes 

Partnership losses, preference income, and foreign 

tax credits would no longer pass through to 

partners. Distributed preference income and 

sheltered foreign source income would be subject 

to compensatory tax (or investor level tax). If 

these results are undesirable, policymakers may 

wish to expand the class of partnerships that are 

exempt from CBIT beyond the small business 

exception discussed in Section 4.C. However, the 

advantages of doing so should be weighed against 

the costs of retaining tax incentives favoring 

noncorpomte forms of organization. 

RICs, REITs, and REMICs 

The analysis for these special purpose passthrough entities may be somewhat different, 

however. There is an argument that they should 

retain conduit status because they serve an important function as pooled investment vehicles for 

small investors. To the extent that individuals and 

tax-exempt organizations could purchase and hold 

nonCBIT investments, e.g., home mortgages, 

Treasury securities, and tax-exempt bonds, directly, they should be permitted to do so indirectly 

through a RIC or REIT. 

Examde. A CBIT corporation would like to issue 

new shares in order to purchase a new building. 

Corporate earnings used to pay dividends on those 

shares would, however, bear tax at the CBIT rate. 

The corporation decides instead to lease its new 

building from a REIT, which issues shares to fund 

the purchase. As a consequence, the corporation 

can deduct the payments of rent, and dividends 

paid by the REIT are taxed at shareholder rates. 

While the preceding example might be viewed 

as avoidance of CBIT, the incentives to engage in 

this form of transaction under current law are as 

strong as they would.be under CBIT. In addition, 

given a decision to simplify CBIT by making it a 

31 percent tax on all capital income, it might be 

considered worthwhile to maintain investment 

opportunities for low-bracket investors that will 

bear tax at the investor’s tax rate rather than the 

CBIT rate.65 Maintaining conduit status for 

RICs, REITs, and REMICs will require the 

expansion of IRC 6 265(a)(3) to deny such conduits the ability to deduct expenditures related to 

the purchase or carrying of CBIT assets. With this 
Prototypes 58 

modification, however, it should be possible to 

retain current rules for such entities. This approach will make enforcement of the leasing 

standards discussed under "Identifying Disguised 

Interest" in Section 4.G particularly important in 

maintaining the CBIT base. 

Given the decision to treat partnerships generally as CBIT entities, it may be appropriate to 

make changes in the REIT qualification rules to 

allow entities with fewer than 100 shareholders 

and state law partnerships to qualify as REITs for 

tax purposes. This would avoid conferring an 

advantage on large, corporate REITs in real estate 

investing. Similar relaxation of the RIC qualification rules might be considered. 

Cooperatives 

We believe the limited conduit status granted 

to Subchapter T cooperatives would continue to 

be the appropriate model for cooperatives under 

CBIT. Cooperatives would thus be CBIT entities 

but could deduct patronage dividends.66As under 

current law, patronage dividends would generally 

be includable in the patron's income. 

4.1 FINANCIAL 

INTERMEDIARIES 

UNDER CBIT 

Financial intermediaries include depository 

institutions, insurance companies, investment 

banks, and other financial services entities. 

Although the specific services provided by these 

institutionsvary, financialintermediaries generally 

solicit funds from investors, depositors, and other 

lenders and use these funds to make loans or to 

acquire the debt and equity issues of other companies. Thus, financial intermediaries earn most of 

their income in the form of dividends and interest 

and tend to have substantial noninterest expense 

that is incurred to produce net interest and dividend income and gains on securities. 

The following analysis suggests the basic 

outlines of the taxation of financial intermediaries 

under CBIT, although furtherconsideration should 

be given to these issues during the period CBIT is 

under discu~sion.~' 

Financial Institutions Generally 

CBIT would exempt from tax much of the 

income received by financial institutions because 

it is received in the form of dividends and interest 

from CBIT entities. In addition, if financial 

institutions were treated as CBIT entities, their 

interest expense would no longer be deductible. 

This raises the question of how other operating 

expenses of financial.institutions should be treated. We have generally recommended that IRC $ 

265(a)(l) and (2), which operate to disallow 

deductions and interest allocable to tax-exempt 

income, be extended to cover investment in equity 

and debt of CBIT entities. Given the large portion 

of financial institution income that can be expected to come from CBIT investments as well as 

from tax-exempt State and local government 

bonds, this general rule would operate to disallow 

a significant portion of their operating expenses if 

deductions for such expenses were not allowed. 

This effect is likely to be less significant for 

direct lenders such as banks and finance companies because they would no doubt begin to charge 

fees (rather than interest) to cover the costs of 

making a loan (as contrasted with the institution's 

cost of funds). Indeed, provisions requiring the 

borrower to pay the lender's transaction costs 

such as attorney's fees, filing fees, survey and 

appraisal expenses, inspection costs and similar 

items are already a common feature of negotiated 

loan transactions. The advantage of converting 

interest income into fee income would be that a 

CBIT borrower could deduct fees but not interest. 

Although the fee income will be includable in the 

income of the CBIT lender, the lender will be 

permitted to deduct operating expenses against 

such income without disallowance under expanded 

IRC 5 265. Thus, recharacterizing interest income 

as fees may permit better matching of a financial 

institution's income and expenses. This strategy, 

however, is likely to be less successful with 

respect to publicly traded instruments of CBIT 

entities, where the intermediary, in many 
59 

instances, will be unable to negotiate borrower fee 

payments to cover its operating expenses. Given 

the prevalence of commissions and fees in the 

compensationpaid to investment banks and securities trading entities, however, it may be that 

market adjustments in these amounts would solve 

the problem for these entities. 

For revised IRC Q 265(a) rules to function as 

described in this section, mechanical provisions 

which match operating expenses with related fee, 

commission, and reimbursement income will be 

necessary. In particular, a proportional allocation 

rule such as that found in current IRC 0 265(b) 

would produce inappropriate results if CBIT 

income were included in the fraction. Instead, 

financial institutions should be allowed to allocate 

operating expenses fully to offset fee income. To 

the extent that fee income is insufficient to cover 

operating expenses, the residual expenses would 

be allocated between CBIT and nonCBIT income 

under the pro rata rule of IRC Q 265(b) and the 

portion allocable to CBIT income could be 

disallowed under IRC Q 265(a). 

Alternatively, financial institutions could be 

exempted from the disallowance rule of expanded 

IRC Q 265(a) with respect to their operating 

expenses.68 This approach would increase the 

incentive for such institutions to generate sufficient nonCBIT income (through investments in 

Treasuries, home mortgages, consumer debt, and 

leasing activities) to absorb fully the portion of 

their operating expenses in excess of their fee 

income. Our analysis indicates that most financial 

institutions currently hold enough nonCBIT debt 

to achieve this result; accordingly, the impact of 

such an approach on actual investment patterns is 

likely to be minimal. However, there is no relationship between the nonCBIT income and the 

expenses related to CBIT investments; hence, the 

allowance of a full offset may reduce other income, rather than matching nonCBIT income.69 

Savings and Loan Associations 

Savings and loan associations (S&Ls) must 

invest heavily in home mortgages to maintain 

their qualification for special tax rules. Assuming 

Prototypes 

these requirements were maintained under CBIT, 

S&Ls would receive primarily taxable income but 

receive no deduction for interest paid to depositors. There should be a significant spread, however, between the interest rates paid on home mortgages (because recipients will pay tax on such 

interest) and the interest rates paid to depositors 

(because the depositor will not be subject to tax 

on interest received from the S&L as a CBIT 

entity). This spread may be sufficient to allow 

S&Ls to satisfy their CBIT liabilities, and, if so, 

no special rules will be needed. Again, a gradual 

transition to CBIT would allow policymakers to 

study the observed impact of CBIT before finally 

resolving structural decisions. Because the need 

for a special rule for S&Ls is not clear, the CBIT 

prototype does not include such a rule. 

If experience proves that the rate differential 

between interest on home mortgages and interest 

on CBIT deposits is insufficient to allow S&Ls to 

operate successfully, consideration could be given 

to allowing S&Ls to'issue certificates of deposit 

that would bear taxable interest to the recipient 

and deductible interest to the S&L. Even such a 

limited provision would undermine somewhat the 

tax parity between debt and equity achieved by 

CBIT, however, and should be adopted only if it 

proves necessary.7o 

Insurance Companies 

Under the CBIT prototype, insurance companies would be CBIT entities.71Like other CBIT 

entities, they would not be allowed a deduction 

for interest paid, but distributions to shareholders 

and creditors would not be taxed to the recipient~.~~ Under CBIT, IRC Q 809 (which Congress 

intended to equalize the treatment of stock and 

mutual companies' equity returns) would be 

repealed, since equity returns from both stock and 

mutual companies would be exempt to the recipient under CBIT. In both types of companies, 

payment of tax on earnings from surplus would 

give rise to an EDA permitting distributions free 

of hrther tax to investors. Distributions in excess 

of the EDA would trigger the compensatory tax 

or an investor level tax, but would preserve the 

equal treatment of investors. 
Prototypes 60 

CBIT will, however, require an adjustment in 

the deduction permitted insurance companies for 

annual additions to reserves. Under current law, 

tax reserves are calculated on a discounted basis. 

Accordingly, the deduction for reserve additions 

each year consists of two components: (1) the 

discounted present value of amounts required to 

fund future casualty and benefit payments plus (2) 

the expected return for the year on reserve funds. 

This system permits companies to claim deductions currently rather than deducting the entire 

loss or claim when paid. The difference between 

the present value of such losses or claims and the 

full (or nominal) value of such payments is deducted each year as expected return until the loss 

or claim is actually paid. The rate used to compute expected return under current law is based 

on the applicable Federal rate (AFR),which 

reflects a taxable rate of return. 

Under CBIT, reserves would be calculated 

with a blended market interest rate, which would 

be a prorated average of a taxable nonCBIT rate 

and a non-taxable CBIT rate, according to the 

mixture of assets held by each insurance company. To the extent that reserve assets are invested 

in CBIT securities, no deduction to shield expected return on CBIT entity dividends and interest 

received by an insurance company would be 

appropriate because such amounts would not be 

included in its income and would increase the 

insurance company’s EDA. Accordingly, insurance companies would be required to maintain 

CBIT and nonCBIT income accounts similar to 

those of pension funds under CBIT. As with 

pension funds, insurance companies would be 

required to treat their expected return on reserves 

as arising pro rata from the CBIT and nonCBIT 

income accounts. An annual deduction for expected return would be permitted only to the extent 

attributable to nonCBIT income. As a result of 

this modification, insurance companies should 

neither obtain new benefits nor lose current law 

benefits with respect to their nonCBIT investments. While insurance companies would pay no 

tax on dividends and interest received from CBIT 

entities, they would enjoy no advantage over other 

investors in this respect. 

Theprototype’s preservation of reserve deductions to prevent entity level taxation of the inside 

build-up (the income earned on reserves held in 

nonCBIT assets) may be regarded as inconsistent 

with the neutrality principles underlying CBIT, 

since the prototype may lead insurance companies 

to prefer nonCBIT investments which benefit from 

this advantage. We believe, however, that a different rule is not necessary for CBIT to function 

effectively and would require reversal of longstanding policies underlying insurance taxation. 
PART 111: PRINCIPAL ISSUES 

INTRODUCTION 

Each of the systems of corporate integration 

considered in this Report would move the U.S. 

tax system in the direction of more neutral taxation of capital income and, in so doing, reduce 

current tax-induced distortions in the allocation of 

capital. All the systems of corporate integration 

would substitute a single level of tax for the 

existing two level classical corporate tax system. 

The CBIT prototype also would eliminate tax 

distortions in the choice between corporate and 

noncorporate forms of business organizations by 

taxing all business income uniformly, at entity 

level tax rates. 

Each of the systems of corporate tax integration is economically equivalent if income earned 

by corporations and individuals were taxed at the 

same tax rate, all income earned by corporations 

were treated the same, and all investors were 

taxed at the same tax rates.' But they are not.2 

The existence of differing tax rates among individuals and between corporations and individuals, 

tax preferences for a variety of kinds of income 

and deductions, domestic tax-exempt and foreign 

suppliers of capital, and foreign source income 

earned by U.S. corporations create significant 

differences among basic systems of integration. 

These circumstances also raise fundamental 

structural issues that must be addressed within the 

context of each of the integration systems. How 

these issues are resolved in an integrated corporate tax system significantly affects the choices 

among the basic integration alternatives and, 

ultimately, the efficacy of the method chosen in 

reducing or eliminating the distortions associated 

with the classical corporate tax system. 

Transition rules also must be addressed in any 

integrationproposal. The speed and administrative 

ease with which integration can be implemented, 

the degree of distortion experienced during the 

transition period, and the revenue impact of 

different rules may affect the feasibility and the 

desirability of different integration prototypes. 

These issues raise important and controversial 

issues of tax policy apart from their effects in 

structuring an integrated corporate tax system. 

Current law reflects compromises among goals of 

economic efficiency, equity in taxation, and other 

political, social, or economic policy goals (including furthering, for example, specific categories of 

investment) as well as the coordination of taxation 

across international borders. 

The appropriate connection between such 

policy considerations and the construction of an 

integrated corporate tax system is further complicated because the Internal Revenue Code to date 

has addressed questions concerning tax preferences, tax-exempt suppliers of corporate capital,

international considerations, and tax rates only in 

the context of a classical corporate tax system, not 

within the structure .of an integrated system. 

Indeed, in some cases, provisions of current law 

have been enacted, at least in part, to redress the 

burdens of the classical corporate tax. Therefore, 

the treatment of these specific issues under current 

law may or may not be the appropriatebenchmark 

for resolving the issue under an integrated system. 

On the one hand, current law tax rules have had 

a major impact on economic decisions and have 

shaped a wide variety of existing financial arrangements; care must be exercised so unwarranted disruptions do not occur in moving to an 

integrated corporate tax system. On the other 

hand, the resolution of these issues may have 

considerable influence on the degree of success of 

an integrated corporate tax system in removing 

the distortions of the existing system. Our task, 

therefore, has been to approach these issues in a 

manner that advances this Report's fundamental 

61 
Principal Issues 62 

objective-more neutral taxation of capital in- Although this part discusses these issues as 

come-where practical, without demanding that a discrete topics, they are often interrelated. For 

move from a classical to an integrated corporate example, decisions regarding the use of tax 

tax system be accompanied by a comprehensive preferences may affect decisions concerning the 

reevaluation of such fundamental issues as the treatment of tax-exempt shareholders, and decitreatment of tax preferences or international sions concerning tax-exempt shareholders may 

business transactions. influence policies regarding foreign investors. 
CHAPTER 5: TR.EATMENT OF TAX PREFERENCES 

Under current law, the Code provides favorable treatment that is generally recognized as 

deviating from standard accounting rules for 

particular items of income or expense.' These tax 

preferences may take the form of exclusions of 

income or preferential rates for items of income, 

accelerated deductions or deferred income recognition rules or credits. Some preferences (like the 

exclusion for interest on certain state and local 

bonds) create a permanent reduction of tax liability. However, most corporate preferences (like 

accelerated depreciation) offer deferral of tax, 

rather than outright exemption. 

Under current law, there are two mechanisms 

for restricting the use of business tax preferences: 

the earnings and profits rules and the corporate 

and individual minimum tax provisions. The 

earnings and profits rules define the pool of 

corporate earnings that is taxable as dividends 

(rather than as a return of basis or as capital gain) 

when distributed to shareholders. Earnings and 

profits are calculated to include most corporate 

tax preferences. Thus, income that is tax-preferred at the corporate level is generally subject to 

tax when it is distributed to noncorporate shareholders.2 Thus, under current law, tax preferences may provide corporations with retainable, but 

not necessarily distributable, tax-preferred funds. 

A strengthened minimum tax for both individuals and corporations was a central feature of the 

Tax Reform Act of 1986. Under current law, the 

alternative minimum tax (AMT) is payable only if 

the computation of the minimum tax produces a 

tax greater than the tax due under the regular 

computation. For individuals, the AMT is imposed at a 24 percent rate on an expanded tax 

base that includes most tax preference items. In 

the case of corporations, the AMT is imposed at 

a 20 percent rate on a tax base that includes a 

broad list of tax preference items. The corporate 

minimum tax serves to limit the capacity of tax 

preferences to reduce tax on retained, as well as 

distributed, earnings. 

The expanded tax bases for the AMT and the 

relatively narrow rate differentials between the 

regular and minimum' taxes make the minimum 

tax provisions of current law a powerful revenue 

source with widespread impact on the tax planning of both high-income individuals and corporations. If the corporate AMT were repealed, a 

significantincrease in the corporate tax rate would 

be required to offset the revenue loss. The minimum tax provisions not only raise revenue directly but also serve to increase the regular income 

tax paid by individual and corporate taxpayers 

who limit their use of preferences to avoid being 

subject to the AMT. 

In integrating the corporate and shareholder 

income tax systems, the fundamental question 

about tax preferences is the continuing role of 

limitations on corporate tax preferences. Some 

commentators have suggested that integration 

implies giving to shareholders tax reductions due 

to corporate level tax preference^.^ They argue 

that if integration is' to achieve tax neutrality 

between corporate and noncorporate investments, 

extending preferences to shareholders is appropriate. The cost of not extending to shareholders 

preferences that are available to noncorporate 

businesses is retaining a bias against the corporate 

form for any activities that are granted tax preferences. Such activities will tend to be performed 

by noncorporate fms. As discussed in Chapter 1, 

an economic loss results to the extent that such 

activities could be carried on by corporations at 

lower 

With respect to deferral preferences, such as 

those permitting rapid depreciation or amortization of capital expenditures, some analysts regard 

distribution of the related income to shareholders 

as the appropriate occasion for ending tax deferral 

and view the earnings and profits provisions of 

current law as approprjately serving that function. 

Retaining the approach of current law and taxing 

preferences when distributed to shareholders 

would continue some disadvantages for 

63 
Principal Issues 64 

distributed, as opposed to retained, earnings, but 

this could be mitigated by treating distributions as 

coming first from fully-taxed income. Where 

corporate tax preferences are intended to alleviate 

the classical system's double taxation of equity 

income, they serve no function in an integrated 

systeni and, at a minimum, should not be passed 

through to shareholders. Some analysts, for 

example, consider the reduced rate on the first 

$100,000 of corporate income as a tax preference 

intended to reduce the degree of double taxation 

for small corporations that decline to elect (or are 

ineligible for) S corporation status. 

In addition, there are substantial revenue costs 

to extending corporate level preferences to shareholders just as there are in cutting back on the 

AMTe5The revenue cost of extending preferences to shareholders or limiting the impact of the 

AMT would increase the cost of corporate integration, require higher tax rates to produce equivalent revenues, and, in effect, increase the value 

of tax preferences relative to taxable income. 

Maintaining current law restrictions on tax preferences would reduce the need to raise tax rates and 

thus reduce the efficiency costs associated with 

such rate increases.6 Hence, the issue of the 

proper treatment of preferences involves a comparison of these possible costs with the benefits 

provided by the preferences in an integrated 

world. 

Finally, if a goal of integration is to tax 

corporate income once, corporate tax preferences 

should not be extended to shareholders. In an 

integrated system, extending preferences to shareholders may eliminate both the individual level 

and the corporate level tax. Foreign systems 

generally do not allow corporate preference 

income to be distributed tax-free to shareholders. 

Belgium, Canada, Denmark, and Japan are 

exceptions. 

Integration of the corporate and individual tax 

systems provides an opportunity to review both 

corporate and noncorporate tax preferences to 

determine whether they are justifiable in an 

integrated system, but such a comprehensive 

review of tax preferences is beyond the scope of 

this Report. This Report concludes, however, 

that, where practical, integration of the corporate 

tax should not become an occasion for expanding 

the scope of tax preferences. Neither equity nor 

economic efficiency would be enhanced by such 

an expansion. 

In practice, this conclusion implies that in a 

distribution-related integration prototype, specific 

mechanisms must be devised to play a role similar 

to the earnings and profits provisions of current 

law to ensure that preferences are not extended to 

shareholders. Similarly, the role and function of 

both the corporate and individual AMT must be 

reexamined to prevent the extension of the scope 

of current tax preferences. 

A simple dividend exclusion or shareholder 

imputation credit method of distribution-related 

integration will not produce the desired result with 

respect to preference income.8 Integrated tax 

systems outside the United States that do not 

extend corporate tax preferences to shareholders 

have principally relied on either or a combination 

of two mechanisms.' The first is an imposition of 

corporate level tax on the distribution of preferences through a compensatory tax system." The 

second is a tracing mechanism or overall limitation that restricts the amount of relief from tax at 

the shareholder level to actual corporate level 

taxes paid." The limitation mechanism eliminates the benefit of preferences on distributed 

income by imposing tax at the shareholder rate on 

distributed preference income. The two methods 

can vary significantly when the shareholder tax 

rate differs from the corporate tax rate, and 

would, for example, impose very different tax 

burdens on distributions of corporate preference 

income to tax-exempt shareholders.l2 

The choice between the two mechanisms is a 

close one and a different alternative may be more 

appropriate depending on the method of 
integration adopted. In the distribution-related 

integration prototypes described in this Report, we 

have recommended limiting tax relief at the 

shareholder level to the amount of corporate taxes 

paid and imposing shareholder level tax on 

distributed preferences. Under the dividend 

exclusion prototype, this is accomplished by 

requiring corporations to keep an account limiting 

65 Principal Issues 

excludable dividend^.'^ In CBIT, this mechanism 

also is possible; on the other hand, since alltax is 

paid at the entity level, a compensatory tax may 

have more a~pea1.l~We conclude that it is not 

practical to attempt to retain the current law tax 

on distributed preference income under the shareholder allocation prototype. '' 
CHAPTER 6: TAX-EXEMPT AND TAX-FAVOREDINVESTORS 

6.A INTRODUCTION 

Current law defines many different types of 

tax-exempt entities (including pension funds, 

charities, hospitals, educational institutions and 

business leagues) and imposes various conditions 

in order for them to obtain or retain their taxexempt status (including nondiscrimination rules, 

minimum payout requirements, limitations on 

maximum contributions and restrictions on investments). Tax exemption is generally limited to 

income received by the entity that is either passive 

in nature or substantially related to an exempt 

function. 

Tax-exempt entities may be grouped into two 

general categories. One group, which includes 

pension funds, 401(k) plans, and similar plans 

(collectively, pension funds), is characterized by 

an exempt entity that holds claims to property on 

behalf of specific individuals, with the earnings of 

the fund untaxed as earned but taxed when distributed to the individuals. The second group, which 

includes charities, hospitals, educational and 

religious institutions, is characterized by investment income that does not inure to the benefit of 

any particular individuals. 

Tax exemption provides both groups with a 

higher after-tax rate of retum on investment 

income than if the earnings were currently taxable. Retirees receive higher after-tax retirement 

income than if pension fund earnings were taxed 

currently or they had invested in taxable savings 

plans themselves, and charities and educational 

institutions can provide more services or activities 

than if the income on their assets were taxable. 

Despite the differences in the mechanics of taxing 

pension funds and other exempt entities, the 

present value benefit is the same. The pension 

fund tax exemption, employer deductibility of 

contributions to the fund and deferral of employee 

tax is equivalent to simply exempting from income tax the pension fund’s investment income.’ 

The Code exempts these entities from income 

tax on all receipts other than net income from a 

business unrelated to the entity’s exempt purpose. 

Such unrelated income, whether earned directly or 

through a partnership, is subject to the unrelated 

business income tax (UBIT), which generally is 

calculated under the regular corporate income tax 

rules.3 The tax generally applies only if the 

business income is unrelated to the organization’s 

exempt purpose. Thus, engaging in a particular 

activity might result in the imposition of UBIT on 

one type of exempt organization but not on another. The Federal Government and State and local 

governments or their instrumentalities (except 

colleges and universities) are exempt from all tax 

including UBIT. The Code explicitly excludes 

income from certain passive investments from 

UBIT, including dividends, interest, rent from 

real property, royalties, and gains from the sale of 

capital assets. Despite the general exclusion, 

passive income generally is subject to UBIT to the 

extent that it is fmanced with debt. 

The tax-exempt sector plays a major role in 

U.S. capital markets, and in the corporate capital 

market in particular. At the end of 1990, pension 

funds and other exempt organizations held over 

one-quarter of total financial assets in the United 

States (Table 6.1). Holdings of the tax-exempt 

sector represented even larger fractions of corporate equity and corporate debt-approximately 37 

percent of directly held corporate equity and 46 

percent of outstanding corporate debt. 

Pension funds dominate tax-exempt sector 

corporate investments, holding more than onequarter of all directly held corporate stock and 

more than two-fifths of corporate bonds. Figure 

6.1 illustrates the dramatic growth in the share of 

corporate debt and equity held by pension funds 

since the 1950s. As the share of corporate capital 

held by pension funds has grown, an increasing 

share of the associated corporate income has 

avoided the investor level tax. 

67 
~ 

Principal Issues 68 

Table 6.1 

Financial Assets of the Tax-Exempt Sector 

End of Year 1990 

Total Credit Mar- Corporate Equity Corporate Debl? 

ket Assets' 

(billions (billions (billions 

of dollars)(percent) of dollars) (percent) of dollars)(percent) 

Foreigners 1,636 12 218 6 203 12 

Pension Funds3 2,695 19 967 28 722 44 

IRAs & Keoghs4 560 4 141 4 11 1 

Nonprofit Institutions' 515 4 130 4 10 1 

Total Tax-Exempt Sector 5,450 39 1,457 43 946 58 

Total All Sectors 13,996 100 3,416 100 1,629 100 ~~ 

Department of the Treasury 

Office of Tax Policy 

'Total Credit Market Assets: total credit market debt owed by domestic nonfinancial 

sectors plus corporateequities (excluding mutual funds). 

zCorporate Debt includes some foreign bonds. The total amount includes bonds held 

by the financial sector. 

3Pension Funds include private pension funds (including Federal Employees 

Retirement Thrift Savings Fund), state and local government employee retirement 

funds, and pension fund reserves held by life insurance companies. 

41ndividualRetirement Accounts @As) and Keogh accounts: figures estimated. 

'Nonprofit institutions include charitable, educational, and similar institutions. 

Estimated as percent of household holdings in Flow of Funds. 

Sources: Federal Reserve Board, Flow of Funds (March 1991 revised); Investment 

Company Institute, Mutual Fund Fact Book (1991),p. 60;and Office of Tax Policy 

calculations. 

Fi re 6.1 

Pension Fund Holdings oPCorporate Capital, 1950-1990 

i!"1 3 Corporatebonds

/ 

/ carp. debt + equity , ' ' 

/---

/

/, corporateequity 

_I 

I. / 

/

,'-

//' 

/- __---

Under current law, taxexempt investors, in fact, 

are not exempt from the 

corporate level tax on 

income from their corporate 

equity investments. 

Although dividends paid to 

tax-exempt shareholders are 

not taxed to the recipients, 

the earnings attributable to 

such investors are taxed at 

the corporate level whether 

or not distributed. By contrast, corporate earnings 

paid to tax-exempt investors 

as interest escape both the 

corporate level tax and the 

investor level tax. 

The fundamental question addressed here is 

whether under an integrated 

tax system this treatment of 

corporate income of taxexempt investors should 

continue, or, alternatively, 

whether tax-exempt investors should be subject to a 

tax increase or receive a tax 

reduction from integration. 

The current level of taxation of corporate equity 

income received by taxexempt investors can be 

retained under integration 

as demonstrated in this 

Report. Integration does not 

necessarily require either an 

increase or a reduction in 

tax on income from capital 

supplied by tax-exempt 

entities to corporations. 

On the other hand, 

corporate integration presents an opportunity to 

reexamine the incentives 

under current law for taxexempt investors to prefer 
69 

debt rather than equity investments in corporations. The specific question raised by corporate 

integration is whether the current distinction in the 

treatment of corporate equity investments by taxexempt entities (which bear the corporate, but not 

the shareholder level tax) versus corporate debt 

investments (which bear neither corporate nor 

debtholder level tax) should be retained or decreased. An integration system best fulfiis its 

goals if it provides uniform treatment of debt and 

equity investments by tax-exempt investors. 

Equating the tax treatment of debt and equity will 

require either an increase or decrease in the taxes 

on corporate capital supplied by tax-exempt 

investors or the introduction of a separate tax on 

investment income of these investors. As Section 6.D discusses, such a tax could be designed 

to maintain the current level of tax on income 

from corporate capital supplied by tax-exempt 

investors while equalizing the treatment of debt 

and equity. 

6.B DISTORTIONS UNDER 

CURRENT LAW 

Current law encourages tax-exempt investors, 

like taxable investors, to invest in debt rather than 

equity. Only two types of income from capital 

supplied to corporations by tax-exempt entities are 

actually tax-exempt. Interest paid by corporations 

is both deductible by the corporate payor and 

exempt from tax in the hands of the tax-exempt 

recipient. Corporate preference income distributed 

to tax-exempt shareholders also is exempt from 

tax at both the corporate and the shareholder 

level.4 Non-preference income is taxed at the 

corporate level, but is not taxed at the shareholder 

level whether it is received by the exempt investor 

as capital gains from the sale of shares or as 

dividends from distributions. Thus, under current 

law, corporate income paid to tax-exempt investors in the form of interest is not taxed at either 

the corporate or investor level, while non-preference income retained or distributed to tax-exempt 

shareholders is subject to tax at the corporate 

level. 

Current law does not, however, encourage 

tax-exempt investors to invest in equity of 

Principal Issues 

noncorporate rather than corporate businesses, because, in both cases, the income is subject to one 

level of tax. While corporate income (other than 

preference income) allocable to tax-exempt shareholders is subject to tax at the corporate level, the 

noncorporate unrelated business income of taxexempt investors generally is subject to UBIT.’ 

For tax-exempt investors who invest in equity, 

current law generally also does not affect their 

preferences for distributed or retained earnings. 

Because corporate income (other than preference 

income) is subject to current corporate level tax 

and both distributed and retained earnings are 

exempt from tax at the shareholder level, a taxexempt shareholder has no tax incentive to prefer 

distributed earnings over retained earnings. 

6.C NEUTRALITY UNDER AN 

INTEGRATED TAX SYSTEM 

Because of the asymmetric treatment of debt 

and equity investments by tax-exempt entities 

under current law, an integrated system can 

achieve neutrality between debt and equity investments for tax-exempt investors only by either 

decreasing the tax burden on equity income or 

increasing the tax burden on interest. A straightforward decrease in the tax burden on equity 

investments might be accomplished by removing 

the corporate level tax on earnings distributed as 

dividends to tax-exempt investors. A deduction 

for corporate dividends, for example, would 

achieve this result. The contrary approach might 

subject interest income on corporate debt earned 

by tax-exempt investors to one level of tax (at 

either the corporate or the investor level). 

The first approach, taxing neither dividends 

nor interest paid to tax-exempt investors, would 

lose substantial amounts of tax revenue relative to 

current law. Extending the benefits of integration 

to tax-exempt investors would add costs of approximately $29 billion annually under distribution-related integration and approximately $42 

billion annually under shareholder allocation. This 

revenue loss would increase the costs of integration and would require offsetting increases in 

other taxes or in tax rates, which might create or 

increase other distortions. This approach also 
Principal Issues 70 

would distort the choice between corporate and 

noncorporate investment for tax-exempt investors 

if UBIT remained in place for noncorporate 

investment. If corporate dividends were taxexempt at both the corporate and investor level, 

while earnings from businesses conducted directly 

or in partnership form were subject to UBIT, a 

tax-exempt investor would always prefer corporate dividends. Indeed, anti-abuse rules might be 

required to preclude tax-exempt organizations 

from avoiding UBIT altogether simply by incorporating their unrelated businesses. 

The second approach, taxing both interest and 

dividends at a single rate, would reduce the 

current advantage of tax-exempt investors relative 

to taxable investors. Tax-exempt investors would 

no longer enjoy an after-tax return on a given 

corporate equity or debt investment higher than 

that available to taxable investors. The principal 

advantage of this approach is that it would equate 

the treatment of debt and equity while maintaining 

the neutrality between corporate and noncorporate 

equity for tax-exempt investors.6 

6.D GENERAL 

RECOMMENDATIONS 

This Report recommends that a level of 

taxation at least equal to the current taxation of 

corporate equity income allocated to investments 

by the tax-exempt sector be retained under integration. The dividend exclusion prototype, described in Chapter 2, essentially continues present 

law treatment of tax-exempt investors under an 

integrated tax system, so fully-taxed corporate 

profits would continue to bear one level of tax 

and preference income would not be taxed at 

either the corporate or shareholder level.’ A 

similar result can be accomplished under an 

imputation credit system of integration, but a 

dividend deduction system would eliminate the 

current corporate level tax on distributed earnings 

on equity capital supplied by tax-exempt investors.* Under the shareholder allocation prototype 

described in Chapter 3, taxes are collected at the 

corporate level on corporate income allocable to 

investment by tax-exempt shareholders and no 

refund is provided to nontaxable shareholders. 

Maintaining one level of tax on equity investments by tax-exempt entities would promote one 

of the primary goals of integration: achieving tax 

neutrality for all investors between corporate and 

noncorporate investments. This choice is consistent with a move to integration for taxable shareholders, because choosing to reduce the double 

tax burden on corporate income distributed to 

taxable investors does not necessarily dictate a 

commensurate reduction in the tax burden on taxexempt investors. Finally, continuing to tax equity 

investments by the tax-exempt sector avoids the 

revenue loss that would result if such investments 

were completely tax-exempt. Increasing other tax 

rates to compensate for such a revenue loss would 

entail other inefficiencies. 

Some countries that have adopted integration 

have chosen to tax separately corporate and other 

income allocable to tax-exempt investors. For 

example, in moving to an integrated corporate 

tax, Australia and New Zealand imposed a tax on 

the income of pension funds, thus reducing the 

number of tax-exempt investors. In both countries, the remaining tax-exempt investor base, 

such as charities, is small. Australia imposed a 15 

percent tax on investment income earned by 

pension funds and made available the full 39 

percent imputation credit from dividends as a 

nonrefundable offset. Australia did not project 

collecting more than a token amount of tax from 

this tax on investment income: it devised the 

mechanism to remove distortions between investing in domestic corporations (which pay Australian tax) and investing in foreign corporations 

(which generally do not). The new Australian 

system also removes distortions between investing 

in equity and investing’indebt. New Zealand went 

further and repealed entirely the tax exemption of 

pension funds; they now function basically as 

taxable savings accounts. Under the U.K. distribution-related integration system, the corporate 

level tax is not completely eliminated, with the 

consequence that income distributed to tax-exempt 

shareholders bears some tax burden.’ 

This Report also encourages an effort to 

achieve uniform tax treatment of corporate debt 

and equity investments by tax-exempt investors. 
Because of the important role played by the taxexempt sector in the capital markets, failing to 

create neutrality for debt and equity investments 

by the tax-exempt sector would limit the extent to 

which integration could achieve tax neutrality 

between the two kinds of investments. This is 

achieved under CBIT by treating tax-exempt 

shareholders and debtholders generally like other 

suppliers of corporate capital, with tax imposed at 

the corporate level." 

One potential alternative approach would tax 

all corporate and noncorporate income allocable to 

investment by the tax-exempt sector at a rate 

lower than the rate applicable to taxable investors." Such a tax on the investment income, 

including dividends and interest income, received 

by tax-exempt entities could be set to achieve 

overall revenues equivalent to those currently 

borne by corporate capital supplied by the 

tax-exempt sector. Under the imputation credit 

71 Principal Issues 

prototype discussed in Chapter 11, for example, 

imputation credits for corporate taxes paid would 

be allowed to tax-exempt shareholders. To the 

extent that the credit rate exceeds the tax rate on 

investment income, the excess credits could be 

used to offset tax on interest or other investment 

income. In addition to the substantial advantage of 

equating the tax treatment of debt and equity held 

by such investors, such an approach would allow 

tax-exempt investors to use shareholder level 

credits for corporate taxes paid to the same extent 

as taxable shareholders.12 By doing so, this 

approach would limit both portfolio shifts and 

other tax planning techniques that might otherwise 

be induced by efforts to distinguish among taxable 

and tax-exempt investors in integrating the corporate income tax. A revenue neutral rate for such 

a system would be in the range of 6 to 8 percent 

depending on the prot~type.'~This would approximate the current law corporate taxburden on 

investments by tax-exempt shareholders. 
CHAPTER7: 

TREATMENT’ OF FOREIGN INCOME AND SHAREHOLDERS 

7.A INTRODUCTION 

International issues are important in designing 

an integrated tax system because there is substantial investment by U.S. persons in foreign countries (outbound investment) and investment by 

foreign persons in the United States (inbound 

investment). At the end of 1990, private U.S. 

investors owned direct investments abroad with a 

market value of $714 billion, and $910 billion in 

foreign portfolio investment, while private foreign 

investors owned $530 billion in direct investment 

in the United States and $1.34 trillion in U.S. 

portfolio investment. U.S. investors received a 

total of $54.4 billion of income from their direct 

investments abroad in 1990, and $65.7 billion of 

income from their foreign portfolio investments, 

while foreign investors received $1.8 billion from 

their direct investments in the United States in 

1990 and $78.5 billion from their U.S. portfolio 

investments. 

The income from transnational investments 

may be taxed by both the country in which the 

investment is made (the host or source country) 

and the country of residence of the investor (the 

residence country). The United States uses two 

primary instruments for mitigating the potential 

problem of double taxation: the foreign tax credit 

and bilateral income tax treaties entered into 

between the United States and about 40 other 

countries. 

Taxation of foreinn investment bv U.S. inves­

-tors. The United States taxes the worldwide 

income of its residents.’ The U.S. tax on income 

earned by U.S. corporations or individuals 

through foreign corporations is generally deferred 

until such income is repatriated through dividend 

or interest payments to U.S. shareholders or 

creditors. 

The United States allows taxpayers to claim a 

foreign tax credit for qualifying foreign income 

taxes paid (the direct foreign tax credit). Current 

law also allows corporate taxpayers that receive 

dividends (or include Subpart F income) from at 

least 10-percent owned foreign subsidiaries to 

claim a foreign tax credit for a ratable portion of 

the qualifying foreign taxes paid by the subsidiary 

on the income from which the dividends are paid 

(the indirect foreign tax credit). The portion of 

the foreign taxes which taxpayers may claim as an 

indirect credit is proportional to the fraction of the 

earnings of the foreign subsidiary distributed or 

deemed distributed. The dividend income for U.S. 

tax purposes is grossed up by the amount of the 

direct and indirect credits ~laimed.~The indirect 

foreign tax credit, like the dividends received 

deduction available domestically, prevents multiple taxation of corporate profits at the corporate 

level. 

The Code limits the maximum foreign tax 

credit to prevent the foreign tax credit from 

offsetting taxes on domestic source income. 

Separate limitations apply to several different 

kinds of foreign source income (baskets) in order 

to restrict the use of foreign tax credits from hightaxed foreign source income against low-taxed 

foreign source income. For each basket, the Code 

limits the amount of foreign taxes paid on income 

in that basket which a taxpayer may claim as a 

credit in the current year to a fraction of the 

taxpayer’s pre-credit tax on worldwide income in 

the same basket. The fraction is the ratio of the 

taxpayer’s foreign source taxable income in the 

basket to the taxpayer’s total worldwide taxable 

income in the same basket. Credits that a taxpayer 

cannot use in a given year because of the limitations may be carried back two years or forward 

five years. Additional limitations apply to taxpayers subject to the alternative minimum tax. 

Taxation of foreign investors. The taxation of 

U.S. investment income of foreign individuals or 

corporations generally depends upon whether they 

are engaged in a trade or business in the United 

States. Foreign corporations and individuals 

engaged in a U.S. trade or business generally are 

73 
Principal Issues 74 

taxed on their net business income under the same 

rules that apply to a U.S. corporation or citizen 

engaged in the same business. 

The treatment of domestic and foreign investors differs, however, at the shareholder and 

creditor level. Foreign investors not engaged in a 

U.S. trade or business are not subject to the 

individual or corporate income tax.4 Instead, 

subject to significant exceptions noted below, they 

are subject to a 30 percent withholding tax on 

their gross dividend, interest and other income. 

Capital gains realized by a foreign investor on the 

sale of stock or securities (except stock in certain 

U.S. corporations owning U.S. real property) 

generally are exempt from tax. 

The Code exempts from the 30 percent withholding tax qualified portfolio interest and interest 

earned by foreign investors on U.S. bank deposits. Interest does not qualify as portfolio interest 

if the investor has a 10 percent or greater equity 

interest in the borrower or is a controlled foreign 

corporation related to the borrower or if the 

interest is paid on a bank loan made in the ordinary course of a banking business. 

Under bilateral tax treaties, interest (if not 

already exempt) and dividends and other income 

paid to residents of a treaty country may qualify 

for a significantly reduced rate of withholding tax. 

The reduced rate of withholding tax applicable to 

dividends is often 15 percent and may be as low 

as 5 percent on dividends distributed by a U.S. 

subsidiary to a foreign direct corporate investor. 

Tax treaties may reduce the rate of withholding 

on otherwise taxable interest income paid to 

foreign investors (in particular, related foreign 

investors) to 5 or 10 percent or, in many cases, 

zero. 

The current U. S. tax treatment of cross-border 

investment generally reinforces the biases created 

by other features of the classical system of corporate taxation: against equity compared to debt and 

for retention rather than distribution of corporate 

earnings. Statutory exemptions for cross-border 

interest payments, together with more favorable 

treaty provisions for interest than for dividends, 

reinforce the bias against equity. Likewise, the 

potential for deferral of U.S. tax liability on nonSubpart F income reinforces the bias towards 

retention of such. income by foreign 

subsidiaries. 

The major international issues that must be 

addressed in any integrated system are: 

Should foreign taxes paid by U.S. corporations be 

treated identically to taxes paid to the U. S. Govern­

-ment? If so, the foreign tax credit for corporate 

taxes paid, in effect, would be extended to shareholders. As a consequence, income that is taxed 

abroad at a rate equal to or greater than the U.S. 

tax rate would not be subject to U.S. tax either at 

the corporate level or at the shareholder level. 

Should the benefits of integration be extended to 

foreign shareholders? If so, income allocable to (or 

paid to) foreign shareholders would be subject to 

only one level of U.S. tax, at either the corporate 

or shareholder level. If the tax is imposed only at 

the shareholder level, U.S. income tax treaties may 

substantially reduce the tax. 

This Report recommends that: (1) foreign 

income taxes paid with respect to outbound 

investment not be treated the same as U.S. taxes 

paid for integration purposes, (2) foreign shareholders not receive by statute benefits of integration received by U.S. shareholders, and (3) the 

United States’ income tax treaties with other 

countries be used as the appropriate vehicle for 

relaxing either of the preceding rules where 

reciprocal benefits are given by the foreign country to U.S. taxes or investors in their integration 

systems. 

7.B OVERVIEW OF U.S. 

INTERNATIONAL TAX 

POLICY 

As indicated above, cross-border investments 

are potentially taxable in at least two countries: 

the residence country (the country where the 

investor resides) and the source country (the 

country where the investment is made). Sovereignty unavoidably complicates international tax 

policy: a country may set its own tax policies, but 

not the policies of other countries, even though 

the policies of other countries have a direct 
75 

impact on the first country’s welfare. As a result, 

a residence country generally must respect a 

source country’s claim to tax income that is 

derived within the source country’s borders. 

However, the source country has little control 

over the ultimate level of aggregate taxes paid by 

foreign investors on profits earned in the source 

country. By choosing to impose additional tax on 

an investor’s income from the source country, by 

exempting such income from its own tax, or by 

choosing some intermediate policy, the residence 

country, not the source country, makes the final 

decision about the tax burden borne by the residence country’s investors. 

Normative Guidance for 

International Tax Policy 

No consensus exists about the proper norms 

for capital taxation in economies with international capital and labor mobility. Integrating models 

of capital taxation and international trade, policymakers have suggested two principles for taxation 

of international investments: 

0 Principle 1 (Capital Exuort Neutralitv). Investors 

should pay equivalent taxes on capital income, 

regardless of the country in which that income is 

earned. 

0 Principle 2 (Capital Import Neutralitv). All investments within a country should face the same tax 

burden, regardless of whether they are owned by a 

domestic or foreign investor. 

Maintaining both principles simultaneously is 

not a practical option, however, because it would 

require that capital income be taxed equally in all 

countries. That will never occur as long as sovereign countries establish different tax rates. 

National tax systems, such as that of the 

United States, can approach capital export neutrality while taxing worldwide income of resident 

multinational enterprises (the worldwide method 

of taxation), if either the residence country provides credits to its enterprises for taxes remitted 

to foreign governments or the source country 

surrenders the right to tax income from foreign 

investments within its borders. Capital import 

neutrality can be achieved if the residence country 

Principal Issues 

decides not to tax income earned from foreign 

jurisdictions and allows the source country to be 

the sole taxing authority for international 

investment income. 

Since capital export and capital import 

neutrality cannot be attained simultaneously when 

international differences exist in capital income 

taxation, a clear advantage for one or the other 

would be useful. However, analyses of international taxation by economists specializing in 

international trade generally offer no strong 

endorsement of one principle relative to the 

other.5 Capital taxation in open economies (economies in which international borrowing and 

lending occur) can distort both the level of saving 

within an economy and its allocation among 

alternative investments at home and abroad. 

Capital import neutrality can enhance worldwide 

economic efficiency if domestic savings are 

inefficiently low by reducing the tax burden on 

savings. 

Capital export neutrality, in contrast, enhances 

worldwide efficiency in the allocation of savings. 

It may be a guiding principle when efficiency 

costs of distortions in the allocation of savings are 

significant relative to costs of tax-induced distortion in the level of savings. Most available evidence supports the proposition that the sensitivity 

of domestic savings with respect to changes in net 

return is small relative to the sensitivity of the 

location of investment with respect to changes in 

net return6 Accordingly, many economists and 

policymakers presume that capital export neutrality offers better guidance for international tax 

policy. Nonetheless, given the existence of taxinduced distortions in both savings and investment, the complexity of the modem multinational 

enterprise (relative to two-country examples often 

considered in theory), and the possibility of 

international tax competition, some compromise 

between capital export and capital import 

neutrality is ine~itable.~ 

Outbound Investment 

Since 1918, through the foreign tax credit, 

the United States has generally implemented the 
Principal Issues 76 

principle of capital export neutrality unilaterally 

and without interruption.’ Since 1921 the foreign 

tax credit has been limited so it does not exceed 

the U.S. tax liability incurred on the foreign 

source income in the absence of the credit. The 

limitation seeks to prevent the credit from offsetting U.S. tax on U.S. source income. However, 

because the limitation allows a foreign tax rate 

that is higher than the U.S. tax on the relevant 

income to go unrelieved, the limitation works 

against the policy of capital export neutrality. 

A taxpayer generally receives a foreign tax 

credit only for income taxes paid to a foreign 

government on the taxpayer’s own income. Thus, 

a shareholder generally may claim a credit for 

foreign taxes withheld from a dividend payment 

includable in the shareholder’s income but may 

not claim a credit for the foreign taxes paid by the 

corporation on the income out of which the 

dividend is paid. The only exception to this 

principle is the indirect foreign tax credit allowed 

for a domestic 10percent corporate shareholder of 

a foreign corporation for the foreign income taxes 

paid by the foreign subsidiary on the income out 

of which the dividend is paid.’ 

In other respects, however, the U.S. taxation 

of outbound investment tends toward capital 

import neutrality-the tax rate on foreign source 

income of a U.S. investor is determined by the 

tax imposed by the source country. First, the U.S. 

tax regime generally allows deferral. That is, the 

U. S. tax on foreign source income of U. S. owned 

foreign companies is deferred until such profits 

are repatriated in the form of dividends. Deferral 

affects a U.S. investor’s initial decision to make 

or forgo a foreign investment because, even if the 

investor is obligated to pay the residual U.S. tax 

(a capital export neutral result), the time for 

paying this tax may be postponed indefinitely. 

Deferral thus substantially reduces, and under 

some conditions virtually eliminates, the present 

cost of the residual U.S. tax (a capital import 

neutral result).” Deferral, however, is not significant with respect to dividends paid from 

current earnings, or where foreign tax rates equal 

or exceed the U.S. corporate rate. In addition, 

certain foreign corporations controlled by U.S. 

residents are subject to current U.S. tax on certain 

types of undistributed income under the Code’s 

Subpart F rules. The advantage of deferral also is 

less where the domestic corporate ownership 

interest is less than 10 percent of the voting stock 

in the foreign corporation. In that case, the indirect foreign tax credit is not available. Thus, 

dividends will incur both the foreign corporate 

level tax and, after deduction of the foreign tax, 

the U.S. corporate level tax. 

Second, the U.S. tax regime allows averaging. 

That is, in determining the residual U.S. tax on 

foreign profits, a high’foreigntax imposed on one 

item of foreign income may be averaged against 

a low foreign tax imposed on another item of 

foreign income, as long as the different items of 

income are both within the same statutory basket 

for purposes of the foreign tax credit limitation 

rules. If the foreign tax rate on an item of foreign 

income is higher than the U.S. rate, the U.S. 

investor may or may not bear the cost of the 

higher foreign rate, depending on the opportunities for averaging. If the investor must bear the 

higher rate, it is placed in parity with local investors in the foreign country, a capital import 

neutral result. If, on the other hand, the investor 

is able to average the high foreign tax rate on the 

income in question against low foreign rates on 

other foreign income, then the investor will avoid 

the extra burden of the high foreign rate. This 

should render the investor capital export neutral 

with respect to the highly taxed foreign income 

(since averaging will reduce the total tax on such 

income to the U.S. rate, but no lower), but also 

should render the investor capital import neutral 

with respect to the lower taxed foreign income 

(because the investor is able to escape some of the 

residual U. S, tax on such income). The opportunities for averaging have been reduced since the 

1986 Act created separate foreign tax credit 

limitation baskets for specific types of income. 

Inbound Investment 

U. S. tax policy on inbound investment generally asserts a substantial source country claim to 

tax on certain types of income coupled with a 

policy of nondiscrimination against foreign 
77 

investors. For foreign owned corporate investment, the United States generally imposes two 

levels of tax. Thus, the United States taxes the 

business profits of foreign owned domestic corporations or U.S. branches of foreign corporations 

similarly to the profits of U.S. owned domestic 

companies and imposes significant withholding 

taxes on dividends paid to foreign investors. The 

U.S. rules for taxing the U.S. branch of a foreign 

corporation also are designed to impose on the 

branch's profits the same amount of tax that 

would be imposed if the branch were a subsidiary 

of a U.S. corporation. The major exceptions to 

the general U.S. policy are the exemption of 

much of the interest income that is paid from 

U.S. sources to unrelated foreign lenders (other 

than banks), the decision to exempt capital gains 

not effectively connected with a U.S. business or 

attributable to a U.S. real property interest, and 

the reduction of withholding taxes on dividends, 

non-exempt interest, and royalties paid to foreigners (whether or not related) through bilateral 

treaties.l1 

The United States's network of bilateral 

income tax treaties significantly modifies the 

statutory orientation toward source country taxation. In general, tax treaties boost the tax claims 

of the residence country, largely by substantially 

reducing the withholding rates at source on investment income. In addition, tax treaties may require 

higher levels of business activity (a permanent 

establishment) before asserting a U. S. claim to tax 

business profits.l2 

7.C INTERNATIONAL TAX 

POLICY AND INTEGRATION 

Outbound InvestmentTreatment of Foreign Taxes 

This Report generally recommends that, in an 

integrated tax system, the statutory treatment of 

foreign taxes paid by corporations should differ 

from the treatment of the taxes they pay to the 

U.S. Government. Equal statutory treatment of 

foreign and U.S. corporate level taxes would 

significantly reduce the current U.S. tax claim 

against foreign source corporate profits and often 

Principal Issues 

would completely exempt such profits from U.S. 

taxation at both the corporate and shareholder 

levels. Such unilateral action would result in a 

significant departure from the prevailing allocation 

of tax revenues between source and residence 

countries.l3 

The integration systems recommended in this 

Report, therefore, generally retain the corporate 

level foreign tax credit but do not extend to 

shareholders the benefits of a foreign tax credit 

for foreign taxes paid by the corporation. However, where foreign income is taxed at a foreign rate 

that is lower than the current U.S. corporate rate, 

there would be less double taxation than under 

current law, because corporate level residual tax 

would be treated identically to any other U.S. 

corporate taxe~.'~Foreign source income subject 

to tax in the source country at source country 

rates higher than the U.S. rate would continue to 

be subject to a single level of U.S. tax when 

distributed. Thus, although foreign source income 

earned by U.S. corporations might be subject to 

more tax than domestic income, foreign source 

income generally would not be subject to double 

taxation to any greater extent than under current 

law. Retaining a single level of tax on foreign 

income should not harm the ability of U.S. fms 

to compete in foreign markets relative to current 

law. 

Critics of continuing to impose any U.S. tax 

on foreign profits might contend that, because the 

United States currently is willing to give up 

entirely its tax on certain types of foreign profits, 

it should be willing to do so generally for foreign 

corporate profits in an integrated corporate tax 

system. This argument is not compelling, however. To be sure, the United States does not always 

currently insist on a single level of tax on foreign 

source income, as evinced by its unilateral decision to grant a foreign tax credit to individuals 

earning foreign income directly or through a 

partnership. Individual profits from foreign 

sources, however, have been a small fraction of 

the foreign source profits earned by U.S.-based 

multinational corporations, and the revenue loss 

from such a policy has therefore been small 

compared to that which would occur if foreign 
Principal Issues 78 

taxes paid by corporations eliminated U.S. tax at 

both the corporate and shareholder levels. Moreover, allowing a foreign tax credit to individuals 

on the foreign source income directly earned 

alleviates the burdensome tax structure that would 

otherwise arise under current law, because deferral would not be available and the foreign and 

U.S. taxes would both be imposed currently. 

Another potential criticism is that failure to 

pass through foreign tax credits to shareholders 

would violate capital export neutrality and, hence, 

would be inconsistent with our underlying goal for 

integration: to enhance economic efficiency. As 

discussed above, however, it is not apparent that 

export neutrality does, in fact, lead to an efficient 

allocation of capital. In any case, if foreign tax 

credits were available to offset the single level of 

tax in an integrated system, the revenue loss 

would be serious-approximately $17 billion a 

year. Taxes would have to be raised elsewhere, 

and that would generate its own inefficiencies. 

Finally, passing through foreign tax credits to 

shareholderswould pose significantadministrative 

difficulties. The foreign tax credit limitation and 

sourcing rules would have to be applied at the 

individual shareholder level both to ensure that 

taxpayers claimed the proper credit for foreign 

taxes and to prevent the U.S. Treasury from 

bearing the cost of high foreign tax rates. Without 

these rules, shareholders in corporations with 

foreign income that is taxed at a rate greater than 

the U.S. rate could use the excess credits to offset 

tax liability on domestic income, with the consequence that the U.S. Treasury would in effect 

provide domestic shareholders with refunds of 

corporate taxes paid to foreign countrie~.'~This 

is a particularly serious issue because tax rates in 

many foreign jurisdictions are higher than current 

U.S. tax rates. The difficulty of ensuring the 

availability of adequate information concerning 

foreign taxes to both the shareholder and the IRS 

would complicate application of these rules at the 

shareholder level for widely held, non-U.S. 

controlled foreign corporations. 

From a legal point of view, continuing to 

impose a single shareholder level of residence 

country taxation on foreign source income would 

not violate the United States' treaty commitments 

to eliminate double taxation by granting a foreign 

tax credit. Because U.S. tax treaties generally 

reflect an assumption that treaty partners have 

classical systems of corporate-shareholder taxation, the United States' treaty obligations require 

that U.S. corporations be allowed a foreign tax 

credit against the U.S. tax on foreign source 

income received directly by the corporation, and 

that individuals be allowed a credit for foreign 

source income received by the individual. No 

treaty obligation requires the United States to 

grant further relief with respect to foreign taxes 

paid or deemed paid by a domestic corporation, 

e.g., by eliminating the shareholder tax on a 

taxable dividend under the dividend exclusion 

prototype (or CBIT) or, if a compensatory tax is 

imposed under CBIT, refunding the compensatory 

tax. In specific circumstances, however, the 

United States might agree to extend, by treaty, the 

benefits of integration.to foreign taxes on profits 

of U.S. multinationals. 

Under the dividend exclusion prototype, a 

problem with maintaining a single level of U.S. 

tax on foreign earnings is a continued bias in 

favor of the noncorporate, rather than the corporate, form for foreign investment, although, as a 

practical matter, this problem may not be very 

serious. Individuals would be entitled to a foreign 

tax credit for foreign taxes imposed on their direct 

investments but not for taxes imposed on the 

investments of corporations of which they are 

shareholders. Thus, by not treating foreign corporate taxes equivalently to U.S. corporate taxes, an 

incentive to structure foreign investment through 

partnerships would continue. If the corporate form 

could not be avoided, there also would continue to 

be an incentive to make foreign investments in the 

form of debt, which would reduce the foreign tax 

base and convert foreign profits to domestic 

profits. Large investors might achieve similar 

effects by using rental or royalty payments or by 

aggressive transfer pricing. 

The dividend exclusion and imputation credit 

prototypes implement our policy recommendations 

by maintaining the current foreign tax credit rules 
and by limiting the amounts of excludable dividends to corporate income on which U.S. taxes 

have been paid (or limiting shareholder imputation 

credits to U.S. taxes paid).16 In effect, dividends 

paid out of foreign source income not previously 

subject to U.S. tax because of foreign tax credits 

would be taxed fully at the shareholder level, as 

under current law. Under CBIT, the U.S. tax may 

alternatively be imposed through a compensatory 

tax at the corporate level on distributions of 

foreign source income shielded from regular 

CBIT by the foreign tax credit.17 In either case, 

corporations are allowed to treat dividends as paid 

first out of U.S. taxed income. Under the shareholder allocation prototype, foreign taxes, in 

essence, would be treated as equivalent to U.S. 

taxes, and this is among the reasons that this 

prototype is not recommended in this Report." 

Inbound InvestmentTreatment of Foreign Investors 

The basic issue that an integration proposal 

must resolve for inbound investment is whether, 

by statute, the United States should continue to 

collect two levels of tax on foreign owned corporate profits or whether foreign investors should 

receive benefits of integration similar to domestic 

investor~.'~For the reasons set forth below, this 

Report recommends that, except in the case of 

CBIT, foreign shareholders not be granted integration benefits by statute, but instead that this 

issue be addressed on a bilateral basis through 

treaty negotiations. Most of the major trading 

partners of the United States that have integrated 

their corporate tax regimes have followed this 

approach.20 

At least two basic obstacles restrain unilateral 

extension of integration benefits to foreign shareholders. The first is the inherent limitation on any 

source country's taxation of foreign investors. The 

residence country, not the source country, ultimately decides the tax burden that should be 

borne by its resident investors. As a consequence, 

if the United States unilaterally extended the 

benefits of integration to foreign shareholders, it 

would abandon its right to source country taxation 

of dividends with no assurance that the foreign 

79 Principal Issues 

investors would not be subject to a second level of 

tax in their country of residence. Substantial 

revenue would be lost without any necessary 

increase in efficiency of capital allocation. 

The second obstacle is the interaction between 

a U.S. integration system and existing treaty 

obligations. For example, extending a refundable 

imputation credit to foreign shareholders by 

statute, combined with traditionally low treaty 

withholding rates on dividends, could significantly 

reduce the aggregate US. tax on profits distributed to foreign shareholders, without any comparable reduction in foreign taxes on U. S. investments 

in the treaty country.21 

Thus, there is no reason for the United States 

by statute unilaterally to extend the benefits of 

integration to foreign shareholders. Integration 

seeks to provide relief for investors using the 

corporate form, not for foreign governments. If a 

second level of tax is to be collected, no obvious 

conceptual or practical reason exists why the 

source country should sacrifice its claim to this 

tax revenue for the sake of consistency. 

Several of our treaty partners adopting imputation credit systems have concluded that refusing 

to extend integration benefits by statute to foreign 

shareholders residing in treaty countries would not 

violate the provisions of tax treaties that prohibit 

discrimination based on capital ownership. These 

countries argue that, under an imputation credit 

system, all profits are taxed at the corporate level 

at the same rate (34 percent, for example), without regard to "capital ownership," and allowing or 

denying the imputation credit to the shareholders 

is an issue of how to tax the shareholder, not the 

corporation. No treaty requires that foreign 

shareholders receive the same tax credits as 

domestic shareholders. Thus, there is no treaty 

violation. Similar arguments could be made about 

the dividend exclusion prototype.22 

As Chapter 2 indicates, the dividend exclusion 

prototype generally would not provide any integration benefits to foreign shareholders, because 

current withholding taxes would continue to 

apply.23 Similarly, inbound investment in an 
Principal Issues 80 

imputation credit system would remain subject to 

two levels of U.S. tax because imputation credits 

would not be made available to foreigners and 

current withholding taxes would continue to 

apply. Neither approach would treat inbound 

investment more harshly than under current law, 

because deferral of the second level of tax would 

continue.% A dividend deduction system, on the 

other hand, would automatically extend the benefits of integration to foreign shareholders, unless 

a rule were adopted to deny the deduction for 

dividends paid to foreigners -a rule that would 

violate U. S. treaty obligations. The shareholder 

allocation prototype avoids extending the benefits 

of integration to foreign shareholders by imposing 

corporate level tax, continuing to impose withholding tax on dividends, and denying refunds of 

corporate taxes paid to foreign shareho1de1-s.~~ 

In contrast, to ensure parity between debt and 

equity, the CBIT prototype generally removes the 

withholding tax on both dividends and interest of 

CBIT entities and repeals the branch profits tax. 

The result is that both debt and equity income 

would be subject to tax once. 

The United States may consider extending the 

benefits of integration to foreign shareholders 

resident in countries that have treaties with the 

United States. The fundamental policy issue in 

deciding whether and how to extend integration 

by treaty to foreign shareholders is how to divide 

the tax revenue from corporate profits between 

the source country and the residence country. As 

noted above, traditional treaty rules reflect an 

allocation of revenue based on the classical, 

two-tier tax system for corporations and shareholders: the source country generally has the 

exclusive right to tax business profits earned 

therein by a domestic corporation and the two 

countries divide the right to tax the profits when 

distributed, with the greater share of this revenue 

going to the residence country. Integration, of 

course, alters the original pool of tax revenue by 

decreasing the total (assuming no offsetting rate 

increases) and by reallocating it between the 

shareholder and corporation. Thus, moving to an 

integrated corporate tax system may upset the 

balance of interests traditionally reflected in the 

treaty rules of the United States. 

Various methods can be devised for extending 

integration by treaty to inbound and outbound 

investment, and these different methods will 

produce differing allocations of the taxes collected 

from the corporation between the source country 

and the residence country. For example, the 

dividend exclusion prototype could be adopted to 

permit the source country to retain its corporate 

tax revenues: the source country would eliminate 

its withholding tax on distributions to treaty 

residents and the residence country would credit 

the source country taxes against the direct and 

ultimate shareholders’ tax liabilities in the residence country and collect any residual tax. An 

alternative approach would impose a tax on 

foreign shareholders at a rate that would approximate the current level of revenues now collected 

by the United States on U.S. source corporate 

income from foreign investments and allow a 

credit against this tax for corporate level taxes 

paid.26 
CHAPTER 8: THE TREATMENT OF CAPITALGAINS INAN 

INTEGRATEDTAXSYSTEM 

Moving from a classical to an integrated 

corporate tax system raises issues relating to the 

taxation of capital gains on sales of corporate 

stock. While each of the integration prototypes 

reduces the biases of the classical system, rules 

selected for taxation of capital gains on sales of 

corporate stock will affect the degree of neutrality 

achieved by each prototype. Taxing shareholder 

level capital gains on stock attributable to earnings 

that have been taxed at the corporate level is not 

appropriate in an integrated system. Taxing such 

gains on stock could perpetuate the classical 

system’s biases against the corporate form and 

against investments in equity rather than debt. In 

addition, a higher effective tax rate on retained 

earnings could provide a tax incentive for corporations to distribute earnings as dividends. On the 

other hand, a failure to taxshareholder level stock 

gains may result in significant deferral or even 

elimination of tax attributable to unrealized 

corporate asset appreciation. 

8.A TAXATION OF CAPITAL 

GAINS ATTRIBUTABLE TO 

RETAINED TAXABLE 

EARNINGS 

When a corporation retains earnings, its stock 

will generally increase in value. There is some 

controversy about the extent to which an incremental dollar of retained earnings translates into 

share appreciation.* In integration prototypes that 

tax earnings at the corporate level, e.g., the 

dividend exclusion and CBIT prototypes, dividends would not generally be taxed again at the 

investor level. Under these prototypes, to preserve 

neutrality in the taxation of corporate capital 

income, shareholders’ capital gains attributable to 

retained earnings that have already been taxed 

fully at the corporate level should not be taxed 

again at the shareholder level. Imposition of a 

capital gains tax in this case would be a double 

tax on the retained earnings of the corporation. 

The second level of tax, however, may prove 

temporary. If the corporation subsequently distributes the retained earnings, the value of the stock 

may decline to reflect the distribution of corporate 

assets. As a consequence, the tax on the selling 

shareholder’s gain may be effectively reversed by 

an offsetting capital loss of the purchasing shareholder. The extent to which the capital loss 

reverses the double tax will depend on the timing 

of the distribution of the retained earnings and of 

the realization and treatment of the capital 10~s.~ 

When the tax reduction from the later capital 

loss precisely offsets the tax on the earlier capital 

gain, the system will collect only one tax on 

corporate earnings. However, a subsequent capital 

loss deduction allowed to a taxpayer different 

from the one who originally is taxed on the 

capital gain will often be an imperfect offset. For 

example, the tax on the gain may occur in a year 

earlier than the tax reduction from the capital 

loss. The acceleration of tax may even approximate, in present value terms, double taxation if 

there is a substantial period between the payment 

of capital gains tax by the first shareholder and 

the recognition of an offsetting capital loss by a 

subsequent shareholder. In addition, limits on the 

deductibility of capital losses may prevent the 

purchasing shareholder from fully using the 

offsetting capital loss. The additional burden 

imposed by a capital gains tax also depends on the 

marginal tax rates of the purchaser and seller of 

sto~k,~and the fact that shareholders with different marginal tax rates will generally face identical 

market prices for their stock further complicates 

analysis of the extent of double taxation. 

81 
Principal Issues 82 

8.B SOURCES OF CAPITAL 

GAINS OTHER THAN 

TAXABLE RETAINED 

EARNINGS 

Not all capital gains from increases in the 

value of corporate equity arise from accumulated 

retained earnings. Gains from other sources may 

imply different tax consequences than those 

applicable solely to gains from fully-taxed 

retained earnings. 

First, capital gains on corporate stock may be 

attributable to retained preference income. In that 

case, taxing capital gains on corporate stock does 

not impose a second level of tax,because no tax 

has been paid at the corporate level. Taxing such 

capital gains produces a single tax on those 

earnings at the shareholder level. If, as we recommend in Chapter 5, integration should not extend 

corporate level preferences to shareholders, such 

gains should be taxed. Providing relief for capital 

gains attributable to retained preference income 

would exacerbate the incentive to retain rather 

than distribute preference income or to distribute 

preference income in a nondividend distribution in 

which capital gain treatment might be a~ailable.~ 

Second, capital gains may be attributable to 

real unrealized appreciation in the value of corporate assets. In that case, the unrealized corporate 

level gain, in effect, will be realized first at the 

shareholder level upon the disposition of the 

stock. The gain also will be realized at the corporate level when the corporation disposes of the 

asset. Although such gains eventually will be 

taxed at the corporate level, in a realization-based 

income tax system, taxing the shareholder level 

gain seems appropriate, since that is the first 

realization event with respect to the appreciation. 

It may, however, be appropriate to prevent double 

taxation when the corporation subsequently disposes of the appreciated asset.6 

Third, capital gains may be attributable to 

changes in the anticipated value of corporate 

earnings, due, for example, to management 

changes or revised estimates of profits from new 

products or inventions. Tax considerations for 

gains attributable to such factors are similar to 

those concerning unrealized appreciation in tangible corporate assets. Accordingly, taxing the 

appreciation when the shareholder sells the stock 

seems appropriate. 

Finally, taxable capital gains may result from 

inflation. In an unindexed system, capital gains 

tax liability can result simply because nominal 

asset values rise with inflation, although a taxpayer may have no increase in real income. Taxing 

such gains can lead to high effective tax rates on 

capital gains. Indeed, granting relief to capital 

gains to offset the effects of inflation has been one 

of the principal justifications advanced for measures such as lower rates on capital gains or 

indexation of such gainse7 

8.C ADJUSTMENTS TO 

ELIMINATE DOUBLE 

TAXATION OF RETAINED 

CORPORATE EARNINGS 

Although avoiding the double taxation of 

corporate retained earnings is an important factor 

to be taken into account, how capital gains are 

treated in an integrated corporate tax system will 

turn ultimately on the resolution of basic policy 

issues that have long been controversial under the 

income tax. Considerations such as the desire to 

stimulate investment and entrepreneurship and to 

avoid the overtaxation of inflationary gains support preferential rates or exclusions for all or a 

part of capital gains income. On the other hand, 

some analysts will contend that capital gains and 

ordinary income should be taxed similarly. 

Integration of the corporate income tax can 

proceed and will serve to reduce substantially the 

distortions of the current system whichever of 

these options for taxing capital gains is chosen. 

However, in designing an integrated corporate 

tax, one must consider the treatment of capital 

gains, as well as dividends, in developing rules 

that minimize distortions in corporate and 

individual fmancial behavior. 

As discussed in Chapter 3, the shareholder 

allocation prototype would allocate corporate 
83 

taxable income to shareholders each year and 

would provide a system of shareholder level basis 

adjustments similar to those used for partnerships 

or S corporations under current law.’ Share basis 

would increase to reflect the corporation’s taxable 

income and certain preference income and would 

decrease to reflect distributions. Thus, under such 

a system, any capital gains on sale of corporate 

stock would be attributable to preference items for 

which no basis adjustment is allowed, unrealized 

appreciation, or inflation. 

On the contrary, the dividend exclusion prototype, set forth in Chapter 2, does not provide any 

adjustments to share basis to reflect the corporation’s retention of income that has been taxed at 

the corporate level. As a consequence, taxing 

capital gains could impose an additional shareholder level tax on retained earnings that have 

already been taxed in full at the corporate level. 

Because retained fully-taxed earnings would face 

a greater tax burden than distributed earnings, 

corporations would have an incentive to distribute 

rather than retain fully-taxed earnings. This 

problem can be limited by allowing a dividend 

reinvestment plan (DRIP), which would permit a 

corporation to declare deemed dividends to the 

extent of its EDA balance and treat the amount of 

dividend as reinvested in the corporation. Under 

such a system, a shareholder would be treated as 

receiving an excludable dividend and would 

increase stock basis to reflect the deemed recontribution. Chapter 9 discusses DRIPS in detail. 

If corporations were to use a DRIP to declare 

deemed dividends equal to their fully-taxed 

income each year, the resulting basis adjustments 

would ensure that such income would not be taxed 

again as capital gains. If, however, nontax considerations lead corporations not to elect DRIP treatment for all their fully-taxed earnings, an elective 

DRIP would not eliminate the potential additional 

tax on retained corporate earnings. For example, 

a corporation that expects to earn substantial 

preference or foreign source income shielded by 

foreign tax credits might want to retain some 

EDA balance to enable it to continue to pay 

excludable cash dividends in future years. If no 

Principal Issues 

DRIP is allowed, or if it is expected that corporations will not elect to make deemed distributions 

of all fully-taxed income, one could reduce or 

eliminate the potential disadvantage for retained 

earnings by adopting a preferential rate (or, 

equivalently, a partial exclusion) for capital gains. 

Taxing capital gains on equity and debt investments in business entities creates special issues 

under CBIT. If a compensatory tax is imposed 

under CBIT, all business income would be taxed 

at the entity level, and investors would exclude 

from income all dividends and interest payments 

received. In that case, taxing capital gains would 

create an even greater disparity between retained 

and distributed income than under the dividend 

exclusion prototype. Thus, if CBIT includes a 

compensatory tax, a complete investor level 

exemption for capital gains (and nonrecognition of 

losses) on equity and debt would be consistent 

with CBIT’s general exemption from investor 

level tax of dividends and interest. If CBIT does 

not include a compensatory tax, but instead taxes 

dividends and interest considered to be paid out of 

corporate preference income at the investor level 

(see Section 4.D), the case for relief for capital 

gains is essentially the same as under the dividend 

exclusion prototype. 

If CBIT includes a compensatory tax, 

exempting gains and losses from the sale of equity 

interests in CBIT entities could be justified on the 

ground that those gains and losses either have 

been, or will be, taken into account in calculating 

the income tax imposed at the entity level. 

Retained taxable income has already been subject 

to tax, retained preference income will be subject 

to compensatory tax under CBIT when 

distributed, and unrealized appreciation represents 

anticipated higher future earnings that will be 

subject to entity level tax if and when they are 

realized.’ Exempting capital gains on CBIT 

equity and debt would promote simplicity in the 

CBIT prototype. For example, exempting capital 

gains on CBIT debt and equity would remove the 

need for a DRIP mechanism to allow holders to 

increase basis to reflect earnings taxed at the 

corporate level. 
Principal Issues 84 

The principal disadvantage of exempting gains 

on CBIT equity is the potential for deferral of tax 

on appreciation in an entity's assets. A realization-based tax system may allow a significant 

delay between the realization of gain by an equity 

investor (through the sale of his equity interest) 

and the realization of future earnings or built-in 

gain at the entity level. Foregoing the opportunity 

to tax gains realized upon a sale of an equity 

interest thus increases the potential for the deferral of tax on unrealized appreciation at the entity 

level. lo Although additional realization rules at 

the entity level could limit deferral," sale of an 

equity interest traditionally has been viewed as an 

appropriate realization event and the more traditional solution to the problem of double taxation 

has been to adjust entity level asset basis to reflect 

investor level realization.l2 

CBIT also raises issues relating to capital 

gains on debt. Some, but not all, changes in the 

value of debt reflect gains and losses that have 

provide some preferential treatment for capital 

gains on corporate stock through a lower effective 

tax rate. For example, Canada, France, and 

Germany all provide for an alternative or reduced 

tax rate applied to such gains. These reductions 

can be substantial. In Germany, for example, all 

gain on securities held more than 6 months may 

be excluded. The United Kingdom does not 

permit a reduction in its marginal tax rate, although the tax base is indexed for inflation, but 

instead allows a specific "dollar" exemption. 

Gains exceeding the exemption are taxed at the 

applicable marginal rate. 

8.E SHARE REPURCHASES 

The differences in taxation of gains from 

similar transactions complicates analysis of the 

proper treatment of capital gains on corporate 

been or will be taxed at the corporate 1e~el.l~ 

For example, one source of capital gains on debt 

is an increase in the creditworthiness of the 

issuer, which may reflect an increase in the 

corporation's expected future earnings. If an 

increase in creditworthiness is due to earnings that 

will be taxed at the corporate level, the issues 

created by taxing capital gains on debt are similar 

to those for equity.I4 Capital gains and losses on 

debt (and corresponding losses and gains to 

issuers) also may arise from unexpected movements in market interest rates.15 The movement 

to a CBIT system does not demand an exclusion 

of gains on CBIT debt that are due to changes in 

interest rates, and it is impossible as a practical 

matter to distinguish between gains attributable to 

interest rate movements and gains attributable to 

other sources.l6 

8.D OTHER COUNTRIES 

Many countries recognize the possible distortion caused by taxing capital gains on sales of 

corporate stock and have taken measures to 

mitigate this effect. Table 8.1 shows the tax 

treatment of capital gains of the G-7 countries 

with integrated tax systems. All the countries 

stock under integration. The treatment of share 

repurchases is one example. A shareholder who 

sells stock to a person other than the corporation 

that issued the stock or who receives a liquidating 

distribution generally can recover the basis in the 

stock against the amount realized on the sale. In 

contrast, current law may treat a redemption of 

stock by the issuing corporation as a dividend or 

as a sale of stock. A redemption generally qualifies for sale treatment if it is "not essentially 

equivalent" to a dividend or is substantially 

disproportionate among shareholders. l7 For 

redemptions treated as a dividend, no basis 

recovery is permitted (although, generally, the 

basis in the redeemed stock is allocated to the 

remaining stock and will be recovered eventually). 

Current law favors share repurchases because 

dividends are taxable to shareholders in full, 

while redemptions generally permit recovery of 

basis by shareholders and may permit taxation of 

gain at the maximum rate of 28 percent for longterm capital gains (rather than at the higher 

marginal rates for ordinary income).'* 

In gene&, each of the integration prototypes 

should greatly reduce current law's incentive to 

engage in share repurchases. Shareholder allocation integration, which treats both distributions 

and sales of stock as' tax free to the extent of 
85 

Table 8.1 

Taxation of Individuals on 

Long-Term Gains on Securities 

Select Foreign Countries 

MaximumIndividual Tax Rate 

Foreign Country Amount of Gain Exempt (capital ~ain~)' 

France All,if the sale roceeds do not 16% exceed FF307,760 ($55,323)' 

United Kingdom All inflationary gains plus an 40 % 

annual exemption of E5,OOO

($8,885) of non-inflationary gains 

Canada 25% exclusion, lus a lifetime 22 %

exemption of CP100,000 

($88,480) 

Germany All gain on securities held more 0% 

than 6 months2 

Department of the Treasury Office of Tax Policy 

'National tax only. Subnational taxes are relevant in Canada onl . Provincial taxes (non-deductible) amount to roughly 50 percent of tBe 

Federal tax. 

'The exem tion does not apply in certain cases where the seller held 

a "substantia? interest" in the corporation whose shares are being sold. 

Principal Issues 

pronounced if a compensatory tax is imposed on 

dividends but not on share 

repurchases. Avoiding the 

compensatory tax would 

allow preference income 

to be distributed to taxexempt and foreign investors without tax at either 

the corporate or the shareholder level. 

One way to eliminate 

the remaining incentive for 

share repurchases under 

the dividend exclusion and 

CBIT prototypes would be 

to treat redemptions like 

dividends. In that case, 

share repurchases, like 

dividends, by a corporation with sufficient earnand Profits would not 

permit basis recovery. 

Share repurchases would 

be tax-free to shareholders 

to the extent of the corporation's fully-taxed income 

share basis and capital gain thereafter, would treat 

share repurchases and dividends similarly,l9 The 

dividend exclusion prototype, which treats dividends paid out of fully-taxed earnings as tax free 

to shareholders, generally would encourage 

corporations to distribute fully-taxed earnings to 

taxable shareholders as dividends rather than 

through share repurchases. Corporations that had 

exhausted their EDA balance and could pay only 

taxable dividends, however, would have an incentive to distribute earnings through share repurchases. Even corporations with sufficient EDA 

balances might desire to make selective share 

repurchases from tax-exempt shareholders to 

distribute earnings without reducing the corporation's EDAe2OThe incentives for share repurchases under CBIT are generally the same as 

those under the dividend exclusion prototype, 

except that the incentive to make share repurchases out of preference income may be more 

(and would reduce the corporation's EDA). Any 

portion of payments to repurchase shares that 

were made out of preference income would be 

taxable to shareholders, in a dividend exclusion 

system, or subject to compensatory tax or an 

investor level tax, in CBIT.21This result may be 

inappropriate, however, in a system in which 

capital gains are subject to tax, because a shareholder's basis would be taken into account on a 

sale to a third party, but not in a corporate repurchase. In theory, dividend treatment could be 

extended to all sales of shares, including sales to 

persons other than the issuing corporation. However, it may be impractical to extend dividend 

treatment to third-party sales, given the large 

volume of daily trading in corporate stock.22 

Limiting dividend treatment to redemptions 

would, however, create disparities between sales 

of stock to the issuing corporation and to third 

parties. 
Principal Issues 86 

The treatment of capital gains also may affect 

the desirability of measures to equalize the treatment of dividends and share repurchases under the 

dividend exclusion and CBIT prototypes. A 

preferential rate for capital gains, for example, 

might reduce, but not eliminate, the disincentive 

for share repurchases out of fully-taxed income 

while increasing the incentive for share repurchases out of preference income. On balance, we 

believe that any of the integration prototypes will 

sufficiently decrease incentives for share repurchases as compared to current law that policymakers may avoid adopting any additional rules 

and let the passage of time demonstrate whether 

the shifting of EJ3A balances among shareholders 

requires additional measures. 23 

8.F CAPITAL LOSSES 

In general, the treatment of capital losses on 

corporate stock under integration should parallel 

the treatment of capital gains. As Section 8.A 

discusses, a purchaser’s capital loss may serve to 

reverse the tax imposed on a seller’s capital gain 

attributable to retained earnings that have 

previously been taxed at the corporate level. 

However, if relief is provided for capital gains on 

corporate stock, the corresponding loss need not 

be allowed in full as an offset. For example, an 

exemption (or partial exclusion) for capital gains 

on corporate stock might imply a disallowance (or 

partial disallowance) of capital losses on corporate 

stock. Policymakers may, however, decide to tax 

capital gains on corporate stock, on the grounds 

that the second level of tax on retained earnings 

may prove temporary and that preferential treatment could exempt from tax other gains (like 

some of those discussed in Section 8.B) that may 

appropriately be taxed under integration. 

Other capital losses on corporate stock may 

arise from unrealized depreciation in corporate 

assets, just as capital gains may arise from unrealized appreciation.” As Section 8.B notes, in a 

realization-based tax system, it seems appropriate 

to allow such losses, although it may be appropriate to make adjustments to prevent a second loss 

at the corporate level, e.g., by adjusting corporate 

asset basis. As under current law, the desirability 

of such measures must be weighted against their 

~omplexity.~’ 
CHAPTER9: DIVIDENDREINVESTMENT PLANS 

Under the dividend exclusion and CBIT 

prototypes, corporations (and other entities subject 

to CBIT) may desire to retain earnings but allow 

their shareholders to increase share basis to reflect 

earnings which have been taxed at the corporate 

level. Allowing basis adjustments would reduce 

the extent to which taxes on investor capital gains 

would be a second tax on retained earnings and 

would reduce the tax incentive for corporations 

(and other CBIT entities) to distribute fully-taxed 

income. See Chapter 8. We contemplate that this 

would be permitted through an elective dividend 

reinvestment plan (DRIP). DRIPs may be adopted by corporations under current law; such plans 

commonly are used by mutual funds and utilities. 

Because dividends are taxable to shareholders 

under current law, participation in DRIPs generally requires an election by the shareholder. Unlike 

existing DRIP arrangements, however, deemed 

dividends reinvested under an integration prototype would not be taxable to shareholders and the 

DRIP could be adopted by the corporation (or 

CBIT entity) without the consent of the individual 

shareholder.2 Adopting a DRIP would simply 

represent a corporate decision to reduce the 

corporate EDA in order to increase share basis. 

9.A MECHANICS 

By adopting a DRIP, a corporation would 

elect to treat shareholders as receiving excludable 

dividends in an aggregate amount not to exceed 

the balance in the corporation’s EDA. The 

amount deemed distributed would be deducted 

from the EDA. The shareholders would then be 

deemed to recontribute the distributed amount, 

and their share basis would increase by the 

amount of the deemed distribution. Share basis 

would increase only by the amount deemed 

reinvested (rather than by the corporation’s pretax earnings), because that would be the result 

had the shareholder actually reinvested a dividend. 

Mechanically, the electing corporation would 

declare deemed dividends in the same manner that 

it declares actual dividends. A corporation would 

choose the amount of deemed dividends and the 

classes of stock on which they would be paid. The 

corporation’s ability to stream deemed dividends 

to taxable shareholders would be constrained by 

the anti-streamingrules generally applicable under 

the prototypes for payments of excludable dividend~.~The corporation would allocate the 

deemed dividends to holders of stock on the 

chosen record date and would provide information 

reports to those shareholders showing the amount 

of the deemed dividend and the associated basis 

increase. 

Dividends are generally paid on a per share 

basis, and the share basis increase under the DRIP 

also would be on a per share basis. It would be 

desirable to have a uniform convention governing 

the allocation of such basis, e.g., equally to each 

share or in proportion to the existing basis. 

Example 1. Corporation X adopts a DRIP and 

makes a deemed distribution of $100 to Shareholder A. The fair market value of X shares on the 

date of the deemed distribution is $20 per share. A 

owns 10 shares of X which he purchased in two 

lots, Lot A (5 shares at $4 each) and Lot B (5 

shares at $6 each). If basis is allocated on a per 

share basis, the basis of each Lot A share will be 

$14 and each Lot B share will be $16. 

Although a shareholder may have purchased 

various shares of a corporation’s stock for different amounts, the treatment of each share under 

current law as having a separate basis may be 

questioned. If the shares are economically 

equivalent, it may be appropriate to require the 

shareholder to recognize the same gain or loss 

regardless of which shares are actually sold. For 

example, a DRIP could be used to reduce basis 

disparities. 

Example 2. The facts are the same as in Example 

1, except that the fair market value of X shares on 

the date of the deemed distribution is $15 per 

share. The DRIP basis increase could be allocated 

between the Lot A and Lot B shares so that the 

shares in each lot have a basis of $15. 

For some shareholders (particularly those with 

recently purchased shares), a DRIP may create 

87 
Principal Issues 

share basis in excess of fair market value, with 

the result that capital losses will be realized when 

the shares are sold. Such losses may serve the 

same function as those discussed in Section 8.A, 

simply "reversing" the double tax imposed on the 

seller of shares. In other cases, however, it may 

be appropriate to craft anti-abuse rules to prevent 

a DRIP from being used to create basis in excess 

of fair market value.4 

The dividend exclusion and CBIT prototypes 

generally adopt stacking rules that treat distributions as made first from fully-taxed income. If a 

DRIP is adopted, further stacking rules would be 

necessary to determine whether cash distributions 

on a class of stock following deemed dividends on 

that class of stock are first a recovery of basis 

from the DRIP or out of other earnings. Thus, 

issuers would keep an account of deemed dividends made on each class of stock (the deemed 

dividend account), in addition to the EDA.' To 

simplify the operation of these accounts and 

minimize the double taxation of retained earnings, 

we recommend that all cash distributions, including cash distributions on shares on which deemed 

dividends have previously been paid, be treated 

first as payments out of any remaining balance in 

the corporation's EDA. Then cash distributions on 

a class of stock on which deemed dividends had 

been paid would be treated as a return of capital 

to the extent of the balance in the deemed 

88 

dividend account for that class of stock. The 

deemed dividend account would be reduced by the 

amount of dividends treated as a return of capital 

under this rule. Distributions in excess of the 

deemed dividend account for a class of stock 

would be governed by the prototype's rules 

applicable to distributions in excess of the EDAe6 

9.B DESIGN CONSIDERATIONS 

We anticipate that deemed distributions will, 

in practice, be made only to holders of common 

(or at least participating) equity, because holders 

of preferred stock typically require cash dividends. Restrictions limiting DRIP distributions to 

common and participating equity could be considered if it were feared that DRIPs could permit 

inappropriate losses, e.g., distributions on preferred stock bearing limited dividends and a fixed 

liquidation or redemption value might create such 

a result.7 

In addition, DRIPs could be made mandatory 

on the theory that double taxation of retained 

earnings through capital gains taxation could be 

minimized by forcing basis allocations as promptly as possible.' However, there seems to be little 

reason why corporations should not be permitted 

to control this, as other aspects, of their 

distribution policy. 

88 
CHAPTER 10: TRANSITION CONSIDERATIONS

10.A INTRODUCTION 

Under current law, investors and corporations 

generally have made decisions and commitments 

based on the two-tier corporate tax system. 

Investors’ decisions to invest in corporate or 

noncorporate entities or in debt rather than stock, 

and corporations’ decisions to distribute earnings, 

to issue debt or equity, or to recognize gains 

inherent in appreciated assets all likely have been 

made with an expectation that corporate equity 

income will likely continue to be subject to tax at 

two levels. Introduction of an integrated system 

will alter these expectations. We believe that a 

transition period is appropriate to prevent undue 

dislocation and to mitigate transitional gains and 

losses. 

We anticipate that shifts in investors’ portfolios will occur under any integration proposal and, 

in some cases, such shifts may be substantial. 

While the magnitude of such shifts will vary with 

the degree of difference between the integration 

proposal and current law, prudence suggests that 

phased-in implementation will permit adjustment 

to the new system while mitigating transition 

gains and losses. It also will provide an opportunity for midcourse corrections, if needed. A 

phase-in appears to be the simplest form of 

transition for both taxpayers and administrators to 

implement. It will not require complicated rules 

of uncertain duration for preenactment assets. 

10.B TAXATION OF 

TRANSITIONAL GAINS 

AND LOSSES 

Some believe that it is important for transitional rules to deal explicitly with gains and losses 

arising from the shift to an integrated system.’ 

Several sources of such transition gains and losses 

can be identified. First, the shift to integration 

may affect the value of corporate shares.2 Second, at the time of the shift, corporations may 

hold assets with unrealized built-in gains or losses 

and hence face different tax consequences upon 

realization than under existing law. (Absent 

specific transitional rules for built-in gains and 

losses, the second effect will likely become a part 

of the first effect.) Finally, some corporations 

may have retained earnings which have been 

realized and taxed while others may have distributed such earnings. The former may gain advantage if the retained earnings are not taxed on 

di~tribution.~ 

While we favor a phase-in of integration 

primarily to allow for gradual portfolio shifting 

and to allow assessment of integration’s impact as 

it is implemented, we do not favor other explicit 

transitional rules to deal with transition gain and 

loss. Phase-in itself will mitigate the impact of 

any change in share valuese4 

Built-in gains and losses are likely to be 

reflected in share value; in any event, the differing tax consequences that will occur arise primarily by virtue of the realization concept fundamental 

to current income tax law. Prior law changes 

(including significant rate changes) generally have 

not attempted to capture this form of transition 

gain (other than through phase-in) and we believe 

that result is appropriate in the shift to integration 

as well. 

Differences in earnings distribution policies 

are likely to be significant only in certain forms 

of integration. They could be significant, for 

example, in the shareholder allocation prototype. 

Because that prototype taxes only current corporate income and treats distributions as a return of 

capital, corporations that retained earnings realized under current law could be significantly 

favored over those that distributed such earnings. 

In contrast, the dividend exclusion and CBIT 

prototypes’ EDA mechanisms will cause distributions from earnings retained before the establishment of the EDA to be taxable to the shareholder 

when distrib~ted.~Accordingly, both the dividend 

exclusion prototype and CBIT will produce results 

for pre-integration retained earnings similar to 

current law .6 

89 
Principal Issues 90 

As an alternative, some form of grandfathering of existing assets or activities could be 

used to limit or eliminate transition gains and 

losses from the shift to integration. Under such an 

approach, current law treatment would be retained 

for assets that otherwise would be treated more 

favorably under integration to preserve asset 

values that reflect the classical corporate tax 

system. In moving to integration, however, a 

permanent grandfather rule would require maintaining a distinction between pre-enactment and 

post-enactment assets and equity interests and, in 

CBIT, old and new debt as well. Making such 

distinctions over an extended period would create 

difficult, if not impossible, reporting burdens and 

administrative complexity and would inevitably 

result in uneven enforcement.' Such an approach 

also could require an extensive array of rules to 

prevent transformation of old equity into new 

equity and to govern conversions of non-corporate 

entities to corporate status.' More importantly, 

preserving a dual system to limit the benefits of 

integration to new equity, would thwart the goal 

of economic reform by perpetuating the very 

distortions the new system seeks to eliminate.' 

We have rejected such an approach on grounds of 

both efficiency and simplicity. 

10.C PHASE-IN OF INTEGRATION 

Phase-ins have been used in recent legislation 

to moderate the harsh effects of significant 

changes in the tax law. For example, the passive 

loss disallowance rules, the personal interest 

disallowance rules, and the new investment 

interest limitations adopted in the Tax Reform Act 

of 1986 all were phased in." 

We generally recommend that a phase-in 

approach be used to implement the transition from 

the classical system to an integrated corporate tax. 

A phase-in approach would moderate the transition effects of integration, while avoiding the 

serious drawbacks of limiting integration to new 

equity. While some transition gains and losses 

may occur, fundamental structural changes in the 

tax law, such as those proposed here, simply are 

not feasible if substantial changes in values of 

taxpayers' assets must be avoided. Indeed, such 

changes have typically been ignored in connection 

with rate changes that raise similar concerns. A 

phase-in also would mitigate the revenue effects 

relative to immediate change. A phase-in would 

delay application of the new rules, however, and 

the delay would reduce the present value of the 

desired economic changes. 

Under a phase-in approach, integration would 

be introduced gradually over a designated period. 

This approach would reduce the magnitude of 

transition gains and losses. A phase-in would not 

distinguish between old and new equity or, in the 

CBIT prototype, old and new debt. Although 

there would be some delay in full implementation 

of integration under a phase-in approach, this 

delay would be of limited duration, in contrast to 

the virtually indefinite delay that would result 

from limiting integration to new equity. The 

length of the phase-in period should depend on a 

variety of factors, including the particular integration prototype adopted. An appropriate period 

should be selected by striking a balance between 

the need to mitigate the disruption to the status 

quo and the desire to achieve as expeditiously as 

possible the full value of the anticipated gains of 

the new system, taking into account administrative 

costs. 

The dividend exclusion prototype could readily 

be phased in. The EDA would automatically limit 

the amounts of dividends excludable by shareholders to the amount of earnings taxed after enactment, although stacking distributions first against 

the EDA would tend to accelerate the benefits of 

integration. See Section 2.B. Additional rules 

distinguishing pre-enactment from post-enactment 

earnings would not be necessary. Because the 

dividend exclusion prototype requires relatively 

few changes to current law, the appropriate phasein period for that prototype might be relatively 

short, e.g., 3 to 5 years. Mechanically, a phase-in 

approach would allow a corporation to pay 

excludable dividends .to the extent of its EDA 

balance but would limit additions to the EDA to 

reflect the phase-in, e.g., amounts based on 25 

percent of corporate taxes paid in the first year 

after enactment, 50 percent in the second year, 

and so on." 
91 Principal Issues 

In contrast, a phase-in of the shareholder 

allocation prototype appears complex. Attributing 

a portion of corporate tax to shareholders in a 

manner that would increase the portion of corporate income so taxed over time, would require a 

complex system for tracking corporate income and 

making share basis adjustments, for example, to 

determine how subsequent distributions of phasein years' earnings would be taxed. On balance, if 

a shareholder allocation system were desired, it 

might be preferable to enact the system in its 

entirety with a delayed effective date. A delayed 

effective date would have effects similar to a 

phased-in effective date in reducing transition 

gains and losses, would allow taxpayers an opportunity to plan for the shift, while avoiding the 

complexity of a phase-in of the shareholder 

allocation prototype. l2 

The CBIT prototype generally eliminates the 

investor level tax on dividends and interest and 

disallows the interest deduction to corporations 

and other CBIT businesses. In addition to the 

transition gains and losses that might occur under 

the other integration prototypes, under CBIT 

lenders to CBIT entities might enjoy an increase 

in the value of existing debt with the elimination 

of tax on interest received. The magnitude of the 

increase would depend on a variety of factors, 

including the remaining term of the debt. From 

the borrower's perspective, the disallowance of 

interest deductions would effectively increase the 

cost of borrowing for corporations unable to call 

their bonds or otherwise refinance their debt.13 

CBIT, therefore, should probably be phased in 

over a longer period than would be appropriate 

for the dividend exclusion prototype. Longer 

phase-ins have greater effect in reducing transition 

gains and losses. Because, as detailed in Chapter 4, a CBIT regime will continue to have cemh 

types of includable interest (such as interest on 

Treasury securities) even when fully phased in, 

proportionate adjustments during the phase-in 

period would add complexity but should not 

create insurmountable recordkeeping problems for 

investors. 

Although eliminating the interest deduction 

ultimately could make certain limitations on 

interest deductibility applicable to CBIT entities 

unneces~ary,'~they 'would remain important 

during the phase-in period. Indeed, a phase-in of 

CBIT may require some strengthening of rules to 

prevent acceleration of interest deductions to 

earlier years of the phase-in, as well as deferral of 

interest income into later years of the phase-in. 

Transition rules also would have to address the 

timing mismatches that arise where interest has 

been deducted by the payor but not yet included 

in income by the lender or where interest has 

been included by the lender but not yet deducted 

by the payor. Alternatively, transition to CBIT 

could be accomplished by beginning with implementation of the dividend exclusion prototype. 

1O.D MECHANICS OF A PHASE-IN 

Dividend Exclusion Prototwe. A dividend 

exclusion could be phased in over 4 years, for 

example, by crediting the EDA with an increasing 

percentage of the fully phased-in EDA amount in 

each transition year, Le., 25 percent of the 

formula amount in the first year, 50 percent in the 

second, 75 percent in the third. Offsetting revenues could be phased in on the same schedule. By 

limiting additions to the EDA at the corporate 

level, shareholder level phase-in will not be 

required. However, only 25 percent of income 

taxed at the corporate level in the first year could 

be distributed tax-free to shareholders. Distributions in excess of this amount, like other distributions in excess of the EDA, would be taxable to 

the shareholder. 

CBIT. CBIT is self-financing through the 

disallowance of the entity level interest deduction. 

Accordingly, the CBIT phase-in must coordinate 

the dividend and interest exclusions for shareholders with entity level interest disallowance. For 

each year of the CBIT phase-in, the EDA would 

be credited with an increasing percentage of the 

fully phased-in EDA amount and the same percentage of corporate interest deductions would be 

disallowed, Le., 10 percent in the first year, 
Principal Issues 

20 percent in the second, etc.. In addition, it 

wo&d be necessary to credit the EDA with. an 

additional amount equal to the phase-in percentage 

for the year multiplied by the sum of the allowable interest deduction for the year plus interest 

paid during the year but deducted in a year before 

phase-in begins.” Absent this adjustment, the 

CBIT compensatory tax or investor level tax on 

distributions in excess of the EDA would treat 

allowable interest like a preference and the income it offsets would be taxed when distributed. 

Unlike the dividend exclusion prototype, CBIT 

requires investor level phase-in to mitigate and 

smooth portfolio shifts during the phase-in period. 

Thus, debtholders would exclude 10 percent of 

interest received from a CBIT entity in the first 

year while shareholders would exclude 10percent 

of dividends received. 

Example 1. A CBIT entity earns $109 of gross 

income and has $10 of interest expense in the first 

year of a 10 year phase-in of CBIT. If the CBIT 

phase-in percentage were 10 percent, the CBIT 

entity would deduct $9 of interest ($10 minus (10 

percent of $10)). It would thus have taxable income 

of $100 and pay CBIT of $31. 

The amount added to the entity’s EDA is $7.80, 

computed as follows:16 

$6.90 (10% of ($31/.31-$31)) 

+.90 (10% of $9 interest allowed as a 

deduction) 

$7.80 

Debtholders would be entitled to exclude $1.00 of 

the $10.00 in interest they receive, thereby reducing the EDA to $6.80.17 If the entity distributed 

its remaining after-tax earnings of $68 ($109 minus 

$10 interest minus $31 tax) to shareholders, shareholders could exclude $6.80 from income, thereby 

reducing the EDA to zero. 

Example 2. The facts are the same as in Example 

1 except that the entity made no distribution to 

shareholders in the first year and it has identical 

income and interest in the second year. Thus, it has 

$109 of gross income and is allowed an $8 interest 

deduction, resulting in $101 of taxable income. 

92 

The entity’s EDA is computed as follows: 

$ 6.80 (balance of EDA from year 1) 

13.94 (20%of ($31.31/.31-$31.31))I, 

1.60 (20% of $8 interest allowed) 

$22.34 

Debtholders in this year would be entitled to 

exclude $2.00 of the $10.00 in interest they receive, reducing the EDA to $20.34. If the entity 

distributed its $68 in. after-tax earnings from year 

1 plus its $67.69 in after-tax earnings from year 2 

($109 minus $10 interest minus $31.31 tax), 

shareholders would be entitled to exclude 20 

percent of the $135.69 dividend or $27.14. This 

amount exceeds the EDA balance of $20.34 because only 10 percent of the earnings from year 

one are reflected in the EDA. To compensate for 

the 20 percent exclusion at the shareholder level, a 

31 percent compensatory tax of $2.11 is imposed 

on the $6.80 differential. (Thus, the differential 

amount is treated like retained earnings from preCBIT years.) 

Example 3. The facts are the same as in Example 

1, except that the entity earns $20 in preference 

income in addition to the $109 in gross income. 

Thus, its after-tax earnings available for distribution to shareholders in year 1 would be $88 ($68+ 

$20). If it distributed the entire $88 in year 1, 

shareholders could exclude 10 percent of that 

amount, or $8.80. As a result, a 31 percent compensatory tax of $.62 is imposed on the $2.00 by 

which the shareholder exclusion exceeded the EDA 

balance ($8.80-6.80). This amount also is 10 

percent of the entity”s preference income. 

As the foregoing examples indicate, a uniform 

investor level phase-in of CBIT could be more 

easily accomplished if the prototype includes a 

compensatory tax. If CBIT does not include a 

compensatory tax, and instead investors are 

subject to tax on preference and sheltered foreign 

source income, a phase-in might be accomplished 

by limiting the portion of dividends and interest 

that are excludable to the lesser of (1) the phasein percentage multiplied by the amount of the 

payment and (2) the EDA balance. As a consequence, all payments would be excludable up to 

the phase-in percentage to the extent of the EDA, 

and all payments thereafter would be taxable. 
PART IV: THE ROADS NOT TAKEN 

INTRODUCTION 

Under an imputation credit system, a shareholder would be taxed on the gross amount of a 

dividend, including both the cash dividend and the 

associated tax paid at the corporate level. The 

shareholder would receive a credit equal to the 

amount of corporate tax associated with the gross 

dividend. From an individual shareholder's viewpoint, this system would mean that the corporate 

tax on earnings distributed as dividends would 

generally resemble the current withholding tax on 

wages and salaries. An employee includes gross 

wages in his taxable income and receives a credit 

against tax liability equal to the amount of tax 

withheld by the employer. Because of the prevalence of imputation credit systems abroad, such a 

system would facilitate international coordination 

of corporate tax regimes, especially in the context 

of bilateral treaty negotiations.' We therefore had 

expected to recommend an imputation credit 

system as our preferred form of distributionrelated integration. 

After a close examination of the imputation 

credit system, reflected in Chapter 11, we determined that its principal advantage is its flexibility 

to respond to different policy judgments on the 

most important issues of integration. For example, 

an imputation credit can extend the benefits of 

integration to tax-exempt and foreign shareholders 

by allowing refundability of imputation credits or 

it can deny such benefits by denying refunds. Its 

major drawback is its complexity in creating an 

entirely new regime for taxing corporate 

dividends. On balance, we concluded that the 

dividend exclusion prototype set forth in Chapter 

2 was the preferable distribution-related integration alternative because it would implement our 

policy recommendations, including such issues as 

the treatment of preferences and tax-exempt and 

foreign shareholders, in a substantially simpler 

manner. 

An imputation credit system may not be the 

most straightforward distribution-related integration alternative even if policymakers were to 

choose policy goals different from ours. A dividend deduction system, described in Chapter 12, 

also would be simpler than an imputation credit 

system if policymakers chose to extend the benefits of integration to tax-exempt and foreign 

shareholders. 

93 
CHAPTER 11: hIPUTATION CREDIT SYSTEM 

1l.A OVERVIEW OF IMPUTATION 

CREDIT PROTOTYPE 

In producing this Report, we looked carefully 

at the integration systems of other countries. See 

Appendix B. The imputation credit prototype set 

forth in this chapter is the one we consider to be 

most consistent with our policy recommendations. 

It closely resembles the system that New Zealand 

adopted in 1988. 

Mechanics. Corporations would continue to 

determine income under current law rule and pay 

tax at a 34 percent rate. Shareholders receiving a 

distribution treated as a dividend would include 

the grossed-up amount of the dividend in 

incomeincluding both the amount of cash 

distributed and the imputation credit allocated to 

the dividend-and could use the credit to offset 

their tax liability. The credit would be nonrefundable; it could reduce tax liability to zero, 

but would not produce a refund. Credits would be 

allowed only for taxes paid after the effective date 

of the proposal. 

Allowing a credit for the full amount of 

corporate tax paid with respect to distributed 

earnings would eliminate the corporate level tax 

if the shareholder’s tax rate at least equals the 

corporate rate. Even if the shareholder rate were 

less than the corporate rate, the corporate tax 

could be eliminated if the credit were allowed 

against tax on other income or as a refund. Currently, the maximum statutory rate for individual 

shareholders (31 percent) is less than the corporate rate of 34 percent. Thus, if the credit were 

computed at the full corporate rate, most shareholders could shelter other income from tax or 

claim refunds. This need not be permitted, however, if the goal of the imputation credit prototype 

is simply to ensure that distributed earnings that 

are taxed at the corporate level are not taxed 

again to shareholders. Accordingly, rather than 

allowing a credit for the full amount of corporate 

tax paid on a distribution, the prototype computes 

the amount of the credit at the 31 percent maximum shareholder rate. This approach does not 

eliminate the corporate level tax. However, it 

would generally permit shareholders to pay no 

additional tax on distributions of corporate eamings that have already been taxed fully at the 

corporate level, while ensuring that shareholders 

taxable at the maximum individual rate do not use 

excess credits to shelter other income from tax or 

to claim refunds.’ Section ll.B explains how 

taxes paid at the corporate rate are converted into 

imputation credits at the shareholder rate. 

A corporation would maintain an account of 

its cumulative Federal income taxes paid, computed as though its taxable income had been subject 

to tax at a rate of 31 percent (the shareholder 

credit account or SCA). A corporation could elect 

to attach a credit to a dividend (frank the dividend) in any amount, provided it does not exceed 

the lesser of (1) the adjusted corporate level tax 

(computed at the 31 percent rate) on the pre-tax 

earnings that generated the dividend (the grossedup dividend),2 or (2) the balance in the SCA.3 

The corporation would reduce its SCA balance by 

the amount of credits used to frank dividends and 

by refunds of corporate tax. It would increase its 

SCA by payments of corporate tax and by credits 

attached to dividends received from other 

corporations. 

Tax-Exempt Shareholders. The prototype 

would effectively retain the current level of 

taxation of income earned on corporate equity 

supplied by tax-exempt shareholders. The credit 

would be nonrefundable, and fully-taxed income 

distributed to tax-exempt shareholders would 

continue to bear one level of tax: the corporate 

tax. Preference income distributed to tax-exempt 

shareholders generally would continue to be 

untaxed both at the corporate and shareholder 

level. 

Corporate Shareholders. The dividends received deduction would be increased to 100 

percent for all intercorporate dividends, and any 

imputation credits attached to a dividend would be 

added to the recipient corporation’s SCA. 

95 
The Roads Not Taken 96 

Tax Preferences and Foreign Source Income. 

By adding only U.S. taxes to the SCA and requiring that imputation credits be paid out of the 

SCA, the prototype ensures that the credit is 

allowed only to the extent of U.S. corporate tax 

payments. By generally allowing corporations to 

decide how much credit to attach to a particular 

distribution, the prototype allows a corporation to 

treat distributions as coming first from fully-taxed 

income and then from preference income and 

foreign source income shielded from U.S. tax by 

foreign tax credits. The prototype does not impose 

a compensatory tax on distributions out of preference or shielded foreign source income. Therefore, the prototype permits a corporation to make 

distributions out of preference or shielded foreign 

source income without incurring additional corporate level tax liability. However, shareholders 

may not claim credits with respect to such distributions. This results in distributed preference 

income and shielded foreign source income 

continuing to be subject to the same level of 

taxation as under present law. 

Foreign Shareholders. The prototype also 

retains the current law treatment of foreign shareholders. The credit would be nonrefundable to 

foreign shareholders, absent treaty provisions to 

the contrary, and dividends would be subject to 

U.S. withholding tax to the same extent as under 

current law. 

Anti-abuse Rules. The imputation credit 

prototype generally permits a corporation to frank 

dividends in any amount (subject to a maximum), 

even if they have a remaining SCA balance. This 

treatment is more liberal than the dividend exclusion prototype, which requires corporations to pay 

fully excludable dividends (equivalent to fully 

franked dividends) until their EDA is exhausted. 

Permitting this additional flexibility in the imputation credit prototype may require additional antiabuse rules to prevent corporations from attaching 

credits to distributions to taxable shareholders and 

not attaching credits to distributions to 

shareholders with low or zero U.S. tax liability, 

such as tax-exempt and foreign shareholders. See 

Section 11.F.4 

CaDital Gains and Share Repurchases. Chapter 8 discusses the treatment of capital gains on 

sales of corporate stock and the treatment of share 

repurchases. 

Structural Issues. The prototype generally 

maintains current law rules for corporate acquisitions, although new rules would be needed to 

govern the carryover or separation of corporations' SCA balanceasin acquisitive and divisive 

reorganizations. 

ImDact on tax distortions. Table 11.1 illustrates the impact of the imputation credit prototype on the three distortions integration seeks to 

address: the current law biases in favor of corporate debt over equity finance, corporate retentions 

over distributions, and the noncorporate over the 

corporate form. The only difference between the 

current law treatment of nonpreference, U. S. 

source business income and its treatment under 

the imputation credit prototype is on corporate 

equity income distributed to individual investors. 

The prototype would reduce the tax rate on such 

income to t, (when ti=tF) or a lower rate (when 

c<t,,,), but as long as t,>tF, the rate will be 

greater than 4. Thus, while the rate on corporate 

equity income distributed to individuals would be 

reduced, it would still be higher than the rate (t,) 

imposed on noncorporate equity income and on 

interest. It would be lower, however, than the rate 

on undistributed corporate equity income. Some 

bias toward debt finance and the noncorporate 

form would remain, while the bias toward corporate retentions would tend to be reversed, in the 

absence of a DRIP. 'See Chapter 9 and Section 

11.1. For tax-exempt and foreign investors, there 

would be no change in the tax treatment of nonpreference, U. S, source income. 
1l.B CHOICE BETWEEN A 

CREDIT LIMITATION 

SYSTEM AND A 

COMPENSATORY 

TAX SYSTEM 

Introduction 

As set forth in Chapter 5, this Report 

recommends that integration not become 

an occasion for extending the benefit of 

corporate tax preferences to shareholders. In implementing this decision in an 

imputation credit system, the most 

significant choice is between a shareholder credit limitation system (in which 

tax is collected only at the shareholder 

level on distributed preference income) 

or a compensatory tax system (in which 

a tax, creditable by shareholders, is 

collected at the corporate level on 

distributed preference income). The 

choice between a credit limitation system 

and a compensatory tax system also is 

influenced by the policy recommendations set forth in Chapters 6 and 7 not to 

eliminate the corporate level tax on 

earnings distributed to tax-exempt and 

foreign shareholders and not to treat 

identically U.S. corporate level taxes 

paid and foreign taxes on corporations' 

foreign source income. These policy 

recommendations imply that imputation 

credits should not be refundable to taxexempt or foreign shareholders and that 

foreign corporate level taxes should not 

be creditable by shareholders. 

97 The Roads Not Taken 

Table 11.1 

To1:a1U.S.Tax Rate on a Dollar of NonPreference,

U.S.Source Income from a U.S.Business 

Under Current Law and an 

Imputation Credit Prototype 

Imputation 

Credit 

Type of Income Current Law Prototype 

I. Individual Investor is Income Recipient 

Corporate Equity: 

Distributed t, +(1-t.)t, [(l-utc +ti -ti"]/( 1-ti")

Undistributed t,+(l -tjtg 

Noncorporate Equity ti 

Interest ti 

Rents and Royalties ti 

E. Tax Exempt Entity is Income Recipient 

Corporate Equity: 

Distributed tC 

Undistributed tC 

Noncorporate Equity tC 

Interest 0 

Rents and Royalties 0 

IU.Foreign Investor is Income Recipient 

Corporate Equity: 

Distributed tc+(1-tc>twr, 

Undistributed tC 

Noncorporate Equity twN 

Interest twl 

Rents and Royalties twR 

Department of the Treasury 

office of TS policy ­

tc = U.S. corporate income tax rate. 

ti = U.S. individual income tax rate. 

tim = Maximum U.S. individual income tax rate. 

tg = U.S. effective individual tax rate on capital gains. 

tm, twN,tw, t, = U.S. withholding rates on payments to 

foreigners of dividends, noncorporate equity income, business 

interest, and rents and royalties, respectively. Generally varies 

by recipient, type of income, and eligibility for treaty 

benefits, and may be zero. 

The choice between a credit limitation system addition, because the dividend exclusion prototype 

and a compensatory tax system may differ de- applies only to corporate equity, a compensatory 

pending upon the kind of integration mechanism tax would tend to increase the incentive for 

adopted. For example, in the dividend exclusion corporations with preference income to issue debt 

prototype, we chose to follow a credit limitation- rather than equity to tax-exempt and foreign 

type approach and to tax distributed preference investors. For similar reasons, we adopt a credit 

income only at the shareholder level. This allows limitation approach in the imputation credit 

adoption of the dividend exclusion prototype with prototype. 

minimal changes from current law and would 

continue current law treatment of dividends paid Experience in other countries makes clear that 

out of preference or foreign source income. In an imputation credit system can accommodate 
The Roads Not Taken 98 

either a credit limitation or a compensatory tax, 

however. Australia and New Zealand, for example, adopted credit limitation systems, while 

France, Germany, and the United Kingdom 

adopted compensatory tax system^.^ 

Comparison of a Compensatory Tax 

and Credit Limitation 

Under current law, preference income distributed to tax-exempt shareholders is not subject to 

tax at either the corporate or the shareholder 

level. If a compensatory tax were imposed on 

preference income at the corporate level and not 

made refundable to tax-exempt shareholders, a 

compensatory tax would impose an additional tax 

on such income.6 Similarly, under current law, 

preference income distributed to foreign shareholders is subject only to the 30 percent withholding tax (often reduced to as little as 5 percent by 

treaty). If distributed preference income were 

subject to a compensatory tax at the corporate 

level and the imputation credits could not be used 

against the foreign shareholders’withholding tax, 

the net tax burden on that income would increase. 

A similar problem arises with distributions of 

foreign source income earned by a U.S. corporation and taxed abroad. As discussed in Chapter 7, 

this Report recommends that foreign taxes remain 

creditable at the corporate level, but that foreign 

taxes not be treated the same as U.S. taxes paid in 

determining imputation credits. Under such a 

rule, distribution of foreign source income that 

has not borne any residual U.S. tax would be 

fully taxable at the shareholder level, as under 

current law. A nonrefundable compensatory tax 

on distribution of foreign source income shielded 

from U.S. corporate tax by foreign tax credits 

would increase the tax burden on distributions of 

such income to foreign and tax-exempt shareholders relative to the burden on such income under 

current law. 

Because of the additional corporate level tax 

imposed by a nonrefundable compensatory tax on 

preference and foreign source income distributed 

to tax-exempt or foreign shareholders, the compensatory tax and credit limitation systems have 

very different implications for corporations that 

currently pay little U.S. tax, due either to substantial use of tax preferences or to foreign tax 

credits. Under current law these corporations 

incur little or no United States corporatelevel tax, 

but the dividends paid do bear a shareholder level 

tax (except in the case of tax-exempt 

shareholders). 

A credit limitation system allows corporations 

to continue to pay dividends out of preference or 

foreign source income without incurring any 

additional corporate level tax. In contrast, a 

compensatory tax system would require such 

corporationsto pay an extra corporate level tax in 

order to maintain their current level of dividend 

payments. In practical terms, a compensatory tax 

may create an extra tax cost for corporations 

engaged in tax-favored activities, such as research 

and experimentation and oil and gas exploration7 

and may affect large multinational corporations 

doing business in high-tax foreign jurisdictions, 

such as certain European countries. In addition, 

U.K. experience with a nonrefundable compensatory tax suggests that corporations that would be 

subject to such taxes will engage in tax planning 

behavior to avoid its burdens. Nevertheless, a 

compensatory tax does promote simpler administration, since it collects tax on distributed corporate preference or foreign source income at the 

corporate level.* 

The extent to which additional tax burdens 

would be created by a compensatory tax system 

depends on the method for determining when a 

distribution is made out of income that has not 

borne U.S. tax.’ A stacking rule that treats all 

distributionsas having borne tax at the full corporate rate (to the extent possible based on total 

corporate tax paid) may mitigate the impositionof 

a compensatory tax. If distributions do not exceed 

fully-taxed income, no compensatory tax is due. 

Choice of a particular stacking rule also affects 

both the revenue effects of distribution-related 

integration and corporate incentives to pay dividends. In this and other prototypes, we have 

consistently rejected a stacking rule that would 

treat dividends as made first from preference 

income, and we have been unable to discover any 
99 

country that stacks preferences first in its distribution-related integration system. Although that rule 

would reduce the revenue loss from adoption of 

distribution-related integration, it also would 

discourage payment of dividends.lo Most foreign 

systems stack preferences last. See Appendix B. 

A credit limitation system may be somewhat 

more complex to administer than a compensatory 

tax system, because it requires shareholders to 

apply a different rate of gross-up and credit for 

each distribution from each corporation. In contrast, under a compensatory tax, all distributions 

from all corporations are subject to gross up and 

credit at the same rate. From the shareholder's 

point of view, however, a credit limitation system 

may not be significantly more complicated. Under 

either system, the shareholder must compute tax 

using two pieces of information-the amount of 

the cash dividend and the associated credit (also 

used to compute the grossed-up dividend). The 

only necessary difference between the two systems is that under a compensatory tax system the 

credit rate can be provided by instructions to the 

tax form, while under a credit limitation system it 

would have to be provided by information returns, 

which may reflect differing amounts of credit for 

different corporations and in different years. 

Both compensatory tax systems and credit 

limitation systems have posed problems for 

countries that have adopted them. For example, 

the United Kingdom imposes a compensatory tax 

by collecting Advance Corporation Tax (ACT) on 

all distributed earnings at the time of distribution. 

ACT is then creditable against regular tax." The 

United Kingdom has found that many corporations 

with a large amount of preference or foreign 

source income have built up substantial excess 

ACT accounts rather than reduce their dividend 

payments. The likelihood of excess ACT accounts 

has led to tax planning efforts to avoid imposition 

of compensatory taxes and the existence of excess 

ACT accounts promotes efforts at trafficking in 

tax attributes. However, credit limitation systems 

have had problems in creating and enforcing 

effective antistreaming rules. Both the Australian 

and New Zealand systems contain an extensive 

network of such rules. 

The Roads Not Taken 

On balance, we believe that a credit limitation 

system is preferable to a compensatory tax in both 

the imputation credit prototype and the dividend 

exclusionprototype. In both cases, a credit limitation system would permit corporations to maintain 

their current dividend policy without the imposition of additional corporate level tax. 

Mechanics of a Shareholder Credit 

Limitation System 

Under the imputation credit prototype, corporations would keep track of cumulative taxes paid 

by maintaining a Shareholder Credit Account 

(SCA)-an account of cumulative creditable taxes 

paid. A corporation would be allowed to attach a 

credit to a dividend (frank the dividend) in any 

amount, up to a limit. The credit attached could 

not exceed the lesser of (1) an amount equal to 

the product of (a) the distribution and (b) the ratio 

of the current maximum shareholder tax rate to 1 

minus the current maximum shareholder tax rate, 

or (2) the balance in the SCA. The corporation 

would reduce the balance in the SCA by the 

amount of credits used to frank dividends and 

refunds of corporate tax and increase the SCA by 

payments of corporate tax (including estimated 

tax) and imputation credits attached to dividends 

received. 

For example, consider a corporation with 

taxable income of $100. Assuming a 34 percent 

corporate tax rate and a 31 percent shareholder 

rate, it would pay a tax of $34 and have $66 

available for distribution. The corporation would 

add $29.65 to its SCA account. The amount 

added to the SCA is determined using the 

following formula: 

Annual additions to SCA = 

[ - 11 [ tax paid for tax*b1eyear - U.S. tax paid for taxable year1 + imputation credits on dividends received 

This is the amount of tax that would fully frank, 

at the 31 percent shareholder rate, the 

corporation's actual after-tax income of $66 

($100-$34).l2 
The Roads Not Taken 100 

If the corporation distributed a cash dividend 

of $33, the corporation could elect to frank the 

dividend in any amount up to $14.83 (determined 

by multiplying the amount of the distribution by 

.4493 (the shareholder rate divided by one minus 

the shareholder rate). The corporation would 

reduce the SCA by the amount of the credit. 

Thus, if the corporation chose to fully frank the 

dividend, the shareholder would report as income 

the gross dividend of $47.83 ($33 plus $14.83) 

and claim a credit of $14.83 against the individual 

tax. If the $14.83 credit exceeded the shareholder 

level tax imposed on the $47.83 gross dividend, 

a low-bracket shareholder could use the excess 

credit to offset tax imposed on other income. For 

example, a shareholder in the 31 percent bracket 

would incur tax liability on the gross dividend of 

$14.83 (.31 X$47.83) and would receive a credit 

of $14.83, exactly offsetting the tax due. A 

shareholder in the 15 percent bracket would incur 

tax liability on the gross dividend of $7.17 

($47.83 X 15 percent) and would receive a credit 

of $14.83, leaving an excess credit of $7.66 to 

offset other tax liabilit~.’~ 

The imputation credit prototype requires 

corporations to report annually to each shareholder and to the IRS the amount of dividend distributions to shareholders and the associated imputation 

credits. The imputation credit prototype also 

requires corporations annually to report to the IRS 

the adjustments to and balance in the SCA. This 

would permit the IRS to verify aggregate allowable credits to a corporation based on the amount 

of taxes paid and to compare the allowable 

amount with credits reported by shareholders. 

A liquidating corporation would distribute the 

remaining balance in its SCA among shareholders 

in proportion to the amount of other assets distributed to them. As with any other distributions for 

which imputation credits are allowed, the amount 

of the shareholder credit would be included in 

income and could be used to offset gain on the 

liquidation or, in the case of excess credits, other 

income. 

The imputation credit prototype, like the 

dividend exclusion prototype, treats adjustmentsto 

prior years’ tax liability as adjustments made in 

the current year.14 Thus, an increase in corporate 

tax liability for a prior year would result in an 

increase in the SCA for the year of the audit 

adjustment. A decrease in a prior year taxliability 

could give rise to a refund, but only to the extent 

of the current balance in the SCA. Any excess 

amount would be carried forward to be applied 

against future corporate taxes.15 

This method ensures that an adjustment that 

affects a corporation’s prior year tax liability 

would not affect shareholders’ individual tax 

positions for the prior year. Shareholders may 

thus claim the credits reported to them as allowable by the corporation, without concern that 

subsequent corporate level adjustments might 

require them to file amended retums.16 

The imputation credit prototype allows corporations to carry back losses to claim refunds only 

to the extent of any balance in their SCA, with 

the SCA being reduced by the amount of the 

refund. This limitation prevents corporations from 

carrying back losses in order to obtain a refund of 

taxes that already have served to reduce shareholders’ taxes through imputation credits attached 

to dividends.17 Any unused losses can be carried 

forward as under present 1aw.l’ 

The prototype generally permits corporations 

to choose the extent to which dividends are 

franked, with the consequence that there is no 

need for a mandatory stacking rule. This flexibility allows a corporation with preference or foreign 

source income to continue to determine its dividend policy by weighing the business reasons for 

maintaining a particular level of cash distributions 

against the possible detriment to shareholders of 

receiving unfranked dividends. In contrast, the 

dividend exclusion prototype requires excludable 

dividends to be paid until the EDA balance is 

exhausted. This is equivalent to an imputation 

credit system that requires corporations to pay 

fully franked dividends to the extent of the SCA. 

Permitting the additional flexibility to pay partially franked dividends requires anti-abuse rules in 

addition to those adopted in the dividend exclusion prototype to prevent corporations from 
101 

paying franked dividends to taxable shareholders 

and unfranked dividends to tax-exempt shareholders. See Section 11.F. 

Corporate Shareholders 

The imputation credit prototype allows a 

corporate shareholder a 100 percent dividends 

received deduction (DRD) for both franked and 

unfranked dividends, regardless of the degree of 

affiliation." Moving to a single level of tax 

under integration does not require increasing the 

DRD to 100 percent for unfranked and partially 

franked dividends. The dividend exclusion prototype, for example, retains current law for taxable 

dividends. See Section 2.B. The imputation credit 

prototype contains a 100 percent DRD for all 

dividends, however, because retaining current law 

for partially franked dividends would create 

unwarranted complexity.20 

As under current law, the DRD would be 

available for dividends from domestic corporations and for a portion of dividends from certain 

foreign corporations engaged in business in the 

United States. Any imputation credit associated 

with a dividend would be added to the corporation's SCA. Adding the credit to the corporate 

shareholder's SCA preserves imputation credits 

for individual shareholders when the earnings are 

ultimately distributed out of corporate solution. 

Because the 100 percent DRD would be 

equally available for fully franked and unfranked 

dividends, distributions of corporate preference 

income would be taxed only when ultimately 

distributedto individual shareholders. Mechanically, this result occurs because unfranked dividends 

do not increase the recipient's SCA.21Retaining 

the DRD for preference income is consistent with 

the rationale for a credit limitation system discussed above. Requiring immediate taxation in 

full of preference income received by corporate 

shareholders would represent a significant departure from current law and would increase the cost 

of intercorporate dividends. Preserving the DRD 

means that the ultimate taxability of preference 

income is determined at the individual level.22 

The Roads Not Taken 

Other countries adopting distribution-related 

integration have dealt with the issues presented by 

affiliated groups in 9 variety of ways. In most 

cases, these countries have permitted the extension of preferences while the income remains in 

corporate solution, as we suggest here. For 

example, New Zealand generally exempts intercorporate dividends from taxation and corporate 

shareholders are permitted to add credits from 

franked dividends to their own SCA. Similar rules 

apply in Australia for dividends received by 

public corporations and for franked dividends 

received by private corporations from within the 

same closely held group. In the United Kingdom, 

although the intercorporate dividends are generally subject to ACT, a "group dividend election" 

can be made to avoid the ACT and the imputation 

of credits with respect to distributions between 

closely affiliated corporations. See Appendix B. 

1l.C ROLE OF THE 

CORPORATE ALTERNATIVE 

MINIMUM TAX 

Under current law, the corporate alternative 

minimum tax (AMT)seeks to ensure that, in each 

taxable year, corporations pay a minimum amount 

of tax on their economic income. A corporation 

must pay the higher of the AMT or the regular 

tax liability on its alternative minimum taxable 

income (AMTI) for the taxable year. Congress 

adopted the corporate AMT system in 1986partly 

in response to widely publicized reports of major 

companies not paying taxes in years in which they 

reported substantial earnings and, in some cases, 

paid substantial dividends to shareh01de1-s.~~ 

The imputation credit prototype retains the 

corporate AMT.u Because the imputation credit 

prototype described here does not substantially 

alter the current treatment of either retained or 

distributed preference income, the AMT would 

continue to serve itsaxrent function of limiting 

corporate tax preferences and ensuring that 

corporations continue to pay some minimum 

amount of tax on retained income.25 

Since some corporations are subject only to 

the AMT and pay no regular corporate tax for 
The Roads Not Taken 102 

long periods, the question whether the AMT 

should be considered taxes paid and added to the 

SCA is important. For these taxpayers, the corporate AMT is the only tax paid, and, despite the 

current law provisions that allow the AMT to be 

credited against regular corporate tax in subsequent years, it would not be realistic to view the 

AMT simply as an advance deposit against ultimate corporate tax liability. We therefore treat the 

AMT in the same manner as regular corporate 

taxes paid. Thus, each dollar of AMT is converted into an SCA balance using the formula set 

forth in Section ll.B.26At the corporate level, 

any AMT paid would continue to be carried 

forward and credited against regular corporate tax 

in subsequent years, but regular corporate tax that 

is not paid by reason of the credit allowed for 

AMT previously paid would not be treated as tax 

paid. Accordingly, under the prototype, both 

regular taxes paid and AMT paid would be added 

to the SCA, and regular tax that is offset by the 

AMT credit would not be added to the SCA. If 

the AMT were not treated as taxes paid, distributions attributable to earnings that have been 

subject to AMT would be taxed twice, and a 

higher rate of tax would be imposed on preference 

activities. However, if distributions are made with 

shareholder credits arising from payments of 

AMT,such reductions in the SCA will reduce the 

corporation’s ability to pay franked dividends 

when the AMT reverses and the corporate tax is 

reduced by AMT credits. 

1l.D FOREIGN SOURCE INCOME 

In general, the prototype permits a U.S. 

corporation to claim foreign tax credits against 

corporate tax to the same extent as under current 

law. A U.S. corporation, however, would increase its SCA only by the amount of the residual 

U.S. tax (if any) imposed on its foreign source 

income. Distributions out of foreign source 

income shielded from U.S. corporate tax by 

foreign tax credits generally would be unfranked 

and, therefore, would be taxed at the shareholder 

level as under present law. 

Thus, U.S. corporate shareholders owning less 

than 10 percent of a foreign corporation’s voting 

stock (the threshold requirement for claiming an 

indirect foreign tax credit under IRC 0 902)

would include in income, as under current law, 

dividends from the foreign corporation and claim 

a foreign tax credit for foreign withholding taxes. 

The corporate shareholder, however, would not 

add foreign income taxes paid by the foreign 

corporation or foreign withholding taxes on 

dividends to its SCA. 

U.S. corporate shareholders owning at least 10 

percent of a foreign corporation’s voting stock 

would continue to include in income dividends 

from the foreign corporation and to claim a 

foreign tax credit for foreign withholding taxes on 

the dividend as well as foreign taxes paid by the 

foreign corporation. The corporate shareholder 

would add to its SCA only the U.S. residual tax, 

if any, paid on the dividend.27 

U.S. corporations with foreign branch operations would continue to be subject currently to 

U.S. tax on their worldwide income with a credit 

for foreign income taxes imposed thereon.28As 

with earnings of foreign subsidiaries, the U.S. 

corporation would increase its SCA only by the 

amount of any residual U.S. tax imposed on the 

foreign source income. 

The imputation credit prototype does not 

change the treatment of individuals owning stock 

in foreign corporations. U. S. individual shareholders would continue to include in income 

dividends received and claim a foreign tax credit 

for any foreign withholding taxes imposed on the 

dividend. Individual shareholders would not 

receive an imputation credit for any income taxes 

paid by the foreign corporation. 

In connection with treaty negotiations with 

countries that have imputation credit systems, the 

United States may wish to consider whether 

imputation credits for foreign taxes paid could be 

extended on a bilateral basis. Serious complexities 

would arise, however, in applying at the individual shareholder level the foreign tax credit limitations that are designed to ensure that foreign taxes 

paid are not credited against U.S. taxes at tax 

rates in excess of the applicable domestic tax rate. 
103 

On the other hand, ignoring the foreign tax credit 

limitation would reduce or eliminate U.S. taxes 

on U.S. source income, in effect transferring 

domestic revenues to foreign treasuries. A possible approach might be to extend the benefits of 

foreign corporate taxes paid to individual U.S. 

shareholders in the form of a shareholder level 

exclusion of foreign source corporate income. 

Even in this event, care would need to be taken to 

avoid inappropriate result^.^' 

1l.E CHOICES REQUIRED

BECAUSE OF 

SHAREHOLDERS WITH 

DIFFERENT RATES 

Tax-Exempt Shareholders 

As discussed in Chapter 6, this Report recommends that integration retain the current treatment 

of corporate income distributed to tax-exempt

shareholder^.^' Corporate taxable income would 

continue to bear one level of tax. Corporate 

preference income and foreign source income 

shielded from U.S. corporate tax by foreign tax 

credits would continue to be exempt from U.S. 

tax at both the corporate and shareholder level to 

the extent distributed to tax-exempt shareholders. 

Imputation credits could not be used against UBIT 

liability.31 

Foreign Shareholders 

Chapter 7 of this Report recommends that 

foreign shareholders making inbound investments 

should not by statute receive the benefits of 

integration available to U.S. shareholders, and 

that any such extension of the benefits of integration should occur only through treaties. Accordingly, the imputation credit prototype does not 

permit foreign shareholders to claim a refund of 

the imputation credit or to use the credit to offset 

withholding tax imposed on dividends. The 30 

percent statutory withholding tax would continue 

to apply to the amount of the dividend without 

gross up, subject to applicable treaty reductions. 

The branch profits tax would continue to apply to 

U.S. branches of foreign corporations. Thus, a 

U.S. branch of a foreign corporation would be 

The Roads Not Taken 

taxable on its income effectively connected with 

a U.S. business (subject to any available treaty 

exemptions), and the branch’s earnings withdrawn 

from the U.S. business (the dividend equivalent 

amount) would be subject to the branch profits tax 

under IRC 0 884(a) (as modified by any applicable treaty), without credit for U.S. taxes paid on 

effectively connected income. 

Denying imputation credits to foreign shareholders follows the approach generally adopted by 

our trading partners that have integrated corporate 

tax systems. Althoughthe imputation credit would 

not be available to foreign shareholders as a 

statutory matter, a dividend to a foreign shareholder would reduce the distributing corporation’s 

SCA by the same amount as if the distribution had 

been to a taxable domestic hareh holder.^^ 

Low-Bracket Shareholders 

The imputation credit prototype uses a rate of 

31 percent to compute the shareholder credit. 

Consequently, taxpayers subject to maximum tax 

rates below 31 percent would receive imputation 

credits on dividends received that may exceed the 

shareholder level tax that would otherwise apply 

to dividends received. Unlike the dividend exclusion or CBIT prototypes, no additional mechanism 

(such as addition of a credit) is required to adjust 

the tax burden to the shareholder’s rate because 

the franking process provides the shareholder with 

the data necessary to compute shareholder level 

tax (the grossed-up income and credit amounts). 

The prototype allows these taxpayers to use 

excess imputation credits to offset tax that would 

otherwise apply to unfranked dividends or other 

sources of income. This feature of the imputation 

credit system produces an additional revenue loss 

in comparison to the dividend exclusion prototype. Taxpayers who could not fully use such 

credits against other income could not claim a 

refund of the excess 

1l.F ANTI-ABUSE RULES 

Adopting an imputation credit system in which 

imputation credits are not refundable to taxexempt and foreign shareholders may create 
The Roads Not Taken 104 

incentives for taxpayers to "stream" fully franked 

dividends to taxable shareholders and unfranked 

dividends to tax-exempt shareholder^.^^ Similar 

incentives arise under the dividend exclusion 

prototype, in which corporations would prefer to 

pay excludable dividends to taxable shareholders 

and taxable dividends to tax-exempt shareholders. 

Section 2.B discusses the anti-abuse rules we 

consider appropriate to limit streaming in the 

dividend exclusion prototype, and we would adopt 

similar rules in the imputation credit prototype. 

Thus, for example, a holding period requirement 

would have to be met for a taxpayer to claim an 

imputation credit. 

In general, opportunities for streaming would 

be reduced if the imputation credit prototype 

required corporations to pay fully franked dividends until their SCA balance were exhausted. In 

that case, the imputation credit system would be 

substantially similar to the dividend exclusion 

system, which requires corporations to pay 

excludable dividends to the extent of their SCA 

balances.35 

Application of this rule in an imputation credit 

context, however, could interfere with corporate 

dividend practices by making the franking level 

(and hence shareholder tax consequences) of 

dividend distributions dependent on taxable income. To permit corporations to smooth the 

pattern of dividends, including the pattern of 

associated credits, the prototype permits corporations to pay partially franked dividends. Using 

this flexibility, a corporation could reserve a 

portion of its SCA balance to pay future franked 

dividends. 

Because the imputation credit prototype permits corporations to pay partially franked or 

unfranked dividends even when they have an SCA 

balance sufficient to frank the dividend fully, two 

additional anti-abuse rules would be required. 

First, to prevent excessive franking of dividends, 

the prototype limits the amount of credit that can 

be attached to a dividend. The imputation credits 

attached to any dividend should not exceed the 

maximum creditable tax on the pre-tax earnings 

that generated the dividend. See Section 11.B. 

Second, the prototype requires corporations to 

frank all dividends paid during a year to the same 

extent. This rule prevents corporations from 

paying unfranked dividends on one class of stock 

held by taxable shareholders and unfranked 

dividends on another class of stock held by taxexempt shareholders. This rule is essentially the 

same as that adopted by New Zealar~d.~~ This 

latter rule, while necessary to avoid distortion of 

corporate dividend payment practices, could give 

rise to significant complications for a corporation 

with multiple classes.of dividend paying stock. 

1l.G STRUCTURAL ISSUES 

Corporate Acquisitions 

The imputation credit prototype retains the 

basic rules of current law governing the treatment 

of taxable and tax-free corporate asset and stock 

acquisitions. Adopting the imputation credit 

prototype would permit taxable asset acquisitions 

to be made with only a single level of tax. Corporate tax paid on gain recognized on the sale of 

assets would be added to the SCA and would 

create imputation credits to offset shareholder tax 

when the corporation liquidatesand distributes the 

proceeds from the sale. Stock acquisitions may 

face a higher tax burden than asset acquisitions 

under distribution-related integration if capital 

gains on corporate stock that are attributable to 

retained earnings are taxed in full at shareholder 

rates. See Section 8.A. This problem could be 

mitigated by a dividend reinvestment option. See 

Chapter 9. 

Nothing in the movement to distributionrelated integration would require a fundamental 

change in the basic pattern of taxing qualifying 

corporate reorganizations. Current law treats a 

qualifying corporate reorganization as tax-free at 

the corporate level (with the target's tax attributes, including its asset basis, carrying over to the 

acquiror) and at the shareholder level. The policy 

underlying the reorganization provisions is that 

imposition of tax is inappropriate where a corporate reorganization merely effects a readjustment 

of shareholders' continuing interests in corporate 

property under modified corporate forms. This 
105 

policy applies equally under distribution-relation 

integration, because it reflects a judgment about 

when income should be recognized under a realization-based tax system that does not require 

corporate assets or stock to be marked to market, 

not a judgment about whether two levels of tax 

should be imposed on recognized corporate 

income.37 

Rules would be needed to divide a corporation's SCA when it engages in a divisive reorganization. Rules are needed to discourage the use 

of divisive reorganizations to isolate amounts in 

the SCA in one corporation for the benefit of one 

group of shareholder^.^' Current law rules generally provide that earnings and profits of the 

distributing corporation in a divisive reorganization that qualifies as a D reorganization under 

IRC 0 368(a)(l)(D) are divided between the 

distributing corporation and the controlled corporation based on the relative fair market value of 

their assets. A similar rule could be adopted to 

govern the allocation of SCA balances in divisive 

reorganizations. 

For the reasons set forth in Chapter 2, we do 

not urge any rules limiting the use of SCA balances following an ownership change. See "Antiabuse Rules" in Section 2.B. 

Earnings and Profits 

The imputation credit prototype, like the 

dividend exclusion prototype, retains the current 

eamings and profits rules for determining when a 

distribution is treated as a dividend rather than a 

return of capital. See Section 2.F. 

1l.H EXTENDING THE 

IMPUTATION CREDIT 

PROTOTYPE TO DEBT 

Adopting any of the methods of integratingthe 

corporateand individualincometaxes discussed in 

this Report would narrow significantly the differences in taxation of debt and equity. Under 

integration, only one level of tax generally would 

be imposed on corporate earnings distributed as 

dividends. Retaining the interest deduction also 

The Roads Not Taken 

ensures that no more than one level of tax is 

collected on corporate earnings distributed as 

interest. Accordingly, the introduction of integration, without any change in the rules for taxing 

debt, would create greater parity in the taxation of 

debt and equity. 

Because the dividend exclusionand imputation 

credit prototypes are designed to retain the existing level of corporate taxes on equity capital 

supplied by foreigners and tax-exempt entities, 

however, some disparities will remain in the 

treatment of debt and equity capital supplied by 

those investors. Retaining the interest deduction in 

an integrated system would permit earnings that 

are used to pay interest to tax-exempt and certain 

foreign bondholders to continue to escape U.S. 

tax entirely. 

Thus, for tax-exempt and foreign investors at 

least, the dividend exclusionand imputation credit 

prototypes generally maintaincurrent law's bias in 

favor of debt financing. Eliminating this bias is a 

principal argument for CBIT, which represents a 

natural extension of the dividend exclusion prototype to debt and imposes tax once at the entity 

level. Equating the treatment of debt and equity in 

an imputation credit prototype would require a 

different approach-a bondholder imputation 

credit system. 

Under a bondholder credit system with no 

corporate level deductionfor interest, the mechanics would generally follow the rules applicable to 

dividends. Corporate tax paid on earnings used to 

pay interest or dividends would be passed through 

to bondholders and shareholders as imputation 

credits. Bondholders and shareholders would 

include in income the amount of the cash interest 

or dividend payments plus the imputation credits 

and could use the credits to offset tax on interest 

income.39 Tax-exempt and foreign shareholders 

would not be entitled to claim refunds of imputation credits, and taxable shareholders could use 

excess credits to offset tax on other income but 

not to claim refund^.^' 

A bondholder credit system differs in certain 

ways from CBIT, which equates the treatment of 
The Roads Not Taken 106 

debt and equity at the business, rather than at the 

individual, level. An imputation credit system 

would tend to impose taxation on the supplier of 

business financial capital rather than on the entity. 

The two approaches are similar when the business 

and its suppliers of capital would be taxed at the 

same rates but will diverge if the tax rate of the 

supplier of capital is different from the CBIT 

rate.41 Thus, for example, if both borrower and 

lender are taxable, but the lender’s rate is less 

than the borrower’s rate, CBIT will tax the 

interest income at the CBIT rate, while the bondholder credit system will generally tax the income 

at the lender’s rate.42 

Although the bondholder credit system would 

generally mirror the imputation credit prototype 

detailed in this chapter, addition of a bondholder 

credit may require reexamination of the treatment 

of foreign investors. The issues would be similar 

to those posed in moving from the dividend 

exclusion prototype to CBIT. Retaining current 

law would require collecting two levels of tax on 

dividends and zero or one level of tax on interest. 

Such treatment would, however, violate the 

equality between debt and equity that is the goal 

of adopting a bondholder credit system. Accordingly, to maintain parity between debt and equity, 

imputation credits should not be refundable to 

foreign investors, but the 30 percent withholding 

tax now applicable to dividends and nonportfolio 

interest (and the branch profits tax) should be 

repealed.43 

11.1 DIVIDEND REINVESTMENT 

PLANS (DRIPS) 

Chapter 9 discusses how a corporation might 

use an elective DRIP in the dividend exclusion 

and CBIT prototypes to allow shareholders to 

increase share basis to reflect earnings that have 

been taxed at the corporate level. A DRIP minimizes the extent to which taxing capital gains on 

sales of corporate stock imposes a second level of 

tax on such earnings. See Chapter 8. 

An elective DRIP could be made a part of an 

imputation credit prototype as well. A corporation 

would be permitted to declare deemed dividends 

up to the amount that can be fully franked by the 

balance in its SCA.44Shareholders would include 

in income the amount of the deemed dividend plus 

the associated imputation credit and could use the 

credit to offset tax due.45 Share basis would 

increase by the amount of the deemed 

dividend.46 

Permitting a DRIP in the imputation credit 

prototype requires one additional rule to limit 

streaming of credits. As discussed in 

Section 11.F, the prototype limits streaming 

through cash dividends by requiring each corporation to frank all cash dividends paid during a year 

in the same proportion (the consistency 

The consistency rule is necessary because the 

imputation credit prototype, unlike the dividend 

exclusion and CBIT prototypes, permits corporations to determine the extent to which dividends 

(and interest payments, if a bondholder credit 

were adopted) are franked. 

Absent additional restrictions, a corporation 

could use a DRIP to stream by paying unfranked 

cash dividends on classes of stock held by taxexempt shareholders and fully franked deemed 

dividends on classes of stock held by taxable 

shareholders. To limit this practice, the prototype 

permits corporations to use an elective DRIP only 

if all cash dividends paid during some defined 

period before and after the deemed dividend are 

fully franked. This rule effectively extends the 

consistency rule to deemed dividends and limits 

the benefits of a DRIP to corporations that pay 

insufficient cash dividends to carry out its SCA 

balance-not those that underfrank cash dividends 

and distribute the remainder of the SCA through 

the DRIP.48 
CHAPTER 12: OTHER PROPOSALS TO REDUCE THE 

BIASAGAINSTCORPORATEEQUITY 

12.A DIVIDEND DEDUCTION 

We have not developed a dividend deduction 

prototype in this Report. However, the 1984 

Department of the Treasury Report on tax reform 

recommended a 50 percent dividends paid deduction and the President's 1985tax proposals included a 10 percent deduction.' A dividend deduction 

system produces results contrary to our general 

recommendations that integration not be the 

occasion for eliminating the corporate level tax 

imposed under current law on distributions to taxexempt and foreign shareholders. We view these 

general recommendations as important in ensuring 

that corporate income distributed to such shareholders continues to bear tax similar to that under 

current law. In addition, a dividend deduction 

proposal would be substantially more expensive 

than either a dividend exclusion or imputation 

credit ~ystem.~ 

The primary arguments for a dividend deduction approach are that it results in equivalent 

treatment for debt and equity and that it taxes 

distributions at the shareholder rate. The first 

claim is not strictly accurate to the extent that 

interest is deductible as it accrues while dividends 

are deductible only when paid.4 The second claim 

is correct but will exacerbate the bias toward 

distribution of earnings inherent in any distribution-based system, particularly when, as under 

current law, the corporate rate exceeds individual 

rates. 

If policymakers were to select a dividend 

deduction system, it would be important to incorporate a mechanism analogous to the EDA of the 

dividend exclusion prototype to limit the amount 

of deductible dividends to the amount on which 

U.S. corporate tax has been paid.5 Absent such 

a restriction, a dividend deduction system would 

allow a deduction for dividends paid out of preference income and foreign source income sheltered 

from U.S. tax by foreign tax credits. Allowing 

such deductions would not simply eliminate 

corporate taxes paid on that income (because, by 

definition no U.S.corporate taxes have been paid) 

but instead would permit the corporation to shelter 

earnings on which U.S. corporate tax would 

otherwise be impo~ed.~ 

It is not altogether clear how a dividend 

deduction system would treat foreign shareholders. Presumably, the deduction would be allowed 

for dividends paid to foreign shareholders, and the 

30 percent withholding tax on dividends would be 

retained, although treaty provisions reduce the 

withholding tax to as low as 5 percent. Similarly, 

the branch profits tax on domestic branches of 

foreign corporations presumably would be retained with a modification to provide parity with 

the dividend deduction for domestic corporations, 

Since dividends would be taxable only to the 

recipient in a dividend deduction proposal, there 

would be no dividends received deduction for 

corporations.' A DRIP probably would not be 

appropriate in a dividend deduction approach 

because it could result in allocation of taxable 

income to shareholders without receipt of cash 

sufficient to satisfy the shareholder's resulting tax 

liability.' 

While we have not developed a dividend 

deduction prototype in this Report, we review 

below two proposals for dividend deduction 

systems, one made in 1991 by the Capital Taxes 

Group of the Institute for Fiscal Studies in the 

United Kingdom and one made in 1989 by the 

Reporter for the American Law Institute's Federal 

Income Tax Project (Subchapter C). These proposals are not presented here as fully as other 

integration prototypes but are included as related 

proposals intended to improve the neutrality of the 

tax treatment of debt and equity finance for 

corporations. 

107 
The Roads Not Taken 108 

12.B INSTITUTE FOR FISCAL 

STUDIES PROPOSAL 

The Capital Taxes Group of the British Institute for Fiscal Studies (IFS) proposed the introduction of an "Allowance for Corporate Equity" 

(AFCE).' Under this approach, a corporation 

would be allowed to deduct in its calculation of 

taxable income an allowance based on shareholders' equity employed in the business. The 

intent of this proposal is to enhance neutrality by 

treating equity finance like debt finance.'' 

The deductible AFCE allowance would be 

equal to the product of "shareholders' funds" 

(generally the corporation's total equity capital)" 

and an "appropriate nominal interest rate." The 

interest rate used for calculating the AFCE would 

be set by the government for all corporations and, 

in general, should reflect a normal market rate of 

return. The IFS recommends that the rate be 

established each month equal to the rate for a 

medium-term government security. Because fms 

with risky opportunities or facing informational 

imperfections in capital markets would have costs 

of funds significantly higher than the allowable 

rate for deduction, mature, less risky fms would 

receive a greater relative benefit from the AFCE 

system. 

The AFCE system prevents double counting of 

intercorporate investments by reducing shareholders' funds by the amount of funds invested in 

other fms. It also prevents allowance of both an 

interest deduction and an AFCE allowance with 

respect to intercorporate equity investments 

funded by debt by imputing a negative AFCE 

adjustment to the borrower. l2 

The AFCE proposal is designed to operate in 

a classical corporate tax system to reduce the tax 

bias against equity finance. The IFS proposal is 

not a true integration proposal. Corporate equity 

income in excess of the AFCE allowance would 

remain subject to a second level of tax when such 

income is distributed or when shareholders are 

taxed on capital gains attributable to such income. 

As a consequence, the IFS proposal would not 

eliminate the bias against the corporate form and 

the incentive to retain rather than distribute 

corporate equity income in excess of the AFCE 

allowance. 

12.C AMERICAN LAW INSTITUTE 

REPORTER'S STUDY DRAJT 

In 1989, the Reporter for the American Law 

Institute (ALI) Federal Income Tax Project 

(Subchapter C) outlined a set of four proposals for 

reform of the corporate tax.13 The Reporter's 

Studv Draft proposals are not integration proposals. They are intended to revise the classical 

corporate tax system to reduce the tax bias against 

new equity finance and to eliminate the tax bias 

against dividend distributions relative to nondividend distributions, e.g., share repurchases. 

The latter goal would be accomplished by increasing tax rates applied to nondividend distributions 

rather than by decreasing tax rates applied to 

dividend distributions. 

The Reporter's Studv Draft advances two 

proposals to reduce the tax bias against new 

equity finance. First, corporations would receive 

a deduction for dividends paid on new equity 

capital (Qualified Contributed Capital or 

QCC).14 The deduction would be equal to a 

prescribed interest rate multiplied by net contributed capital less extraordinary dividends and 

nondividend distributions. The prescribed interest 

rate for deductions would be limited to the longterm borrowing rate specified under IRC § 1274, 

plus 2 percent. 

Second, the Reporter's Study Draft would 

limit corporate interest deductions to the net 

amount of debt capital raised. In particular, no 

deduction would be allowed for interest on "converted equity," including debt incurred to finance 

an extraordinary dividend or stock acquisition, 

share repurchase, or any other nondividend 

distribution. The deduction allowed for interest on 

any other type of debt also would be limited to 

the long-term borrow.ing rate specified under IRC 

5 1274 plus 2 percent. 
109 The Roads Not Taken 

Taken together, these two proposals are 

designed to reduce the tax bias against new equity 

finance.l5 

The concern over the taxbias against dividend 

distributions relative to nondividend distributions 

motivates the other two proposals in the 

Reporter's Study Draft. First, the ALI Reporter 

proposes a "minimum tax on distributions" 

(MTD) equivalent to 28 percent of the gross 

amount of any extraordinary dividend or nondividend distribution, including distributions in 

redemption and liquidation and any purchase of 

shares. The tax would be collected by the distributing corporation, and would be creditable against 

a shareholder's tax on the distribution (but not 

against other income).l6 

Second, in the case of direct investments in a 

corporation by another corporation, the Reporter's 

Study Draft would treat a purchase of shares in a 

corporation by another corporation that owns at 

least 20 percent of the shares as a nondividend 

distribution subject to the MTD and other applicable rules. However, intercorporate dividends 

would not be subject to tax, and basis adjustments 

similar to those provided under the current consolidated return regulations would be made. For 

portfolio investments, on the other hand, the 

investor corporation .would be taxed in full like 

any other investor and no dividends received 

deduction would be allowed." 

The Reporter's Study Draft proposals would 

reduce the tax bias against new equity finance, 

while maintaining the tax bias against dividend 

payments from accumulated equity. The economic 

assumptions underpinning the ALIproposals seem 

to be those of the "new view" of dividend taxation, in which the taxes on dividends from accumulated equity are capitalized into share values 

and do not affect dividend decisions. As a result, 

extending dividend relief to accumulated equity is 

perceived as conferring a windfall gain to "old" 

equity, since under the assumptions of the new 

view, dividend distributions are unavoidable. As 

discussed in Chapter 13, we accept the "traditional view," in which reducing the tax burden on 

dividends generally increases dividend payouts 

and economic efficiency.l8 
PART V: ECONOMIC ANALYSIS OF INTEGRATION 

CHAPTER 13: ECONOMIC EFFECTS OF INTEGRATION

13.A INTRODUCTION AND 

SUMMARY 

This chapter presents quantitative estimates of 

the impact of the integration prototypes developed 

in the Report on the allocation of resources, 

corporate financial policy, portfolio allocation, 

and Federal tax revenues. 

We examine the effects of each integration 

prototype using four alternative models of the 

economy and two assumptions about how integration would be financed. Results differ from model 

to model, as well as by financing assumption, but, 

in general, the integration prototypes reduce the 

tax penalty on corporate investment and encourage 

capital and other resources to flow into the corporate sector. Depending on the prototype, model, 

and financing assumption, this capital expansion 

ranges from a 2 to 8 percentage point increase in 

the capital stock used in the corporate sector. In 

dollar terms, this ranges approximately from $125 

billion to $500 billion in additional corporate 

capital. CBIT generally produces the largest 

expansion of corporate capital, but in several of 

the calculations, the more traditional integration 

prototypes yield a similar expansion. 

In addition, each of the integration prototypes 

generally encourages corporations to use less 

debt. Estimated debt to asset ratios decrease by 1 

to 7 percentage points, depending upon the model, 

financing assumption, and prototype. CBIT is the 

best prototype for encouraging firms to reduce 

their relative use of debt. 

The integration prototypes encourage corporations to increase the portion of earnings distributed as dividends. Both CBIT and the shareholder 

allocation prototype promote efficient corporate 

dividend policy by almost entirely eliminating 

taxes as a consideration. In contrast, the distribution-related prototypes encourage fms to pay out 

more of their earnings as dividends than may be 

optimal. Depending on the model, financing 

assumption, and prototype, nominal dividend 

payout ratios would increase by 2 to 6 percentage 

points. 

By shifting resources into the corporate sector, 

reducing corporate borrowing, and encouraging 

dividends, the integration prototnes generate 

changes in economic welfare. Overall, the prototypes improve economic welfare in all calculations, and the improvement ranges from an 

amount equivalent to 0.07 percent of annual 

consumption (total consumer spending on goods 

and services) to an amount equivalent to 0.73 

percent of consumption, or from approximately 

$2.5 billion to $25 billion per year. CBIT or 

shareholder allocation prototypes generally contribute the greatest increases in welfare, but the 

distribution-related prototypes also produce significant economic welfare gains. Much of the variation in results reflects differences in the models 

used to analyze the prototypes or differences in 

financing assumptions, rather than differences 

among prototypes. Indeed, one striking feature of 

the calculations is that within each model, and for 

a given financing assumption, structurally different prototypes often have similar overall effects 

on economic well-being. These results accord 

with the general economic equivalence of basic 

integration prototypes in the absence of distortions 

induced by rate differentials demonstrated in 

Appendix C. 

The results summarized above are generated 

from models of the economy that abstract from 

international capital flows. While internationally 

mobile capital can cause tax law changes to have 

different effects from those predicted by closedeconomy models, there is no consensus among 

economists regarding the sensitivity of international flows of debt and equity capital to changes in 

net returns, especially for a country such as the 

United States with a very large domestic 

economy. Consequently, the Report does not 

111 
Economic Analyses 112 

present a detailed quantitative analysis of integration in an international context, although the 

effects of the integration prototypes on international capital flows and portfolios are discussed in 

Section 13.F. The distribution-related and shareholder allocation prototypes are estimated to have 

only a small effect on the net capital flows into 

the United States; the effects of CBIT are more 

uncertain. Each integration prototype, however, 

may change substantially the composition of 

international portfolios, even if net flows of 

capital are not greatly affected. 

Section 13.Banalyzes the principal economic 

issues surrounding the debate over the benefits of 

corporate tax integration, building on the discussion in Chapter 1. Section 13.C describes important methodological issues in modeling effects of 

integration on economic efficiency, Section 13.E 

evaluates effects of integration on the cost of 

capital and corporate financial decisions. A more 

complete analysis of economic effects of integration using a set of computable general equilibrium 

models is provided in Section 13.F. Issues relating to distributional implications of integration are 

discussed in Section 13.G. Finally, estimates of 

integration prototype’s effects on Federal tax 

revenue are presented in Section 13.H. 

13.B CORPORATE TAX 

DISTORTIONS: ECONOMIC 

ISSUES 

Bias Against Investment in 

Corporate Form 

The waste of economic resources from the 

tax-induced misallocation of capital between the 

noncorporate and corporate sectors was the 

original focus of economists’ criticism of the 

classical corporate income tax system. Beginning 

with Harberger (1962), economists have argued 

that a classical corporate tax system increases the 

share of capital allocated to the noncorporate 

sector, thereby raising pre-tax required rates of 

return in the corporate sector. 

Harberger’s model divides the economy into 

two sectors, a corporate sector and a noncorporate 

sector, The Harberger model has four central 

assumptions. First, in both sectors, output is 

produced by combining capital and labor. Second, 

the total amounts of capital and labor supplied in 

the economy are fixed. Third, although the total 

amounts of capital and labor supplied are fixed, 

the amounts supplied to each sector can vary. 

Fourth, suppliers of capital and labor seek to 

maximize their incomes. 

Taken together, the third and fourth assumptions above have an important implication: In the 

long run, the net return on the last dollar of 

capital in each sector must be the same, since 

suppliers of capital invest their capital where its 

net return is highest. As a result, capital will flow 

out of the sector with a low net return and into 

the sector with the high return. This flow continues until net rates of return are equalized between 

the two sectors. 

Over the years, more sophisticated versions of 

Harberger’s model have been developed to examine more carefully the costs of the economic 

distortions related to the corporate income tax. 

One important step was the development of more 

complex models with many sectors of the economy.’ Most recently, researchers have noted that 

economic distortions from the corporate income 

tax are greater than earlier estimates to the extent 

that the tax distorts the relative importance of 

corporate and noncorporate producers within an 

industry.2 Costs associated with this additional 

margin of distortion arise when corporate and 

noncorporate producers within an industry have 

different advantages, for example, greater ability 

to exploit scale economies by corporations or 

greater entrepreneurial skill in noncorporate 

organizations. 

Current U. S.taxlaw distorts the allocation of 

investment away from the economy’s corporate 

sector and into the noncorporate sector whenever 

investors require equity to finance investment. 

The corporate cost of equity capital generally 

exceeds the noncorporate cost of capital because 

of the two-level tax on corporate equity income. 

Consequently, corporate investment projects 

require a higher pretax rate of return than projects 
-- -- 

113 Economic Analyses 

of noncorporate business enterprises. Therefore, 

some corporations fail to undertake investments 

that would be profitable if the tax burden on 

corporate and noncorporate investments were the 

same. Moreover, for some business enterprises, 

the added corporate taxes exceed the benefits of 

incorporation, and such businesses forego the 

advantages of incorporation and choose instead to 

operate as partnerships or sole proprietorship^.^ 

While the classical system may encourage 

corporations to operate in noncorporate form, 

aggregate data to date do not document a longterm trend of shifting economic activity away 

from the corporate sector. Figure 13.1 shows that 

incomes of owners of noncorporate businesses 

have fallen as consistently as a share of net 

national product as have corporate profits. By 

contrast, the total income (profits, interest, rents, 

and wages) generated in the corporate sector has 

increased slightly, from an average of 50 percent 

of net national product in the 1950sto an average 

of 53 percent in the 1980s (Figure 13.2). Other 

long-term comparisons of corporate activity to the 

general economy also fail to present any general 

net income accounted for only 3 percent of total 

corporate net income, up only slightly from 2.1 

percent in the previous decade. Data for 1987and 

1988,in contrast, indicate a substantial increase in 

S Corporation net income to 8.6 percent of all 

corporate income in 1987 and 9.5 percent in 

1988.7 This increased S corporation activity 

seems to be a response to the 1986 Act's inversion of the top individual and corporate tax rates 

and repeal of the capital gains rate preference.* 

A measure of the bias against equity investment in a corporation that pays dividends is the 

extent to which the combination of the corporate 

tax rate on earnings and the individual tax rate on 

dividends exceeds the individual tax rate on 

business income. In the case of equity investments 

in a corporation, retained earnings are taxed 

ultimately at the shareholder level as capital gains. 

Accordingly, the measure of the bias against 

equity investment in the corporate sector in that 

case is the extent to which the combination of the 

corporate tax rate and the individual capital gains 

rate exceeds the effective individual tax rate on 

business income. 

pattern of disincorporationO5However, data for 

the past few years (some of 

it preliminaq) does suggest 

reduction in the size of the 

corporate sector relative to 

the overall economy and to 

the noncorporate sector.6 

Subchapter S corporations have accounted for an 

increased share of corporate 

profits and have contributed 

to the declining role of the 

corporate income tax, 

particularly since 1986.The 

Subchapter S Revision Act 1 % -

b of 1982 increased the PI 

attractiveness of S corporations and led to an 

expansion of S corporation 

activity. However, in the 4 

years following the 1982 

amendments, S corporation 

Fi re 13.1 

Profits of No,fg"mancial Corporations, Proprietors' Incomer and Net Interest as a 

Percentage of Net National Product, 1950-1990 

Nonfinancial Corps.Net Interest ,*--.-- ______ /I-­

/-- /--___I ~ _--____-- ,- '_' __.___- ____---- ____--------- __.--- Proprietors' Net Interest 
- - - 

Economic Analyses 114 

figure 13.2 

Measures of Corporate Activity in the Economy 1950-1990 

60% 

8

fl8 55% 

PI 

50% . 

r* \I \I 

45% 

corporate investments. The 

overall effect depends upon 

whether the combination of 

the corporate tax rate and 

the effective capital gains 

rate is greater than, equal 

to, or less than the individual tax rate on business 

income. Even when realized capital gains are taxed 

at the same rate as ordinary 

income, the effective capital gains rate is generally 

lower than the statutory 

rate, because the capital 

gains tax can be deferred 

until gain is realized 

1950 1955 1960 1965 1970 1975 1980 1985 1990 through a sale or exYlXU change." In an extreme 

case, if the combination of ..-. -.- Corporatestoss Domestic product as a pacentage of Gaoss Domestic product the corporate tax rate and ---. Nonfinaucial Corporete Gross Domestic Productas a pacentage of Gross Domestic Rcduct capital gains rate is lower 

NC"cial Corporate Gross Domestic Product as a pacentage of Gross National Product than the individual rate, the 

classical system may actualCorporate Gioss Domestic Incomeaa a pntage of Net National Prcduct ly create a bias in favor of 

Source: National Income and Product Accounts, Bureau of investing in corporate 

Economic Analysis, US.Department of Commerce. equity." Currently, however, even a full exclusion 

Assuming a positive effective corporate tax 

rate, the classical system always creates a bias 

against investing in equity in a corporation that 

distributes all current earnings relative to a noncorporate investment. If the corporate tax rate 

were zero, corporate earnings would be taxed 

only at the shareholder rate, and therefore the bias 

against corporate equity would be eliminated.' 

That the corporate rate currently exceeds the 

individual rate does not create a new bias; it 

merely exacerbates a bias that is present whenever 

all current earnings are distributed and the corporate rate exceeds zero, regardless of its relationship to the individual rate. 

For equity investments in a corporation that 

retains earnings, differences among tax rates may 

reduce, eliminate, or even reverse the bias against 

from tax of capital gains on 

corporate shares would 

generally not eliminate the tax system's bias 

against equity investment in the corporate sector 

because the corporate rate exceeds the top 

individual rate. 

Two other features of the tax system currently 

reduce the tax bias in favor of noncorporate 

investments. First, the benefits of accelerated 

depreciation are somewhat greater for corporations, because corporate tax rates tend to exceed 

individual tax rates on shareholders and on noncorporate businesses. Second, to the extent that 

corporations finance investments through debt, the 

relative tax advantage afforded noncorporate fms 

is diminished. Considering only tax factors, 

corporate and noncorporate entities face the same 

cost of debt financed capital. Thus, to the extent 

corporations finance new investment with debt, 
115 

the difference in tax burden for total investment, 

both debt and equity financed, will be reduced. 

Bias Against Equity Finance 

The Tax Bias Against Equity 

The source of the bias against equity financing 

is similar to the source of bias against corporate 

investment described in the preceding section.12 

An investment in corporate equity is subject to tax 

once at the corporate rate and again at either the 

individual rate or the effective rate on capital 

gains. In contrast, interest earned on debt, like 

income from an unincorporated business, is 

subject to tax only at the investor’s rate. Consequently, equity funded projects generally require 

a higher pretax rate of return than projects 

financed with debt.l3 

Nontax Benejh and Costs of Debt Finance 

Chapter 1 discussed important nontax and tax 

considerations in corporate borrowing decisions. 

Central to the argument that the tax bias against 

equity finance distorts corporate financing decisions is the existence of nontax costs and benefits 

associated with corporate debt fmancing. If nontax 

costs of debt are signifrcant, losses in economic 

efficiency can accompany the greater debt levels 

resulting from the tax bias against equity finance. 

As corporate borrowing remained high during 

the 1980s, many nontax arguments for high debt 

financing appeared. Analysts most sanguine about 

the rise in debt financing typically maintain that 

debt is desirable because it gives suppliers of 

capital an indirect means to monitor the activities 

of managers. Their reasoning is that the need for 

supervision results from the separation between 

ownership and management that is characteristic 

of the traditional corporate structure. A conflict 

between ownership and management can emerge 

if it is difficult for suppliers of capital to observe 

and evaluate the activities of entrenched managers. In this kind of environment, management’s 

self interest may not always coincide with efficiently operating the business enterprise-with 

maximizing value.l4 

Economic Analyses 

In practice, increased debt financing may be 

an ineffective way to improve managerial incentives. It works best when most of the variation in 

an enterprise’s cash flow is specific to the fm.It 

works poorly when most of the variation is common across business enterprises (as with industrywide or business cycle fluctuations).l5 Thus, 

even when there are incentive benefits from debt, 

the most efficient financial arrangement will 

involve both debt and equity, with equity serving 

as a cushion against economywide fluctuations in 

profitability. 

Many academic and business economists have 

stressed the nontax costs of a declining reliance 

on equity finance. One concern is that the costs of 

financial distress and bankruptcies could be 

greater than in the past, more businesses with 

high debt financing. Firm level data illustrate the 

reason for this concern. Warshawsky has calculated weighted average, median, and ninetieth 

percentile values of (market-value) debt to asset 

ratios for fms in the COMPUSTAT Industrial 

and Full Coverage samples, over the period from 

1969 to 1988.16 As with the aggregate data discussed in Chapter 1, all statistics for the subsamples indicate a rising debt to asset ratio, 

though much of the increase occurred before 

1980. This measure can, of course, be distorted 

by large swings in the value of equities (as, for 

example, in 1973 and 1974). The debt to asset 

ratio has, however, climbed since 1983 in spite of 

significant increases in the value of equity.” 

Warshawsky also calculated the ratio of interest 

payments to cash flow for the individual business 

enterprises. Over the 1969-1988period, the mean 

and median value of the ratio virtually doubled; 

the value for the ninetieth percentile fms more 

than tripled. Much of the change occurred during 

the 1980s. In addition, the average quality of 

publicly issued debt (as measured by bond ratings) 

declined steadily in the 1980s. 

To put the macroeconomic concern in sharper 

perspective, Bernanke and Campbell considered 

the experiment of imposing a reduction in cash 

flows similar to those experienced during the 

1974-1975 recession on a sample of fms with 

financial conditions corresponding to 1986 data. 
Economic Analyses 116 

The sample was drawn from Standard and Poor's 

COMPUSTAT file, and therefore consisted 

primarily of large firms. The simulations implied 

that a downturn like 1974-1975would force more 

than 10 percent of the sampled fms into bankruptcy. Updates for later years in Bernanke, 

Campbell, and Whited and in Warshawsky yielded 

similar conclusions.l8 

What role have tax distortions played in tilting 

the balance between benefits and costs of different 

degrees of debt financing?" Under a tax system 

that treats equity finance unfavorably, fms are 

induced to have less equity outstanding, thereby 

lowering their "equity cushion" against business 

cycle risk, and raising the chance of incurring 

costs of financial distress during a future downturn.2o The tax distortion makes this decision 

rational for individual corporations but socially 

inefficient. 

Bias Against Corporate

Dividend Distributions 

The current system of corporate income 

taxation also may distort a corporation's choice 

between distributing or retaining earnings and, if 

amounts are distributed, whether they are paid in 

the form of a nondividend distribution, such as a 

share repurchase. There are two alternative 

explanations in contemporary corporate finance 

commonly known as the "new view" and the 

"traditional view"-of why corporations continue 

to pay dividends despite the high relative taxation 

of dividends compared with capital gains generated by reinvested earnings or share repurchases.21 

The traditional view asserts that dividends offer 

special nontax benefits to shareholders that offset 

their tax disadvantage. For example, dividends 

may provide signals to investors about a corporation's relative financial strength or future 

prospects.22Alternatively, high dividend payouts 

may reduce managerial discretion over internal 

funds (see the analogous discussion above of the 

incentive benefits of corporate debt financing). 

According to the traditional view, corporations set 

dividend payments so that, for the last dollar of 

dividends paid, the extra benefit of dividends 

equals their extra tax cost. Thus, the amount of 

dividends paid out is expected to decrease as the 

tax burden on dividends relative to capital gains 

increases. Dividend taxes also raise the cost of 

capital (and thereby lower investment) to the 

extent that corporations pay out earnings as 

dividends. Thus, the traditional view argues that 

raising dividend taxes will lower the dividend 

payout ratio and incentives for real investment. 

Moreover, under the traditional view, the need to 

maintain dividend payments constrains the use of 

retained earnings as corporations' marginal source 

of equity financing for new investments; instead, 

corporations frequently must turn to new equity 

issues. 

Under the new view, dividend payments offer 

no nontax benefits to shareholders relative to 

retentions.= The hypothesis further assumes that 

corporations have no alternative to dividends for 

distributing funds to shareholders. Given these 

assumptions, investor level taxes on dividends 

reduce the value of the fm,but do not affect the 

fm's dividend or investment policies. Since 

dividend taxes must eventually be paid, they are 

capitalized in share values, reducing share prices 

enough to compensate for the tax burden. In 

effect, a dividend tax acts as a lump-sum tax on 

equity existing when the tax is imposed, and on 

new equity contributions. Therefore, corporations 

prefer not to issue new shares to finance 

additional investment opportunities, Retained 

earnings and debt are preferred sources of funds. 

Dividends are determined as a residual after the 

fm undertakes all profitable investments. 

Consequently, a permanent change in the tax rate 

on dividends will not change a fm's investment 

policies or payout decisions.24 Although the 

dividend tax does not affect investment incentive~,~~ the capital gains tax affects investment 

incentives because retentions increase the value of 

a fm's shares and such appreciation is taxable as 

a capital gain.26 

The tax policy implications of the traditional 

and new views with respect to the taxation of 

corporate income are quite different. The new 

view assumes that the investor level taxes on 

distributions are capitalized into share values, 

with the consequence that (1) existing shares are 
117 Economic Analyses 

valued below the market value of corporateassets, 

so eliminating or reducing taxes on existing 

corporate assets would produce gains to current 

shareholders and (2) moving to a system that is 

more neutral in taxing retentions and distributions 

would not encourage corporations to pay more 

dividends.27 

In contrast, under the traditional view, where 

new funds rather than retained earnings provide 

the source of finance for additional investments by 

the corporation (1) shares should not sell at a 

price below corporate asset values despite the 

existence of the existing two level corporate tax 

system, so a major shift in the relative treatment 

of dividends and retentions should not create 

significant share price increases for current 

shareholders and (2) making the tax system more 

neutral between retentions and distributions would 

increase corporate dividend distributions and 

economic efficiency.28 

As discussed above, these differentviews have 

different theoretical implications about whether 

corporations will vary payout behavior in 

response to changes in the tax rate on dividends 

relative to the tax rate on capital gains. The 

traditional view regards differences in the tax rate 

on dividends relative to the tax rate on capital 

gains as a determinant of payout decisions; the 

new view does not. One way to resolve the 

controversy would be to determine how dividend 

payout ratios vary over time with the tax rate. 

Poterba has calculated that the average dividend 

payout ratio (the ratio of dividends to inflationadjusted after-tax profits) for U. S, corporations 

was 0.46 in the 1950s, 0.40 in the 1960s, and 

0.45 in the 1970s, but increased to 0.61 in the 

period from 1980 to 1986 during which the 

taxation of dividends was reduced relative to the 

taxation of capital gains.29Although this pattern 

tends to support the traditional view, it does not 

provide convincing evidence, because nontax 

factors also affect a corporation’sdividend policy. 

Statistical analysis of the determinants of dividend 

payment policy is required to determine the 

independent effect of dividend taxes on corporate 

payout behavior, and several studies have undertaken this task.30The studies use different data 

sources and methodologies, and estimates of the 

elasticity of the payout rate with respect to dividend taxation. Nevertheless, all of the studies 

conclude that dividend payout ratios do respond to 

changes in the tax rate on dividends.31Thus, this 

type of empirical evidence is consistent with the 

traditional view.32 

Corporations also distribute significant 

amounts of earnings to shareholders by 

repurchasing shares. This is inconsistent with the 

assumption underlying corporate fmancial policy 

under the new view. The tax consequences of a 

nondividend distribution, such as through a share 

repurchase, are significant: The shareholder is 

able to recover at least a portion of the cost of the 

shares free of tax, and gain on the sale is taxed as 

capital gain, which may be taxed at a rate lower 

than the ordinary income tax rate on dividends. 

Share repurchases have increased substantially 

in recent years. Shoven presents data suggesting 

that aggregate share repurchases increased from 

$1.2 billion in 1970 to $27.3 billion in 1985 (5.4 

percent and 32.7 percent of dividends, respectively). Data presented by Poterba show a similar 

pattern. Share repurchases increased from $1.8 

billion in 1976 to $43 billion in 1985 (5.0 percent 

of dividends and 50 percent of dividends, respectively) .33 Department of the Treasury calculations reveal that share repurchases rose from $5.5 

billion in 1980 (10 percent of dividends) to $48.8 

billion in 1985 (57 percent of dividends), peaking 

at $65.8 billion in 1989 (47 percent of dividends). 

In 1990, corporate share repurchases totaled 

$47.9 billion (34 percent of dividend^).^^ 

To summarize, the principal distinction between the two views of corporate dividend policy 

for our purposes relates to their assumptions about 

nontax benefits of alternative corporate fmancial 

policies. The new view assumes that dividends 

offer no nontax value to shareholders relative to 

retained earnings. Underlying the traditional view 

is the idea that information and incentive 
Economic Analyses 118 

problems in financial markets make particular 

corporate financial policies valuable for nontax 

purposes.35 

The present U.S. tax system treats retained 

earnings more favorably than dividends. Alternatively, given the potential nontax benefits of 

dividend distributions, one might consider reversing this bias by impoeing relatively higher taxes 

on retained earnings using, for example, an 

undistributed profits tax. However, this approach 

would disadvantage corporationsfacing high costs 

of external finance relative to internal finance for 

nontax reasons. Such financing cost differentials 

could arise from the transaction costs of issuing 

securities or from problems of asymmetric 

information between corporations and capital 

markets.36 

Effects on Savings and Investment 

The corporate tax increases the tax burden on 

the returns from saving and investing. Taxes on 

capital income generally reduce capital formation. 

Because of the importance of international capital 

flows, which reflect the possibility of investing 

abroad if U.S. investment opportunities are not 

sufficientlyattractive (or, conversely,the possibility of increased investment in the United States by 

foreign investors ifopportunities are more attractive here), the corporate tax may have a larger 

effect on U.S. investment than on U.S. savings. 

The magnitudes of tax-induced distortions of 

investment and savings decisions depend on (1) 

the size of the wedge between pre-tax and aftertax returns and (2) the responsiveness of savers 

and investors to changes in after-tax returns. The 

more responsive savers and investors are to 

changes in taxes, the larger the effect of a tax 

wedge of a given size.37 

In a closed economy, domestic saving equals 

domestic investment, and the average cost of 

capital summarizes tax incentives to save as well 

as to invest. International capital flows break the 

equivalence of domestic saving and investment, 

however. Consider the case of perfect international capital mobility. Domestic investmentwould be 

governed by the pre-tax return needed to cover 

taxes and the worldwide opportunity cost of 

funds. At the same time, domestic saving depends 

on the after-tax retum to investor, eamed from 

investing at the world rate of return. Domestic 

investment would thus depend on domestic corporate level taxes, although domestic saving would 

depend only on domestic individual level taxes. 

More broadly, in the presence of international 

capital flows, the U.S. corporate income tax can 

reduce incentives to invest in the United States, 

even if it has a relatively small effect on saving 

by U.S. citizens. 

13.C METHODOLOGICAL ISSUES 

IN ANALYZING THE 

ALLOCATION EFFECTS OF 

INTEGRATION 

The Importance of Using a 

General Equilibrium Model 

By distorting incentives, the classical corporate tax system produces an inefficient allocation 

of resources. The size of the inefficiency depends 

in part on how the households’ and corporations’ 

decisions respond to changes in the tax system. 

For example, the more responsive dividend 

distributions are to tax considerations, the greater 

the financial inefficiency induced by the double 

tax on dividends. The analysis of the economic 

effects of integration is complicated by behavioral 

effects in one market that can affect other markets. For example, if the corporate tax tends to 

drive capital out of the corporate sector, prices 

and rates of return in the noncorporate sector are 

affected. 

Thus, to assess the economic consequences of 

integration, one must analyze how the various 

markets in the economy operate and interact with 

each other. Economists have responded to this 

challenge by constructing computer representations of the economy and using these representations to simulate how the economy would respond 

to various changes in the tax system. These 

representations of the economy are called computable general equilibrium (CGE) models.38 
119 Economic Analyses 

The Advantage of 

Using Several Models 

As with all economic models, the results 

generated by a CGE model depend on underlying 

assumptions about how the economy operates. 

Since there is no consensus regarding a single best 

set of assumptions, this Report analyzes integration proposals using four different CGE models. 

This procedure assures that the findings are not 

associated with a particular modeling ~trategy.~' 

The general equilibrium models used to 

evaluate integration are detailed representations of 

the U.S.economy and its actual (and proposed) 

tax system. Nonetheless, all the models abstract 

from some important details of both the economy 

and the tax system. For example, none of the 

models captures effects from changes in the 

degree to which corporate preferences are passed 

through to shareholders. In addition, all the 

models focus on long-run results. Various transition issues, which might have important implications for economic behavior and for tax revenues, 

are not considered. This focus on the long run is 

correct, however, because the goal of achieving 

an improved long-term performance of the economy is the prime factor motivating a concern with 

integration. Nevertheless, short-run transition 

effects can be substantial. 

The Importance of Replacement Taxes 

Given current budgetary constraints, a complete analysis of the integration prototypes requires viewing integration as a revenue neutral tax 

reform, including both direct tax changes and 

secondary changes required to maintain the same 

total revenue yield for the government. 

We do not recommend in this Report specific 

changes in the tax system to finance integration. 

Nonetheless, to avoid confusing the results of the 

simulation analysis by introducing changes in 

government spending on goods and services, some 

form of replacement taxes must be specitied to 

hold government revenue constant after the 

introduction of the integration prototypes. In part 

because of the arbitrary nature of choosing 

replacement taxes, we consider two types of replacement taxes: (1) lump-sum taxes and (2) 

adjustments to statutory tax rates on capital 

income. Both the size of each prototype's economic effects and the ranking of prototypes by 

their relative impact may depend on the form of 

replacement taxes chosen. 

Lump-sum taxes are hypothetical, unavoidable 

taxes. That is, taxpayers cannot change their tax 

liability under such a tax by changing behavior. 

As a consequence, by definition lump-sum taxes 

do not distort economic decisions. Though they 

are commonly used in academic studies of economic efficiency, lump-sum replacement taxes 

have an important drawback for modeling integration prototypes. They can bias comparisons 

among prototypes in favor of the prototype that 

loses the most revenue, because the efficiency 

gain from replacing distorting taxes on capital 

income with nondistorting, lump-sum taxes increases with the amount of revenue that must be 

replaced. This effect is important in an analysis of 

integration because the prototypes have disparate 

revenue costs. Compared to the actual gains that 

might be realized from integration, the calculations based on lump-sum replacement taxes can 

both overstate the size of the gain realized from 

each revenue losing prototype and produce a 

misleading ranking of prototypes. However, 

because not all distortions are analyzed, e.g., the 

"lock in" of capital gains and distortions of 

intertemporal consumption decisions are ignored, 

the lump-sum calculations do not necessarily 

generate efficiency gains that exceed the true 

gains. In addition, since CBIT raises revenue, 

results from the lump-sum replacement may 

understate its true gain. 

Because of the problems with lump-sum 

replacement taxes, calculations also are performed 

holding government revenue constant by proportionately increasing or reducing all tax rates on 

capital income. In these calculations, the tax rates 

applied to corporate income, noncorporate equity 

income, dividends, capital gains, interest, and 

home mortgages are increased or reduced by an 

amount sufficient to hold government revenue 

constant at its current law level. Calculations 
Economic Analyses 120 

using scaled tax rates offer an important advantage over those based on lump-sum replacement 

taxes: The scaled-tax-rate calculations raise 

replacement revenue (and distribute excess revenue) by raising (or lowering) taxes that distort 

economic decisions, and so reduce the bias in 

favor of revenue losing tax changes. Nonetheless, 

these calculations are not definitive. In particular, 

to the extent that the integration prototypes could 

be made revenue neutral by more efficient tax 

changes, the actual economic welfare gains may 

be larger than those obtained in our scaled tax 

rate calculations. 

Because each of the CGE models provides 

only a limited picture of the economy, the ability 

of these models is to simulate the revenue consequences of each of the prototypes is somewhat 

restricted. In particular, none of the models 

provide an adequate treatment of the financial 

services industry, and indeed only the Portfolio 

Allocation model (described in Section 13.F) can 

account for shifts in the ownership of the various 

financial instruments issued by businesses and 

governments. Even this model, however, tends to 

adopt a mechanical approach to the arbitrage 

possibilities possible under the different integration prototypes; in contrast, the revenue estimating models recognize that non-tax factors limit 

actual shifts in asset holdings. Thus, requiring that 

any loss (or gain) in revenues be made up with a 

positive (or negative) replacement tax also reduces 

any disparities in the results of the different 

models that would otherwise arise from 

differences in anticipated revenues. 

The analysis presented in this Report focuses 

on the scaled-tax-rate calculations, but results 

based on the lump-sum replacement mechanism 

also are presented. 

13.D OVERVIEW OF THE 

INTEGRATION PROTOTYPES 

The basic features of the integration prototypes that are incorporated in the CGE models are 

reviewed below. The actual prototypes are described in more detail in Chapters 2, 3, 4, and ll 

of this Report. In particular, it should be noted 

that the CGE models generally do not capture the 

investor level tax imposed when distributions are 

made from tax preference or foreign-taxed 

income. 

Distribution-Related Integration 

Under the distribution-related prototypes, 

corporate earnings are taxed at the corporate 

level, but dividends are excluded at the shareholder level (dividend exclusion system), or shareholders receive a credit for the corporate tax paid 

on distributed income (imputation credit system). 

Under these prototypes, the bias against corporate 

equity investment is reduced to the extent that 

returns are paid out as dividends; similarly, the 

relative bias against equity relative to debt fmance 

is reduced to the extent earnings are distributed as 

dividends. Distribution-related integration, in 

principle, can create a tax bias for or against 

dividends, depending on the values of the corporate tax rate, shareholder tax rate, and accrualequivalent capital gains tax rate. The prototypes 

assume that the current corporate and individual 

tax rates are maintained. Thus, it is likely that 

distribution-related integration would increase 

dividend distributions. 

Dividend Exclusion. The dividend exclusion 

prototype applies the corporate tax rate of 34 

percent to both distributed and retained income, 

but eliminates the second shareholder level tax on 

dividends paid from earnings taxed at the 

corporate level. 

Imputation Credit. Relief from the corporate 

income tax is provided to the extent that corporate 

earnings are distributed as dividends. This relief 

takes the form of a tax credit available to shareholders. The nonrefundable tax credit is calculated 

at a 31 percent rate, so that it does not offset 

completely the corporate income tax paid on 

distributed earnings. 

Shareholder Allocation Integration 

The shareholder allocation prototype adopts a 

"modified conduit" approach. Under a pure 

conduit approach, corporations would be treated 
121 Economic Analyses 

like partnerships, so the corporate level tax would 

be eliminated and all income and expenses would 

be imputed to shareholders, who would then 

include the income and expenses in their own tax 

liability. Shareholders would adjust their basis in 

shares upward by the amount of net income 

imputed to them, and reduce their basis in shares 

downward by the amount of net losses imputed to 

them and by the amount distributed to them by the 

corporation. 

The modified conduit approach taken in the 

shareholder allocation prototype differs from the 

pure conduit approach. For example, the prototype imputes net income to shareholders, but not 

net losses. In addition, the prototype retains the 

corporate tax at a rate of 34 percent, but credits 

the shareholder with the payment. This tax is 

creditable against shareholder tax liability at a rate 

of 31 percent, but it is not refundable. The shareholder allocation prototype reduces but does not 

eliminate the distortions of organizational form 

and corporate financial policy under current law. 

CBIT 

The CBIT prototype imposes a uniform tax 

rate of 31 percent on returns to both debt and 

equity generated by all business. Because the tax 

would be collected at the business entity level, 

interest and dividends would be untaxed to the 

recipient. Under CBIT, interest on U.S. Government debt would remain taxable. Home mortgage 

interest would remain deductible by the borrower 

and taxable to the lender. 

Investments in corporate equity paying current 

dividends would not be penalized under CBIT 

because, as modeled, all business entities other 

than very small entities, regardless of form, 

would be subject to the same tax rate. Under 

CBIT, neither interest nor dividends would be 

deductible at the business level or taxable in the 

hands of the recipient. Thus, the CBIT prototype 

would equalize the tax burden on interest and 

dividends. The efficiency calculations do not take 

into account any compensatory tax (see Chapter 4) 

on distributions from preference income.4o 

Hence, CBIT would replace the combined 

corporate-individual tax rate on distributed earnings with a single tax'levied at the CBIT rate. The 

same rate would apply to corporate retentions, 

and since, as modeled, capital gains on CBIT 

assets are exempt from taxation, CBIT would not 

distort corporate dividend policy. 

13.E INTEGRATION, CORPORATE 

FINANCIAL POLICY, AND 

THE COST OF CAPITAL 

Table 13.1 illustrates how successful each 

prototype is in reducing the three biases in current 

law that integration is meant to reduce: the bias 

against investment in corporate form, the bias 

against equity finance, and the bias against corporate dividend distributions. For individuals, all 

prototypes would reduce the tax rate on distributions of corporate equity nonpreference, U. S. 

source income. This .reduction would address, at 

least in part, the current law biases against the 

corporate form and equity finance. The distribution-related and CBIT prototypes would result in 

a lower overall tax rate on distributed than on 

undistributed corporate equity income, reversing 

the current law bias against corporate dividend 

distributions. However, this bias could be removed from the CBIT and dividend exclusion 

prototypes by allowing shareholders to adjust 

basis of stock for retained earnings through a 

Dividend Reinvestment Plan (DRIP). Only the 

shareholder allocation prototype, as designed, 

would completely remove the bias against corporate dividend distributions. 

Absent a special provision such as the investment income tax discussed in Chaper 6, the CBIT 

prototype alone reduces the current law differentials across business income sources for tax 

exempt entities and foreign investors. For both 

classes of income recipient, CBIT equalizes the 

tax rate on all forms of business incomecorporate equity income (whether or not distributed), noncorporate equity income, and interest. 

The only exception is rent and royalty income, 

which would be taxed as under current law. Thus, 

CBIT would address all three of the current law 

biases. 
Economic Analyses 122 

Table 13.1 

Total U.S. Tax Rate on a Dollar of NonPreference, U.S. Source Income from a U.S. Business 

Under Current Law and the Integration Prototypes 

Shareholder Distribution-Related Integration Allocation 

Type of Income Current Law Integration Credit Exclusion CBIT 

I. Individual Investor is Income Recipient 

Corporate Equity: 

Distributed t,+(l-tJti ti tC ti" 

Undistributed tc+(1-tJt, ti tc+(l-t&

[(l -ti)t,+ti-ti"]/(l -tim) 

t, +(1-t,)t, 6" +(1-ti")t, 

Noncorporate Equity ti ti ti ti ti" 

Interest ti ti ti ti ti" 

Rents and Royalties ti ti ti ti ti 

II. Tax Exempt Entity is Income Recipient 

Corporate Equity: 

Distributed 

Undistributed 

Noncorporate Equity

Interest 

Rents and Royalties 

tC ti" 

t, ti" 

tC ti" 

0 ti" 

0 0 

m. Foreign Investor is Income Recipient 

Corporate Equity: 

Distributed tc+(l-tJtw tc+(l-tJtwr, t,+ (1-tJtm t,+(l-tJtwr, tim 

Undistributed 

Noncorporate Equity 

Interest 

Rents and Royalties 

Department of the Treasury 

Office of Tax Policy 

tC tC tC tC ti" 

twN twN twN twN ti= 

tw tw twI twI ti" 

twR twR twR tw-R twR 

t, = U.S. corporate income tax rate. 

ti = U.S. individual income tax rate. 

tim = Maximum U.S. individual income tax rate. 

tg = U.S. effective individual tax rate on capital gains. 

tw, twN,tw, twR = U.S. withholding rates on payments to foreigners of dividends, noncorporate equity income, business 

interest, and rents and royalties, respectively. Generally varies by recipient and may be zero. 

Tax Distortions in Real and Financial 

Investment Decisions 

Although the most succinct measure of the 

economic benefits possible under each of the 

integration prototypes is the estimated welfare 

gain resulting from reduction or elimination of the 

tax distortions affecting real and financial investments, this is not the most descriptive or intuitive 

characterization of the effects of integration. In 

this section, we thus focus more directly on the 

extent of these distortions, relying on a more 

commonly used measure of the impact of the tax 

system on investment decisions-the cost of 

capital. Although the specific results noted are 

based on a specific CGE model (the augmented 

Harberger model described in Section 13.F),these 

results are less sensitive to the model used than 

the estimates of the welfare gains, which will be 

discussed in the following sections. We therefore 

also defer discussion of the various CGE models 

used to the following sections. 

An important effect of integration is that it 

would change the tax cost of real investment in 

the corporate sector. We measure the effects of 

taxes on investment decisions using the cost of 

capitall concept described in Chapter 1. Taxes on 

capital income generally raise the cost of capital 

above investors' required rate of return. All other 

things equal, a higher cost of capital reduces 

incentives to invest. The cost of capital includes 
123 Economic Analyses 

the effects of tax rates, depreciation allowances, 

tax credits and inflation. The cost of capital also 

can depend on the method of financing. Our 

calculations are designed to be representative, and 

therefore reflect a mix of debt and equity 

financing. 

As Section 13.B discusses, the size of the 

distortions created by the classical corporate tax 

system depends in part on whether one believes 

that there are nontax benefits and costs to alternative corporate financial policies so that differential 

taxation of financial arrangements can distort 

financing decisions. 

Under current law, corporations can reduce 

the tax costs of investment by financing with debt 

rather than with equity and by retaining rather 

than distributing profits. Altering financial behavior to reduce tax liability may itself cause distortions, and raise the cost of capital. For example, 

as a corporation becomes more highly leveraged, 

it increases the chances that it will experience 

costs associated with financial distress. Investors 

in the corporation would require compensationfor 

the expected value of these costs, thereby raising 

the return the corporation must earn on its investments. To capture such costs, the model augments 

the traditional corporate sector cost of capital to 

reflect compensation to investors for the efficiency costs of tax-induced distortions in corporate 

debt and dividend policy. Tax distortions in 

corporate financial policy raise the cost of capital 

for corporate investment, and thereby act as a 

disincentive to investment in the corporate sector. 

Because economists differ on the appropriate way 

to model costs of fmancial distortion, the Report 

also presents effects of integration prototypes on 

the cost of capital that ignore the efficiency costs 

of tax distortions in corporate financial behavior. 

Corporate Financial Behavior 

Description of the Model 

Corporate financial policy-which affects the 

debt to asset (leverage) ratio and the dividend 

payout ratio-is determined within the model 

rather than assuming leverage and distribution 

patterns at the outset. More specifically, the 

corporation chooses its financial policy to minimize its cost of capital. Consider first debt policy. 

Under current law a corporation may deduct its 

interest expense from its taxable income, so 

interest is taxed only to the lender. In contrast, 

corporate profits are taxed twice, because they are 

(in general) subject to both the corporate income 

tax and the individual income tax when distributed 

as dividends or recognized as a capital gain on 

corporate shares. Consequently, equity financed 

corporate investment is tax disadvantaged relative 

to debt financed corporate investment. This 

difference induces corporations to increase their 

use of debt. Increased use of debt, however, also 

carries with it the increased possibility that the 

corporation will incur costs associated with financial distress. In determining their leverage ratio, 

corporations trade off the lower tax cost of financing with debt against the nontax costs of debt, 

e.g., costs of financial distress. In contrast to 

some earlier treatments, however, debt is assumed 

to offer nontax benefits relative to equity (see the 

discussion in Section 13.B). That is, if debt and 

equity were taxed equally, we assume that corporations would continue to finance part of their 

capital stock using debt.41 

Consider now corporate dividend policy. 

Under current law, the shareholder level taxes on 

dividends and retained earnings differ. Dividends 

are taxed as ordinary income, while retained 

earnings raise share values and are taxed on a 

realization basis as a capital gain. Because retained earnings benefit from the deferral of the 

second level of tax, they enjoy a tax advantage 

over dividends. On the other hand, corporate 

distributions may be valued differently by shareholders than retentions. As a result, the determination of optimal dividend distributions reflects a 

tradeoff of tax costs and nontax benefits. 42 

For modelingpurposes, the corporate dividend 

payout ratio divides real corporate earnings into 

dividends and retentions; all purely inflationary 

earnings values are assumed to come in the form 

of asset appreciation and to be taxed as a capital 

gain upon the sale of corporate shares. Corporations choose the real,dividend payout ratio (ratio 
Economic Analyses 124 

of real dividends to real earnings) that minimizes 

the cost of equity financed investment. Because 

the inflationary component of nominal income is 

excluded, real payout ratios are higher than 

conventional nominal payout ratios. Although real 

dividends are the choice variable in the formal 

models, nominal dividend payout ratios also are 

presented in the results. Taxes are assumed not to 

affect financial choices in the noncorporate business and the owner-occupied housing sectors of 

the augmented Harberger model used in obtaining 

the results presented in this section.43 

Corporate Financial Policy Under Current Law 

and the Integration Prototypes 

Table 13.2 shows a measure of the size of the 

tax incentive for a corporation to finance with 

debt rather than with equity and to retain rather 

than distribute profits. Results are presented for a 

neutral tax system that does not distort these 

decisions, for current law, and for each of the 

integration prototypes. The table also shows 

estimates of the effects of these tax incentives on 

corporate borrowing and dividend distribution 

policy. 

Consider first corporate borrowing policy. 

Under a neutral tax system, neither debt nor 

equity would be tax favored, so there would be no 

tax advantage to debt. The behavioral model 

predicts that under such a tax system, corporations on average would finance 30 percent of their 

investments using debt. In contrast to the neutral 

tax system, current law discriminates against 

equity finance. To cover its higher tax cost and 

still offer the ultimate investor a 4 percent real 

after-tax rate of return, an equity financed investment must earn a real pre-tax rate of return that 

is 3.7 percentage points higher than would be 

required were the same investment instead financed with debt. Given the assumptions used in 

the calculation, this is equivalent to a 90 percent 

higher real after-tax required rate of return. The 

extra 3.7 percentage point return reflects debt’s 

tax advantage over equity and is the amount 

needed to pay the higher taxes on the doubletaxed equity investment. Because of this tax 

advantage to debt, or penalty to equity, 

corporations are induced to use more debt than 

under the neutral tax system and choose a 37 

percent leverage ratio, 7 percentage points greater 

than its value under a neutral tax regime.44 

Compared to current law, all the integration 

prototypes would reduce debt’s taxadvantage over 

equity. Consequently, all of the prototypes would 

promote more efficient corporate borrowing 

decisions by moving the corporate leverage ratio 

closer to its undistorted value. As modeled, CBIT 

eliminates differences in the taxation of debt and 

equity by taxing all corporate income once at the 

entity level at a 31 percent statutory rate. Under 

CBIT, corporate borrowing decisions would be 

undistorted by taxes. The other prototypes reduce 

debt’s current tax advantage over equity less 

significantly. 

Consider now corporate dividend policy. 

Under a neutral tax system, neither dividends nor 

retained earnings are tax-favored, so there is no 

tax advantage to retentions, nor penalty on dividends. The behavioral model predicts that under 

such a tax system, corporations would distribute 

as dividends 80 percent of their real after-corporate tax profits, while retaining and reinvesting 

the remaining 20 percent of real after-tax profits. 

In contrast to the neutral tax system, current 

law favors retained earnings over dividends. 

Given the assumptionsunderlying Table 13.2, this 

tax advantage is 1.1 percentage points. That is, 

under current law, to provide an equity investor 

with a real after-tax rate of return of 4 percent, a 

corporation distributing all of its earnings as 

dividends must earn a real pre-tax rate of return 

that is 1.1 percentage points greater than that 

required were the company instead to retain its 

earnings. As a result of this tax distortion, corporations pay out roughly 73 percent of their aftertax real profits as dividends instead of the fully 

efficient 80 percent. Including inflation in the 

measure of after-tax corporate profits yields a 

corresponding nominal dividend payout ratio 

under current law of about 43 percent. 

All the integration prototypes reduce the tax 

on dividends relative to that on retained earnings. 
125 

Table 13.2 

Effect of Integration on Corporate Financial Policy' 

Shareholder DistributionCurrent Allocation Related Integration

Undistorted Law Integration Credit Exclusion CBR 

A. Scaled Tax Rate Replacement 

Corporate borrowing policy 

Tax incentive to borrod 

Leverage ratio3 

Corporate dividend policy 

Tax penalty on dividends4 

Dividend payout ratio 

Real' 

Nominal6 

B. Lump Sum Replacement 

Corporate borrowing policy 

Tax incentive to borrog 

Leverage ratio' 

Corporate dividend policy 

Tax penalty on dividends4 

Dividend payout ratio 

Real' 

Nominal6 

.OOO .037 

30.0% 36.6% 

.ooo .011 

80.0% 72.8% 

- 42.8% 

.OOO .037 

30.0% 36.6% 

.ooo .011 

80.0% 72.8% 

- 42.8% 

,035 .036 .035 ,000 

36.5% 36.5% 36.5% 30.0% 

.ooo -.010 -.005 ,000 

80.0% 85.9% 82.9% 80.0% 

42.8% 46.4% 45.9% 42.7% 

,022 .023 .026 .OOO 

34.6% 34.7% 35.1% 30.0% 

.OOO -.006 -.003 .OOO 

80.0% 84.4% 

A3 !2% A< <% 

'Calculations are based on the augmented Hargerber Model described in section 13.F. 

All calculations assume a 3.5 percent inflation rate and a 4 percent real after-tax rate of 

return. 

'Calculated as the difference between the cost of capital for an equity financed investment and that for a debt financed investment. The calculations assume that tax depreciation equals economic depreciation and that the corporate tax rate is the maximum statutory 

rate. Debtholder and shareholder tax rates are estimates of average effective marginal 

rates based on calculations from the Office of Tax Policy Individual Tax Model, adjusted 

for the taxation of banks, insurance companies and tax exempt institutions. 

3The ratio of debt to total assets. 

4Calculatedas the difference between the cost of capital for an investment whose return 

is subject to the dividend tax and one whose return is subject to tax as a capital gain. 

Economic Analyses 

the model results), both of 

these prototypes are found 

to come very close to 

eliminating tax distortions 

relating to payout decisions. 

The distribution-related 

prototypes reverse the bias 

under current law. They tax 

retentions less favorably 

than dividends because they 

provide relief from the 

double tax on corporate 

equity only to the extent 

that earnings are distributed. This is illustrated in 

Table 13.2 by a negative 

tax penalty, i.e., a tax 

advantage to dividends 

relative to retentions for the 

porations to pay about 83 

percent of real after-tax 

profits (or about 46 percent 

of nominal after-tax profits) 

as dividends, as opposed to 

the 72 percent payout ratio 

(43 percent of nominal 

after-tax profits) under 

current law .45 

Table 13.2 also presents 

calculations based on lumpsum replacement taxes. In 

these calculations, all the 

'The ratio of (cash) dividends to after-tax real profits. 

6Theratio of (cash) dividends to after-tax nominal profits. 

Therefore, all of the prototypes encourage corporations to raise their dividend payout ratio. Both 

the shareholder allocation prototype and CBIT 

achieve uniformity in the taxation of real dividends and real capital gains. Under either prototype there is no tax penalty (nor tax advantage) to 

dividends, so corporations would choose the 

efficient 80 percent real dividend payout ratio defmed by the model. Even when the taxation of 

distributions out of tax preference or foreign-taxed 

income is considered (this feature is ignored in 

integration prototypes encourage (1) more efficient corporate borrowing decisions by reducing 

the tax advantage to debt and the leverage ratio 

and (2) higher, generally more efficient, dividend 

distributions. 

Cost of Capital Under 

Integration Prototypes 

Tables 13.3, 13.4, and 13.5 summarize the 

cost of capital calculations. Current law imposes 
Economic Analyses 126 

a tax penalty on investment in the corporate sector 

and fmancial distortions can raise this penalty. 

Thus, current law can create important distortions 

in the allocation of the U.S. capital stock. To 

assess effects of the integration prototypes on the 

current tax penalty on corporate investment, 

effects on the cost of capital must be calculated. 

Table 13.3 presents the effect of the current tax 

system on the cost of capital among sectors 

calculated both with and without the inclusion of 

the costs of the fmancial distortions. Table 13.4 

reports calculations of the cost of capital which 

include the efficiency cost of tax distortions in 

corporate financial policy, while the calculations 

in Table 13.5 ignore such costs. The estimated 

reductions in the costs of capital suggest that the 

integration prototypes enhance economic efficiency relative to current law. All of the prototypes 

reduce the tax bias against investment in the 

corporate sector under current law, thereby 

improving the allocation of capital among sectors 

in the economy. 

These calculations again assume that investors 

require a 4 percent real, financing distortion 

adjusted, after-tax rate of return on all investments, and that the expected inflation rate is 3.5 

percent. The summary measures reported in the 

table are weighted averages of more detailed 

calculations of the cost of capital for each of 38 

real assets, including 20 types of equipment, 14 

types of nonresidential structures, residential 

structures, residential and nonresidential land, and 

inventories. 

Cost of Capital Under Current Law 

As noted above, there is no universally agreed 

upon model of effects of financial distortions on 

the cost of capital. The calculations in the first 

column of Table 13.3 therefore ignore such 

distortions. In these calculations, no premium is 

imposed to compensate investors for the deviation 

of the leverage and dividend payout ratios from 

their undistorted values. 

To illustrate the effects of the corporate 

income tax on the cost of capital, Panel A shows 

both the corporate and noncorporate cost of 

capital for three particular investments: engines 

and turbines, industrial buildings, and business 

(nonresidential) land. The cost of capital for each 

asset is higher if the investment is undertaken by 

a corporation, because of the extra tax, than if the 

investment is undertaken by a noncorporate 

business. An investment in an industrial building, 

for example, must earn a real return of 6.5 

percent if the investment is made by a corporation, but only 5.1 percent if the investment is 

made by a noncorporate business. These estimates 

reflect a significant disincentive for corporate 

investment; to cover extra taxes, the corporate 

investment must earn 27.5 percent more than the 

comparable noncorporate investment. 

The summary measures in Panel B of Table 

13.3 also illustrate the current tax bias against 

investment in the corporate sector. On average, 

the cost of capital for corporate sector investment 

(5.9 percent) exceeds the cost of capital for investment in the noncorporate sector (4.9 percent). 

Some of this difference, however, results from a 

different mix of capital assets in the corporate and 

noncorporate sector, hence only part of the 

difference is due to intersectoral tax distortions. 

Table 13.3 

Cost of Capital Under Current Law 

No Financial With Financial 

Distortions Distortions 

A. Representative Assets 

Engines and turbines 

Industrial 

Corporate .os1 .os2 

Noncorporate .044 .044 

Corporate .065 .066 

Noncorporate .os1 .os1 

buildings 

Business land 

Corporate .061 ,063 

Noncorporate .049 .049 

B. Summary Measures 

Average Cost of Capital 

Corporate .os9 .060 

Noncorporate .049 .049 

Owner-occupied housing .040 .040 

Economy wide .os0 .os1 

Coefficient of Variation .155 ,165 

Department of the Treasury 

Office of Tax Policy 
127 

Owner-occupied housing has the lowest cost of 

capital (4.0 percent). The return on owner-occupied housing is virtually free of tax because (1) 

the imputed rental value of the housing is not 

taxed to the owner, and (2) interest on debt 

financing is includable by the lender and deductible by the owner. Unless the lender’s tax bracket 

is higher than the borrower’s, the tax system as a 

whole does not collect tax on the return on the 

investment. Thus, current law discourages investment in the corporate sector in favor of investment in noncorporate enterprises, and discourages 

investment in business enterprises in favor of 

investment in owner-occupied housing. Overall, 

capital income taxes increase the average cost of 

capital for the economy as a whole (5.03 percent) 

to a level greater than the investor’s required 

after-tax real return (4 percent). Current law may 

reduce the level of resources devoted to investment and capital formation and distort the allocation of capital across sectors of the economy. 

The last line in Panel B shows the coefficient 

of variation for the cost of capital. The coefficient 

of variation is a summary measure of the degree 

of dispersion in the cost of capital. If all investments were taxed equally, all would have the 

same cost of capital and the coefficient of variation would be zero. Taxes that distort investment 

decisions create dispersion in the cost of capital 

and raise the coefficient of variation. Under 

current law, the coefficient of variation is 0.155. 

The second column of Table 13.3 includes in 

the corporate cost of capital a premium for tax 

distortions in corporate borrowing and dividend 

policies. Tax distortions in corporate financial 

policies raise the cost of capital for corporate 

sector investments by approximately 0.1 percentage point, compared to the prior calculations 

which ignore financial distortions, while leaving 

unchanged the cost of capital for investments in 

the noncorporate sector and in owner-occupied 

housing. Including financial distortions, therefore, 

increases the tax-induced disparity in the cost of 

capital between corporate and other investments. 

With fmancial distortions, current law’s 

coefficient of variation in the cost of capital is 

Economic Analyses 

0.165, greater than the 0.155 coefficient of 

variation obtained when financial distortions are 

ignored. By raising the cost of investing in the 

corporate sector, financial distortions also raise 

slightly the overall cost of investing in the 

economy. 

Cost of Capital Under the 

Integration Prototypes 

Tables 13.4 and 13.5 present summary measures of the cost of capital under current law and 

each of the integration prototypes, with and 

without financial distortions, respectively. Table 

13.4 presents calculations assuming scaled tax 

rates for replacement revenue (Panel A), and 

lump-sum replacement taxes (Panel B). All the 

calculations in Table 13.4 assume that corporations vary their borrowing and dividend distributions in response to changes in tax rates, and 

include a premium for tax-induced distortions in 

corporate borrowing policy. 

Table 13.4 presents results from calculations 

that include the efficiency cost of tax distortions 

in corporate financial policy. In these calculations 

the integration prototypes change both the corporate leverage ratio and dividend payout ratio from 

their values under current law, but also change 

the magnitude of the associated financial distortions. In the scaled-tax-rate calculations, statutory 

tax rates on capital income are increased or 

decreased proportionately to hold the overall tax 

burden on investment at its current level. Each 

prototype reduces the corporate cost of capital 

toward the lower average for the rest of the 

economy, thereby reducing the coefficient of 

variation below its current law level. CBIT reduces the coefficient of variation in the cost of capital 

most significantly. Compared to current law, 

CBIT reduces the coefficient of variation in the 

cost of capital by more than one-third, from 0.165 

to 0.104, The other prototypes produce a smaller 

reduction in the coefficient of variation, a reduction that is nearly the same for each prototype. 

Thus, in these calculations, CBIT provides the 

greatest incentive for an efficient allocation of 

physical capital.46 
Economic Analyses 128 

Table 13.4 

The Cost of Capital Under Current Law and the Integration Prototypes: With Financial Distortions 

ShareholderDistribution-Related 

Current Allocation Integration 

Law Integration Credit Exclusion CBIT 

In the scaled tax rate 

calculations, benefits from 

CBIT still exceed those of 

other prototypes, but 

because- CBIT reduces 

financial distortions more 

than other prototypes, 

there is less difference 

between CBIT and the 

other prototypes in Table 

13.5 than in Table 13.4. 

Nonetheless, the results in 

the two tables are similar. 

In both tables, each prototype reduces the extra tax 

cost of investing in the 

corporate sector, therefore 

encouraging a more 

efficient allocation of 

capital. Additionally, in 

both tables, shareholder 

allocation leads to the 

greatest reduction in the 

coefficient of variation in 

the calculations based on 

A. Scaled tax rate replacement 

Average cost of capital 

Corporate sector .060 .OS7 

Noncorporate sector .049 .os2 

Owner-occupied housing sector .040 ,040 

Economy wide .os1 .os1 

Coefficient of variation .165 .143 

B. Lump sum replacement 

Average cost of capital 

Corporate sector .060 .os2 

Noncorporate sector .049 .049 

Owner-occupied housing sector .040 .040 

Economy wide .os1 ,048 

Coefficient of variation .165 .lo7 

Department of the Treasury 

Office of Tax Policy 

The results based on lump-sum replacement 

taxes presented in Panel B are similar to those in 

Panel A. All prototypes reduce current tax distortions in the allocation of capital, particularly by 

reducing taxes on corporate investment relative to 

investment elsewhere in the economy. Thus, all 

prototypes lower the coefficient of variation in the 

cost of capital. The lump-sum replacement mechanism, however, allows all of the prototypes except 

CBIT to benefit from lower taxes on capital 

income. Consequently, the shareholder allocation 

prototype most significantly reduces the coefficient of variation, and provides the greatest incentive for an efficient allocation of physical capital. 

Table 13.5presents cost of capital calculations 

that abstract from the costs of tax distortions in 

corporate financial policy. In those calculations, 

financing is unaffected by tax policy changes, so 

corporations have a 73 percent real dividend 

payout ratio and a 37 percent leverage ratio under 

current law as well as under the integration 

prototypes. 

,057 .058 .OS3 

.os2 .051 .OS4 

.040 .040 .042 

,051 .051 .os0 

.144 .148 ,104 

.os2 ,054 ,056 

.049 .049 .OS7 

.040 .040 .043 

.048 .049 .OS3 

.111 .120 -.123

lump-sum replacement, while CBIT reduces the 

coefficient of variation most in the calculations 

based on the scaled tax rate replacement 

mechanism. 

13.F INTEGRATION AND THE 

ALLOCATION OF 

RESOURCES 

This section reviews the simulated effects of 

each integration prototype on the allocation of 

resources and economic efficiency. Results from 

three models are presented. The first is a 

Harberger-type CGE model modified to account 

for tax distortions in corporate financial policies. 

The two alternative CGE models respond to 

important limitations of the Harberger-type model. Overall, the cost of capital calculations provided in the preceding section are reinforced by the 

results from the more comprehensive CGE 

calculations. 
129 Economic Analyses 

Table 13.5 

The Cost of Capital final goods. In the original 

Under Current Law and The Integration Prototypes: model, the total supplies of 

No Financial Distortions capital and labor were 

fixed. In the augmented 

ShareholderDistribution-Related model, the supplies of labor 

Current Allocation 

Law Integration 

A. Scaled tax rate replacement 

Average cost of capital 

Corporate sector .OS9 .os5 

Noncorporate sector .049 .OS2 

Economy wide .os0 .os0 

Coefficient of variation .155 ,137 

B. Lump sum replacement 

Owner-occupied housing sector .040 .040 

Average cost of capital 

Corporate sector .059 .os1 

Noncorporate sector ,049 .049 

Owner-occupied housing sector .040 .040 

Economy wide .os0 .047 

Coefficient of variation .155 .lo3 

Department of the Treasury 

Office of Tax Policy 

The Augmented Harberger Model 

Model Description 

In Harberger’s original model, the corporate 

tax induces capital to leave the corporate sector, 

a migration that continues until after-tax returns 

are equalized in the corporate and noncorporate 

sectors. Through this adjustment process the 

burden of the corporate tax is spread to owners of 

noncorporate capital and possibly to labor.47The 

corporate tax thus causes too much capital to be 

allocated to the noncorporate sector and not 

enough to the corporate sector, so that an inefficient allocation of resources results. 

The first model used to study the integration 

prototypes is an augmented version of Harberger’s 

original c~ntribution.~’While the original 

Harberger model had only two sectors, the augmented model embodies a richer depiction of the 

economy. It has 18 industries and 35 different 

types of assets, and includes both intermediate and 

Integration and capital can vary deCredit Exclusion CBIT pending on their rates of 

return, but in the simulations the supply of capital 

is held constant. Investment 

.OS6 .OS7 .OS3 decisions are based on the 

.OS2 .OS1 .OS4 cost of capital described in 

.040 .040 .042 the preceding section. 

.050 .OS1 .OS0 

.138 .143 .lo3 Harberger’s approach 

implicitly assumed that 

corporate financial policy 

.OS2 .OS3 .OS6 was unaffected by the tax 

.049 .049 .057 system. In contrast, the 

.040 .040 augmented model incorpo­

,048 .048 .os3 rates the model of financial 

.io8 .lis .i23 behavior discussed above, 

and so allows the tax system to influence corporate 

borrowing and dividend 

policies. Allowing financial 

decisions to be influenced by the tax system is 

particularly important in the present context, 

because previous research has suggested that 

ignoring tax-induced distortions in financial 

behavior can lead to substantial underestimates of 

the efficiency costs of the classical income tax 

As emphasized earlier, the simulation of each 

integration prototype holds constant real government spending. As in the discussion of the cost of 

capital, we emphasize calculations using scaled 

tax rates, though calculations based on lump-sum 

replacement taxes are presented for comparison. 

The method of estimation proceeds by comparing a single equilibrium representing current 

law with a corresponding equilibrium under each 

integration prototype. The simulations are static, 

in the sense that they abstract from savings and 

growth issues by holding constant the economy’s 

capital stock in the face of each prototype’s tax 

changes. Thus, the model captures effects from 
Economic Analyses 130 

the prototype's shifts in the allocation of real 

resources across sectors and industries and from 

changes in corporate financial decisions, but 

abstracts from any tax-induced changes in saving 

and capital formation. Since integration generally 

is perceived as a way to improve the static allocation of real resources and to improve corporate 

financial policy, this is appropriate.50 

Simulation Results 

Table 13.6 presents the results of simulations 

that include the costs of tax distortions in 

corporate financial policy, and Table 13.7 presents results of calculations excluding such costs. 

The results in Table 13.6 that include the costs of 

financial distortions illustrate most broadly the 

costs of tax distortions under current law. 

The first three rows of Panel A show each 

prototype's effect on the allocation of capital, 

based upon the scaled-tax-rate replacement mechanism. In these calculations, CBIT generates the 

largest changes in capital allocation. CBIT increases the corporate share of capital by almost 5 

percentage points, and decreases the share of 

Table 13.6 

General Equilibrium Results, Augmented Harberger Model: 

With Financial Distortions 

Shareholder Distribution-Related Integration -

Allocation Credit Exclusion Integration CBIT 

A. Scaled tax rate replacement 

Percentage change in capital allocation' 

Corporate sector 2.6 2.3 1.7 4.6 

Noncorporate sector -2.7 -2.4 -1.8 -3.8 

Owner-occupied housing 0.1 0.1 0.1 -0.8 

Annual change in welfare', by source of change, as a 

percentage of consumption (and as a percentage of tax 

revenue from corporate capital) 

Consumption 0.10 (2.38) 0.10 (2.38) 0.08 (1.90) 0.20 (4.76) 

Corporate debt policy -0.00 (-0.00) -0.00 (-0.00) -0.00(-0.00) 0.17 (4.05) 

Corporate dividend policy 0.03 (0.71) 0.01 (0.24) 0.03 (0.71) 0.03 (0.71) 

Total 0.13 (3.09) 0.11 (2.62) 0.11 (2.62) 0.40 (9.52) 

B. Lump sum replacement 

Percentage change in capital allocation' 

Corporate sector 3.4 3.2 2.6 4.3 

Noncorporate sector -2.5 -2.4 -1.9 -4.2 

Owner-occupied housing -0.9 -0.8 -0.6 -0.1 

Annual change in welfare', by source of gain, as a percentage of consumption (and as a percentage of tax 

revenue from corporate capital) 

Consumption' 0.24 (5.71) 0.23 (5.47) 0.20 (4.76) 0.10 (2.38) 

Corporate debt policy 0.08 (1.90) 0.07 (1.67) 0.06 (1.43) 0.16 (3.81) 

Corporate dividend policy 0.03 (0.71) 0.02 (0.48) 0.03 (0.71) 0.03 (0.71) 

Total 0.35 (8.33) 0.32 (7.62) 0.29 (6.90) 0.29 (6.90) 

Department of the Treasury 

Office of Tax Policy 

'These represent changes in each sector's share of total private capital. 

'Welfare changes from improvements in real resource allocation are measured as changes in 

"expanded" national income, i.e., changes in national income plus changes in the value of leisure. 

3Welfare changes from changes in financial policies are measured using an excess burden function 

derived from investors' preferences for debt and for equity. 
131 

Table 13.7 

General Equilibrium Results, Augmented Harberger Model: 

No Financial Dlstortions 

Shareholder Distribution-Related Integration 

Allocation 

Integration Credit Exclusion 

A. Scaled tax rate replacement 

Percentage change in capital allocation' 

Corporate sector 2.5 2.1 1.6 

Noncorporate sector -2.6 -2.2 -1.7 

Owner-occupied housing 0.1 0.1 0.1 

Annual change in welfare' as a percentage 

of consumption (and as a percentage of tax 

revenue from corporate capital) 0.08 (1.95) 0.08 (1.71) 0.07 (1.71) 

B. Lump sum replacement 

Percentage change in capital allocation' 

Corporate sector 3.3 2.9 2.4 

Noncorporate sector -2.4 -2.2 -1.8 

Owner-occupied housing -0.8 -0.7 -0.6 

Annual change in welfare' as a percentage 

of consumption (and as a percentage of tax 

revenue from corporate capital) 0.21 (5.12) 0.20 (4.88) 0.17 (4.15) 

Department of the Treasury 

Office of Tax Policy 

'These represent changes in each sector's share of total private capital, 

Economic Analyses 

CBIT 

4.1 

-3.5 

-0.6 

0.17 (4.15) 

3.8 

-3.9 

0.1 

0.07 (1.71) 

'Welfare changes are measured as changes in "expanded" national income, i.e., changes in national income plus 

changes in the value of leisure. 

capital allocated to other sectors by an equivalent 

amount. The other prototypes stimulate somewhat 

smaller changes in the allocation of capital across 

sectors. 

The next set of calculations in Panel A represents effects on economic well-being resulting 

from adoption of each prototype. Economic 

welfare effects are shown separately for (1) the 

gain caused by the improved consumption choices 

made possibleby integration's improvement in the 

allocation of real resources, and (2) the gain due 

to improved corporate financial policy. These 

welfare gains do not reflect gains (or losses) 

arising from changes in savings and economic 

growth attributableto the prototypes. Two welfare 

measures are presented. The fvst measure 

expresses the welfare gain as a percentage of 

consumption under current law, and can be 

interpreted as the percentage gain in annual 

consumption possible under each prototype once 

the economy fully adjusts to the change in law 

and reaches its new equilibrium. The second 

measure (in parentheses) expresses the welfare 

gains as a percentage of the annual tax revenue 

from corporate capital income. 

In this model, the annual economic welfare 

gains from the improved allocation of resources 

range from 0.08 to 0.20 percent of current consumption or 1.9 to 4.8 percent of tax revenue 

from corporate capital income (equivalent to a 

range of about $2.3 to $5.7 billion per year). 

CBIT produces welfare gains at least twice as 

large as that generated by the other prototypes. 

The other integration prototypes generate a 

smaller improvement from a more efficient allocation of real resources, equivalent to about 8.10 

percent of current consumption for each. Thus, 

although these prototypes appear structurally 

different, from an economic perspective they may 
Economic Analyses 132 

be quite similar. Indeed, this result can be anticipated from the above discussion of the cost of 

capital, which showed that these prototypes had 

nearly identical effects on the coefficient of 

variation in the cost of capital. 

The next simulated economic welfare gain 

represents welfare effects of changes in corporate 

debt policy. All the integration prototypes lower 

the corporate leverage ratio. CBIT, however, 

completely eliminates the tax bias against equity, 

thereby producing the largest gain, equivalent to 

0.17 percent of consumption, or more than 4 

percent of tax revenue from corporate capital 

(about $4.8billion). The dividend exclusion and 

shareholder allocation integration prototypes 

produce only negligible gains from this source. 

Table 13.6 also shows the simulated economic 

welfare effects of changes in corporate dividend 

policy. With the exception of the imputation credit 

prototype, the prototypes yield welfare gains in 

this respect that are equivalent to an annual 

increase in consumption of 0.03 percent (or 0.71 

percent of tax revenue from corporate capital). 

Welfare gains accompanyingthe imputation credit 

prototype are smaller at this margin. 

Combining the economic welfare effects from 

changes in debt policy and changes in dividend 

policy, shows that all three prototypes improve 

overall corporate financial policy. These gains are 

largest for CBIT. By eliminating distortions in 

corporate financial policy, CBIT produces a 

welfare gain equivalent to 0.20 percent of consumption, or 4.76 percent of tax revenue from 

corporate capital. The shareholder allocation 

prototype and the dividend exclusion prototype 

produce much smaller welfare gains from improvements in corporate financial policy, roughly 

equivalent to 0.03 percent of consumption, (0.71 

percent of tax revenue from corporate capital). 

Perhaps the most striking feature of these results 

is that the CBIT prototype's welfare gains from 

improved corporate financial policy are as large 

as the welfare gains from improved real resource 

allocation. 

The total improvement in economic welfare 

ranges from a high under CBIT of 0.40 percent of 

consumption to a low for the imputation credit 

and dividend exclusion prototypes of 0.11 percent 

of consumption. By contributing most signifcantly to the efficient allocation of real resources and 

to the promotion of efficient corporate financial 

choices, CBIT stimulates the largest gains in 

economic welfare. 

Panel B presents results based on lump-sum 

replacement taxes. In some respects these calculations are similar to those in Panel A. For example, in both set of calculations, the integration 

prototypes expand modestly the size of the corporate sector relative to the rest of the economy. In 

addition, in both sets of calculations, all prototypes generate modest economic welfare gains. In 

the calculations based on lump-sum replacement 

taxes, however, all prototypes except CBIT show 

welfare gains from.reducing taxes on capital 

income (and replacing them with more efficient 

lump-sum taxes). In contrast, as modeled, CBIT 

raises distorting taxes on corporate capital income 

and distributes the excess revenue to consumers 

through lump-sum rebates. Consequently, CBIT 

compares less favorably with the other prototypes 

in the lump-sum calculations than in the scaled tax 

rate calculations, although this result is largely an 

artifact of the revenue estimate for CBIT obtained 

from this model. In the lump-sum calculations, 

the shareholder allocation prototype produces the 

largest improvement in economic well being, 

roughly equivalent to an annual gain of 0.35 

percent of consumption. 

Table 13.7 presents results of calculations that 

do not include the cost of tax-induced distortions 

in corporate financial policy. In those calculations, the prototypes do not change financial 

variables from current law values, and financial 

distortions do not create welfare costs. 

The calculations in Table 13.7 are similar in 

several respects to those reported in Table 13.6. 

All prototypes continue to shift capita9 into the 

corporate sector and produce overall gains in 
133 

welfare, measured relative to annual consumption 

or annual tax revenue from corporate capital. The 

shareholder allocation prototype increases 

economic welfare the most under the lump-sum 

replacement taxes, while CBIT increases economic welfare the most under the scaled-tax 

replacement approach. 

The Mutual Production Model 

Model Description 

An important problem with models based on 

the original Harberger approach is the implicit 

assumption that if a commodity is produced in the 

corporate sector, it also cannot be produced in the 

noncorporate sector, and vice versa. This conflicts 

with empirical evidence of such coexistence. To 

address this issue, we use a Mutual Production 

Model (MPM), in which corporate and noncorporate businesses coexist in industries because 

each has certain advantages: corporate businesses, 

which are relatively large, have the advantage of 

economies of scale, and noncorporate businesses, 

which are smaller, have the advantage of more 

effective managerial skill.51 

This approach has been incorporated in a 

large-scale model that contains twelve sectors and 

allows for the production of capital goods as well 

as intermediate goods (goods used in other businesses). Each industry produces with managerial 

input, labor input, and a fixed capital composite 

of 31 different assets. The model is a closed 

economy model characterized by a representative 

consumer, a fixed labor supply, and a fixed 

capital stock. Financial decisions about corporate 

debt to equity and dividend payout ratios are 

affected by the tax system. 

In many ways, the analysis of resource allocation in the modified MPM is structurally similar 

to the augmented Harberger model discussed 

above.52 For example, both are disaggregated, 

competitive models, which base decisions about 

capital allocations on the user cost of capital. In 

addition, both are closed economy models that 

abstract from international capital flows. The 

models differ, however, in at least two key 

Economic Analyses 

respects. First, greater substitution exists between 

corporate and noncorporate activity in the MPM 

than in the augmented Harberger model. Second, 

the MPM assumes a fixed labor supply, while the 

augmented Harberger model allows labor supply 

decisions to vary depending upon the after-tax 

wage rate. Consequently, one would expect 

similar, but not necessarily identical, results from 

the two models. Results from the MPM are 

presented in Table 13.8. 

Simulation Results 

Panel A of Table 13.8 presents the results of 

calculations based on the scaled-tax-rate adjustment approach. The first rows of panel A show 

the percentage change in the share of total capital 

used in each of the corporate, noncorporate 

business, and owner-occupied housing sectors, 

respectively. All of the prototypes shift capital 

(and other resources) into the corporate sector. 

CBIT’s 7.1 percentage point increase in the 

corporate sector’s share of total capital would be 

the largest shift, while the dividend exclusion 

prototype’s 2.9 percentage point increase would 

be the smallest. For all prototypes, the resource 

flow into the corporate sector come primarily 

from a contraction of the noncorporate business 

sector, but owner-occupied housing also would 

decline slightly in the CBIT and imputation credit 

prototypes. 

The next two rows of panel A illustrate the 

change in corporate financial policy attributable to 

each prototype. As a point of reference, a 5 

percentage point reduction in the corporate leverage ratio would elimmate current law’s distortion 

in this model. In these calculations, CBIT eliminates the tax incentive to borrow, and thus reduces the corporate leverage ratio to its undistorted 

level. The shareholder allocation prototype 

achieves only a slight reduction. In contrast, the 

distribution-related prototypes do not improve 

corporate borrowing policy in this 

Both the shareholder allocation and CBIT 

prototypes eliminate the taxpenalty on dividends. 

Consequently, under both prototypes, corporations 

increase their real dividend payout ratio by 9 
Economic Analyses 134 

Table 13.8 

General Equilibrium Results, Mutual Production Model: 

With Financial Distortions 

Shareholder Distribution-Related Integration 

Allocation 

Integration 

A. Scaled tax rate replacement 

Percentage change in capital allocation’ 

Corporate sector 4.3 

Noncorporate sector -4.5 

Owner-occupied housing 0.2 

Percentage change in financial policy 

relative to current law 

Corporate debt to asset ratio -1.0 

Real dividend payout ratio 9.0 

Annual change in welfare2, by source of 

change, as a percentage of consumption 

(and as a percentage of tax revenue from 

corporate capital) 

Consumption 0.27 (3.57) 

Corporate debt policy 0.06 (0.79) 

Corporate dividend policy 0.07 (0.94) 

Total 0.40 (5.30) 

B. Lump sum replacement 

Percentage change in capital allocation3 

Corporate sector 6.1 

Noncorporate sector -5.0 

Owner-occupied housing -1.1 

Percentage change in financial policy 

relative to current law 

Corporate debt to asset ratio -3.O 

Real dividend payout ratio 9.0 

Annud change in welfare2, by source of 

gain, as a percentage of consumption (and 

as a percentage of tax revenue from 

corporate capital) 

Consumption2 0.54 (7.15) 

Corporate debt policy’ 0.11 (1.46) 

Corporate dividend policy3 0.07 (0.93) 

Total 0.72 (9.54) 

Department of the Treasury 

Office of Tax Policy 

Credit Exclusion 

5.5 2.9 

-5.3 -3.O 

-0.2 0.1 

2.0 1.o 

16.0 10.0 

0.37 (4.90) 0.22 (2.91) 

-0.22(-2.91) -0.10(-1.32) 

0.01 (0.13) 0.07 (0.93) 

0.16 (2.12) 0.19 (2.52) 

6.2 4.2 

-5.0 -3.5 

-1.2 -0.7 

-1.0 -1.0 

14.0 10.0 

0.50 (6.62) 0.39 (5.16) 

0.11 (1.46) 0.07 (0.93) 

0.04 (0.53) 0.07 (0.93) 

0.65 (8.61) 0.53 (7.02) 

CBIT 

7.1 

-6.7 

-0.4 

-5.0 

9.0 

0.43 (5.69) 

0.23 (3.05) 

0.07 (0.93) 

0.73 (9.67) 

7.2 

-6.7 

-0.5 

-5.0 

9.0 

0.44 (5.83) 

0.23 (3.04) 

0.07 (0.93) 

0.74 (9.80) 

‘These represent changes in each sector’s share of total private capital. 

2The model measures the welfare change from an improved allocation of real resources as the 

compensating variation of the change from current law to integration. Compensating variation is a 

measure of the dollar value of the change in consumer’s utility as a result of integration. 

3Welfare changes from changes in financial policies are measured using an excess burden function 

derived from investor’s preferences for debt and for equity. 
135 

percentage points to the undistorted value calibrated in the model. Corporations also increase their 

dividend payout ratio under the two distributionrelated prototypes. Because distribution-related 

prototypes relieve the corporate level tax on 

corporate equity only to the extent profits are 

distributed, corporations actually pay an 

inefficiently large fraction of their earnings as 

dividends under these prototypes. Nonetheless, 

compared to current law, both prototypes encourage corporations to reduce the difference between 

their actual payout ratio and the undistorted 

payout ratio. 

The final four rows of Panel A present each 

prototype's welfare changes in total, and a decomposition by the source of change. Annual welfare 

gains are expressed as a percentage of consumption under current law and as a percentage of 

current revenue from corporate capital income (in 

parentheses). By improving the allocation of 

resources, all of the prototypes generate improved 

consumption choices, but CBIT has the largest 

improvement, equivalent to 0.43 percent of 

consumption. The dividend exclusion prototype 

yields the smallest improvement, equivalent to 

0.22 percent of consumption. 

The shareholder allocation and CBIT prototypes improve corporate borrowing policy. CBIT 

generates an economic welfare gain equivalent to 

0.23 percent of consumption. While the welfare 

gain accompanying the shareholder allocation 

prototype is smaller in this dimension, the distribution-related prototypes encourage corporations 

to increase borrowing slightly above levels under 

current law and thereby generate a small welfare 

loss. 

The shareholder allocation and CBIT prototypes both eliminate the tax distortion in corporate 

dividend policy, and in so doing generate a small 

welfare gain equivalent to 0.07 percent of consumption. Although the distribution-related prototypes encourage fms to distribute an inefficiently 

large fraction of their profits as dividends, by 

inducing firms to move the payout ratio closer to 

its undistorted level, both generate welfare gains 

at this margin. 

Economic Analyses 

In total, in the scaled-tax-rate calculations the 

prototypes produce annual economic welfare gains 

ranging from a low of under 0.2 percent of 

consumptionfor distribution-related integration to 

a high of 0.73 percent of consumption for CBIT. 

In these calculations, CBIT generates as large or 

larger welfare gains than the other prototypes in 

every category. 

Panel B shows calculations based on lump-sum 

replacement. In these calculations, all of the 

prototypes promote more efficient consumption, 

corporate borrowing, and corporate dividend 

policies. The other prototypes compare more 

favorably to CBIT than in panel A because, as 

modeled, CBIT would raise taxes on capital 

income, while the other prototypes would lower 

capital income taxes. Consequently, although in 

part an artifact of the modeling, the shareholder 

allocation prototype would generate an annual 

welfare gain equivalent to 0.72, almost as large as 

that under CBIT (0.74 percent of consumption). 

Annual welfare gains for the imputation credit and 

dividend exclusion prototypes would be 0.65 and 

0.53 percent of consumption, respectively. 

Portfolio Allocation Model 

Model Descn'ption 

Both the augmented Harberger model and the 

MPM capture tax distortions in the allocation of 

physical capital among the corporate, noncorporate, and owner-occupied housing sectors. 

Both also capture tax distortions in the supply of 

corporate debt and dividends. Neither model, 

however, is designed to capture tax distortions in 

the allocation of financial assets across households. The portfolio allocation (PA) model addresses this shortcoming by focusing on tax 

distortions in household portfolio decisions.54 

The PA model combines an allocation of capital 

across sectors reflecting production characteristics 

and consumer preferences with an allocation of 

capital across investors and forms of investment 

through a portfolio mechanism. In the PA model, 

real and financial variables are determined simultaneously, and taxes can distort both real and 

financial decisions. 
Economic Analyses 136 

The PA model explicitly links individual 

financial decisions with real variables in the 

economy. Households and pension funds acquire 

securities in a manner consistent with their riskreturn preferences, while businesses and the 

government sector issue securities to meet their 

demands for capital. Individuals allocate their 

wealth among corporate equity, noncorporate 

equity, rental housing, owner-occupied housing 

equity, durable goods, tax-exempt bonds, and 

taxable debt according to the riskiness as well as 

the after-tax rate of return on these assets. Individual households are distinguished by income and 

wealth levels, tax filing status, and whether they 

rent or own their homes. 

Simulation Results 

Results from the PA model are displayed in 

Tables 13.9 and 13.10. As with the other models, 

two sets of calculations are performed. In the first 

set of calculations, presented in Table 13.9, 

statutory tax rates on capital income are increased 

or decreased proportionately to satisfy the constraint that revenues remain constant. In an alternative set of calculations, presented in Table 

13.10, lump-sum taxes or rebates are used to 

satisfy the equal yield constraint. 

Scaled Tax Replacement. Table 13.9 presents 

integration’s aggregate effects on the allocation of 

real and financial capital and on corporate fmancia1 policy. The top panel shows changes in the 

allocation of real capital. In the portfolio allocation model, all of the prototypes shift capital into 

the corporate sector. The CBIT prototype produces the largest increase in corporate capital, equivalent to 2.5 percent of total U.S. real capital, 

followed by shareholderallocation integration (1.7 

percent expansion) and then by distribution-related 

integration (1.6percent expansion for the dividend 

exclusion prototype). In all prototypes, the flow 

of capital into the corporate sector comes from a 

contraction of other sectors. The prototypes 

improve the allocation of capital within the business sector as well as between the business and 

nonbusiness sectors. 

The middle panel of Table 13.9 presents 

changes in holdings of financial assets, divided 

into changes in households’ holdings and changes 

in pension funds’ holding^.^' In the PA model, 

households can make financial investments in 

corporate stock, noncorporate equity interests, and 

debt. All of the prototypes induce households to 

raise their holdings of corporate stock, CBIT 

produces the largest such shift, equivalent to 6.5 

percent of total wealth, compared to about 3 to 4 

percent for the other prototypes. In addition, all 

prototypes reduce households’ holdings of taxable 

bonds. The shareholder allocation and distribution-related prototypes produce a reduction equivalent to between 2.0 percent and 2.5 percent of 

total wealth. CBIT generates a larger reduction, 

and the household sector becomes a net borrower 

in the taxable debt market. Traditional tax-exempt 

debt holdings are largely unaffected by integration 

(except under CBIT). CBIT debt, which is taxexempt to the lender, accounts for 11.6percent of 

total wealth. To a large extent, CBIT debt substitutes for taxable debt under current law. Thus, it 

is useful to compare the sum of taxable and CBIT 

debt holdings under CBIT and current law. Combining CBIT’s 14.8 percent reduction in taxable 

debt with the 11.6 percent of total wealth that 

corresponds to CBIT debt shows that CBIT 

reduces households’ direct holdings of formerly 

taxable debt by 3.2 percent of total wealth. The 

other prototypes reduce direct household holdings 

of currently taxable debt by an amount equivalent 

to 2.0 to 2.5 percent of private wealth. Combining all types of debt shows that CBIT generates a 

larger reduction in direct debt holdings by households, equivalent to 4.3 percent of total wealth 

while the other prototypes generate a smaller 

reduction, equivalent to between 2.0 and 2.6 

percent of wealth. Finally, note that holdings of 

noncorporate capital decline under all the 

integration prototype^.'^ 

Pension funds’ portfolio shifts are the reverse 

of household portfolio shifts. In the PA model, 

pension funds allocate assets between debt and 

corporate equity. By lowering the tax burden 

households face on corporate equity, but not 

extending the tax reduction to pension funds, all 

prototypes induce pension funds to reduce 
137 

Table 13.9 

The Effect of Integration on the Allocation of 

Physical Capital, Wealth, and Corporate Financial Policy Results from the Portfolio Allocation Model 

(Scaled Tax Rate Replacement) 

Distribution-Related 

Shareholder Integration 

AUOcation Credit Exclusion 

Prototype Integration CBIT 

A. Change in the Allocation of Physical Capital 

(as a percent of total physical capital) 

Corporate Business 1.7% 1.3% 1.6% 2.5% 

Noncorporate Business -0.1% -0.1% -0.1% -0.1% 

Noncorporate Rental Housing -0.3% -0.3% -0.4% -0.4% 

Total Noncorporate Capital -0.4% -0.4% -0.5% -0.5% 

State and Local Government -0.1% -0.1% -0.1% 0.0% 

Owner-occupied Housing -0.7% -0.4% -0.5% -0.8% 

Consumer Durables -0.5% -0.5% -0.5% -1.2% 

Total Household Capital -1.3% -0.9% -1.0% -2.0% 

B. Change in The Allocation Of the Household Sector's Portfolio 

(as a percent of total wealth) 

Corporate Stock 3.9% 3.2% 4.0% 6.5% 

Debt 

Taxable to Investors -2.3% -2.0% -2.5% -14.8%' 

Not Taxable to Investors 

Traditional Tax-Exempt -0.1% -0.1% -0.1% -1.2% 

CBIT 0.0% 0.0% 0.0% 11.6% 

Total Tax-Exempt -0.1% -0.1% -0.1% 10.5% 

Total -2.4% -2.0% -2.6% 4.3% 

Noncorporate Business -0.1% -0.1% -0.1% 0.0% 

Noncorporate Rental Housing -0.2% -0.2% -0.4% -0.4% 

Noncorporate Total Capital -0.3% -0.3% -0.5% -0.4% 

Owner-occupied Housing -0.6% -0.4% -0.4% -0.7% 

Consumer Durables -0.5% -0.4% -0.5% -1.1% 

Total Household Capital -1.1% -0.8% -0.9% -1.8% 

Pensions 

Corporate stock -2.0% -1.7% -2.5% -0.3% 

Debt 2.0% 1.7% 2.5% 0.3% 

Leverage Ratio -3.2% -2.7% -2.3% -14.7% 

(Nominal) Dividend Payout Ratio 3.2% 3.3% 3.8% 3.0% 

Department of the Treasury 

C. Change in Corporate Financial Policy (in percentage points) 

Office of Tax Policy 

'The household sector goes from a net lender in the market for taxable bonds 

Economic Analyses 

the distribution-related 

and shareholder allocation 

prototypes stimulate a 

move into corporate equity equivalent to between 

1.5 and 1.9 percent of 

total wealth. CBIT generates a much larger net 

increase in holdings of 

corporate shares, equivalent to 6.2 percent of total 

wealth. The total shift 

from debt is equivalent to 

-4.0 percent of total 

wealth under CBIT, and 

to between -0.1 and -0.4 

percent of total wealth for 

the other prototype^.^' 

The bottom panel of 

Table 13.9 presents each 

prototype's effect on 

corporate borrowing and 

dividend policy. All prototypes encourage corporations to use less debt, 

but CBIT generates a 14.7 

percentage point reduction 

in the corporate leverage 

ratio, much larger than 

the reduction generated by 

the other integration 

prototypes. Dividend 

payout ratios increase in 

all cases (by between 3.0 

and 3.8 percentage 

points); not surprisingly, 

the largest such increase 

accompanies the dividend 

exclusion prototype. 

Lump-Sum Tax Re- under current law to a net borrower under CBIT. 

corporate equity holdings and increase debt holdings. Consequently, for the economy as a whole, 

the shift out of debt and into equity is less 

pronounced than the change for the household 

sector alone. Overall, in their effects on households' direct holdings pluspension fund holdings, 

placement. Table 13.10 su".rkes PA model 

results flustmtbg integration's aggregate effects 

on the allocation of real and fmancial capital and 

On corporate fmancial Policy assum@ lumP-Sum 

taxes are Used to ~~enue neutrality. The 

allocational impacts of integration are qualitatively 

similar to those based on scaled tax rate 
Economic Analyses 138 

Table 13.10 

Summary of the Effects of Integration on

Real and Financial Decisions: 

Results from the Portfolio Allocation Model 

(Lump Sum Replacement) 

Distribution-Related 

Shareholder Integration 

~OCatiOn Credit Exclusion 

Prototype Integration CBIT 

A. Change in the Allocation of Physical Capital 

(as a percent of total physical capital) 

Corporate Business 2.8% 2.6% 2.6% 2.8% 

Total Noncorporate Capital -0.3% -0.3% -0.3% -0.4% 

State and Local Government -0.1% -0.1% -0.1% 0.0% 

Total Household Capital -2.3% -2.2% -2.2% -2.3% 

B. Change in the Allocation of the Household Sector’s Portfolio 

domestic economy to 

assess the likely effects of 

integration. The models 

are in general agreement 

with respect to the major 

effects of integration on 

capital allocation, corporate financial policy, 

portfolio allocation, and 

the overall effect on economic welfare. 

The results of all the 

models indicate that integration will encourage 

capital to shift into the 

corporate sector. Most of 

this shift comes from the 

noncorporate business 

sector,58 but in some 

cases owner-occupied 

housing also is reduced. 

With only one exception, the models that 

allow for tax-induced 

distortions in corporate 

borrowing behavior agree 

that the integration proto-

(as a percent of total wealth) 

Corporate Stock 6.2% 5.5% 

Debt -3.8% -3.3% 

Total Noncorporate Capital -0.3% -0.2% 

Total Household Capital -2.0% -1.9% 

Pensions 

Corporate Stock -2.3% -2.0% 

Debt 2.3% 2.0% 

C. Change in Corporate Financial Policy 

(in percentage points) 

Leverage Ratio -8.3% -7.3% 

Nominal Dividend Payout Ratio 3.25 3.4% 

Department of the Treasury 

Office of Tax Policy 

replacement: (1) the share of physical capital 

allocated to the corporate sector rises while that 

allocated to the noncorporate and household 

sectors declines, (2) households shift toward 

corporate equity and away from debt, while 

pension portfolios are reallocated in the opposite 

direction, (3) corporations reduce their leverage 

ratio and increase their dividend payout ratio, and 

(4) CBIT generates shifts in the allocation of 

physical capital and financial assets that are at 

least as large as those generated by the other 

prototypes. 

Summary of Results 

There is no universal agreement about the 

most appropriate way to model the effects of the 

corporate income tax (and the effects of reforms 

of that tax) on real and financial decisions. This 

Report examined three different models of the 

5.3% 6.5% 

-3.1% 4.1% 

-0.2% -0.4% 

-1.9% -2.1% 

-1.9% -0.2% 

1.9% 0.2% 

-6.9% -16.6% 

3.8% 3.0% 

types will improve efficiency by reducing corporate borrowing. In general, the models suggest 

that because shareholder allocation and CBIT 

reduce most significantly the tax penalty on 

corporate equity, they similarly reduce most 

significantly tax-motivated corporate borrowing. 

The models also agree that the integration 

prototypes will increase corporate dividend payments relative to current law. Shareholder allocation integration and CBIT promote fully efficient 

corporate dividend policy, while the distributionrelated prototypes can encourage corporations to 

make inefficiently large dividend payouts. Nonetheless, in some calculations even the distributionrelated prototypes improve corporate dividend 

policy relative to current law. 

All the models show that the integration 

proposals stimulate improvements in overall 
139 

economic well-being. The exact magnitude of the 

improvements can vary from model to model and 

from prototype to prototype, so integration’s 

improvement in welfare ranges between 0.07 

percent and 0.73 percent of current consumption. 

Importantly, these gains take into account that, for 

some of the prototypes, taxes would have to be 

raised to finance integration. Shareholder allocation integration and CBIT tend to produce the 

largest welfare gains. In addition to the traditional 

welfare improvement from the reallocation of 

physical capital (and other real resources) from 

the rest of the economy into the corporate sector, 

the models also show that, under reasonable 

assumptions, integration may stimulate important 

welfare gains from improvements in corporate 

financial policy. 

Comparison of Welfare Gain 

Among Models 

The welfare gains from integration are generally larger in the MPM than in the augmented 

Harberger model. This is especially true for the 

gain from improved resource allocation, and in 

some cases for the gain from changes in corporate 

financial policy as well. An important explanation 

for this difference is the MPM’s greater substitutability between corporate and noncorporate 

businesses within an industry. Thus, in the MPM, 

current law reduces economic efficiency more 

than in the augmented Harberger model. Both 

models predict a similar range of welfare changes 

from changes in corporate debt, ranging from 

roughly zero to about 0.20 percent of consumption. Additional reasons for this variation include 

(1) slight differences in the underlying behavioral 

models in the measurement of the tax advantage 

of equity and (2) differences in the tax rates 

required for the scaled-tax-rate calculation^.^^ 

The size of the simulated gains are comparable 

to, or can be reconciled with, results from simulations of similar tax law changes published in 

economic literature.60 Consider first the gains 

from an improved allocation of real resources. 

Using a simple two sector model, Harberger 

originally estimated that the corporate income 

tax’s distortion in the allocation of real resources 

Economic Analyses 

produced a welfare gain roughly equivalent to 

between 0.5 percent and 1.0 percent of GNP, 

corresponding to between 0.75 percent and 1.5 

percent of consumption. Shoven corrected two 

errors in Harberger’s original analysis, dmatically reducing the size of the corporate tax’s 

welfare cost. He then expanded the model from 

two to twelve industries, increasing the welfare 

cost of the tax.On balance, Shoven’s estimates of 

the welfare costs of the corporate tax ranged 

between 0.75 percent and 1.5 percent of consumption. Fullerton, et al. obtained a similar 

estimate of the welfare cost of the distortion in the 

allocation of real resources under the corporate 

tax.61 

These studies differ in several respects, but 

share a common feature. They all use average 

effective tax rates to measure the distortions of 

the corporate income tax. Average effective tax 

rates are measured for existing assets by taking 

the ratio of the observed tax payments from the 

existing stock of capital to the income generated 

by that stock. While such rates may be useful for 

many purposes, they can be crude representations 

of the effect of taxes on investment incentives. 

For example, they can include tax revenue from 

lump-sum features of the tax system, from investments made under tax systems no longer in 

existence, from unexpectedly profitable investments, or from pure monopoly profits. In addition, as an empirical matter, they bear little 

resemblanceto the theoretically preferable concept 

of marginal effective tax rates.62 

A better measure of the effect of taxes on 

investment incentives is the marginal effective tax 

rate (or, equivalently, the cost of capital), which 

relates to incentives for incremental uses of 

capital. The marginal effectivetaxrate is calculated using information on expected financing sources, economic depreciation rates, inflation rates, 

required rates of return, statutory tax rates, 

depreciation allowances, and credits. It represents 

taxes that business enterprises would expect to 

pay on an additional unit of new investment that 

is just profitable at the margin. Thus, in contrast 

to the average effective tax rate, it relates closely 

to the forward-looking nature of a business 
Economic Analyses 140 

enterprise’s investment decisions. Although such 

calculation cannot include every detail of the tax 

code, marginal effective tax rates dominate average effective tax rates as a measure of the 

incentive to invest. 

Studies using marginal effective tax rates have 

found smaller welfare costs for tax distortions in 

the allocation of real capital than those using 

average effective tax rates. For example, 

Fullerton and Henderson adopt this approach and 

find that eliminating all differences in the taxation 

of corporate and noncorporate investments would 

produce a very small annual economic welfare 

gain, equivalent to about 0.007 percent of expanded national income (national income plus labor), 

or roughly 0.014 percent of con~umption.~~ They 

find that eliminating all intersectoral tax distortions, including those between corporate and 

noncorporate capital and between business and 

housing capital, would produce larger gains. 

Depending on the assumed ease with which 

capital can migrate across sectors, these annual 

gains range from 0.039 percent of consumption 

when such migration is relatively difficult to 0.35 

percent of consumption when such migration is 

relatively easy. For a unitary elasticity of substitution between corporate and noncorporate capital 

(as assumed in the augmented Harberger calculations above), the annual gain is roughly equivalent 

to 0.11 percent of consumption. 

Fullerton and Henderson obtain these relatively small gains in part because, at the margin, debt 

finance and favorable individual level taxation of 

capital gains on corporate stock eliminate much of 

the tax disadvantage to investment in the corporate sector.@ In addition, Fullerton and 

Henderson’s calculations are based on the new 

view of dividend taxes, which magnifies the 

benefit of the favorable taxation of capital gains 

on corporate share appreciation, thereby reducing 

the welfare cost of the current tax system. Even 

under the traditional view adopted in this Report, 

the Fullerton-Henderson estimates of the welfare 

costs of the corporate tax based on marginal 

effective tax rates are likely to remain small 

compared to earlier estimates. Finally, in all 

calculations, Fullerton and Henderson hold 

constant the overall average effective tax rate for 

the economy as a whole. Since the tax changes 

they consider would otherwise reduce revenue, 

their estimated welfare gains are smaller than 

those resulting from lump-sum replacement taxes. 

In both the augmented Harberger model and 

the MPM used in this Report, we have adopted a 

marginal approach to measuring investment 

incentives, and so obtain results that are more 

comparable to those of Fullerton and Henderson 

than to the early results of Harberger and Shoven. 

For a variety of reasons, however, one would not 

expect identical results in the two models. For 

one thing, in several key respects, the modeling 

assumptions used in the augmented Harberger 

model differ from those in Fullerton and 

Hender~on.~’ In addition, Fullerton and 

Henderson analyze tax policy changes starting 

from 1985 law, while this Report analyzes tax 

policy changes starting from current law. 

Fullerton and Henderson also hold constant the 

revenue from capital income taxes by directly 

adjusting the cost of capital, while we maintain 

revenue neutrality by using lump-sum taxes or by 

adjusting statutory tax rates. Finally, this Report 

studies integration prototypes that differ substantially from the hypothetical effective tax rate 

equalization policies considered by Fullerton and 

Henderson. Thus, one might expect that the 

results presented in this Report should be similar, 

though not equivalent, to those presented in 

Fullerton and Henderson, if financing distortions 

are ignored. 

That is indeed the case, especially for the 

calculations based on the scaled tax replacement 

mechanism. For the integration prototypes studied 

in this Report, the augmented Harberger model 

simulates annual welfare gains from improved 

consumption choices ranging from 0.07 to 0.17 

percent of consumption when financial distortions 

are ignored, and from 0.08 to 0.20 percent of 

consumption when financial distortions are captured. The most shilar calculation in Fullerton 

and Henderson yields a 0.11 percent gain for 

complete elimination of intersectoral tax distortions, the same order of magnitude as results 

presented in this Report. In part because they 
141 Economic Analyses 

adopt the new view of dividends, however, they 

estimate smaller welfare gains from eliminating 

the corporate-noncorporatetax differential. 

The allocationalgains in the MPM used in this 

Report are substantially larger than most of those 

obtained by Fullerton and Henderson; in the 

scaled-tax-ratecalculations,the annual gains range 

from 0.22 percent to 0.43 percent of consumption. Despite the use of marginal effective tax 

rates, these gains are almost as large as those 

obtained by Harberger and Shoven. The primary 

reason for the MPM’s relatively large welfare 

gain is the greater substitutability of capital and 

other resources between the corporate and noncorporate sector of each industry. As a result, 

even small tax differences can reduce economic 

efficiency. Thus, the MPM calculations can be 

compared most fruitfully to the upper range of the 

Fullerton-Henderson calculations. Both sets of 

calculations assume significant substitutability of 

resources across sectors, thereby yielding large 

welfare gains associated with reforms at this 

margin. 

Consider now the size of the gains from 

improved corporate debt policy. In the scaled-taxrate calculations, the augmented Harberger model 

used in this Report produces annual gains ranging 

from negligible improvements under some prototypes to 0.17 percent of consumption for CBIT, 

while the modified MPM yields annual gains 

ranging from -0.22 percent of consumptionfor the 

distribution-related prototypes to 0.23 percent of 

consumption for CBIT. These gains from improved corporate borrowing decisions appear 

smaller than those estimated by others.66Several 

factors account for this Report’s somewhat smaller gain. One is that not all the integration prototypes eliminate debt’s tax advantage over equity, 

while earlier studies considered complete elimination of debt’s tax advantage. Second, our scaledtax-rate calculations significantly reduce gains 

from improved financial choices by raising the 

difference between the statutory corporate tax rate 

and the tax rate on interest income for nonCBIT 

prototypes. No such effect would be found in 

earlier studies that implicitly used lump-sum 

replacement taxes or that assumed that integration 

would eliminate debt’s tax advantage. Third, 

earlier studies assumed that corporate debt would 

decline to zero, absent a tax advantage, while this 

Report recognizes potential nontax benefits of 

debt so even without a tax advantage corporations 

would continue to finance a substantial portion (30 

percent) of their capital investments with debt. 

Thus, there is a much larger scope for improvement from eliminating or reducing the tax advantage of debt in the earlier studies than in the 

models used in this Report. 

Finally, increases in economic well-being 

accompanying integration are similar to those 

estimated using CGE models for the Tax Reform 

Act of 1986. For example, using lump-sum 

replacement taxes, Gravelle (1989) estimated that 

the 1986 Act would generate annual welfare gains 

ranging from 0.08 to 2.00 percent of consumption. Also using lump-sum replacement taxes, 

Fullerton, Henderson, and Mackie (1987) estimated that annual welfare changes attributed to the 

1986 Act would range from -0.30 to 0.89 percent 

of consumption. In their calculations most similar 

to those in this Report, they estimated an annual 

welfare gain equivalent to 0.37 percent of consumption. The annual welfare gains presented in 

this Report are therefore on the same order of 

magnitude as estimates for the 1986 

Integration in an International Context 

Although the models described in the preceding sections differ in many respects, they all 

ignore international trade and capital flows and 

treat the United States as if it were a closed 

economy. Closed economy effects of tax policies 

may be modified in important ways in an open 

economy, For example, in a closed economy, a 

successful saving incentive might be expected to 

lower the cost of capital and increase domestic 

investment. In contrast, in a small, open economy 

much of the incremental saving might flow 

abroad, leaving the domestic capital stock largely 

unaffected. It is desirable in principle, therefore, 

to analyze the integration prototypes using a 

model incorporatinginternationalcapital mobility. 

Such a model, which is presented in the next 

section, permits analysis of effects of tax changes 
Economic Analyses 142 

on holdings of debt and equity by U.S. and nonU.S. investors. 

Economists have analyzed the degree to which 

capital is internationally mobile, but there is no 

consensus.68Also important in the study of integration is the relative mobility of debt and equity 

capital, since the integration prototypes examined 

in this Report affect returns from debt and equity 

investments differently.69 While there is controversy over the extent of mobility of debt and 

equity capital, this Report analyzes some possible 

consequences of the integration prototypes on 

capital flows. The effects of integration proposals 

on foreign investment in the United States, U.S. 

investment abroad, the components of the balance 

of payments, and the U.S. domestic capital stock 

are examined using an open economy model. 

While the Report offers some tentative conclusions based on the model results regarding possible net effects of integration-related changes in 

incentives in an open economy setting, more 

research is needed before reaching firm 

conclusions. 

A Model of Taxation and 

Intemationul Capital Mobility 

Introducing trade and capital flows complicates significantly the analysis of corporate taxation. As a consequence, economic models of 

international corporate flows typically embody a 

much simpler representation of the domestic 

economy than the closed economy models described above. This Report uses a model of trade 

and capital flows between the United States and 

an aggregate of all other countries, viewed as a 

single foreign co~ntry.’~While such a representation is stylized, it offers an indication of the 

likely importance of internationally mobile debt 

and equity capital for assessing economic effects 

of integration. 

In the model, each country has four production sectors: import-competing goods (from the 

U.S . perspective), equipment (producers’ durables, such as machines and airplanes), nonequipment export goods, and nontraded goods and 

services. Consumers in each country can choose 

between the consumption of domestic and imported traded goods depending on relative prices. 

Residents of each country allocate wealth 

among four assets: domestic debt, foreign debt, 

domestic equity, and foreign equity. The allocation depends on real after-tax rates of return. 

Foreign and domestic debt are assumed to be 

closer substitutes than foreign and domestic 

equity, and, thus, international holdings of debt 

are much more responsive to changes in relative 

returns. Business enterprises in each country 

choose the mix of debt and equity to supply 

depending on market interest rates and equity 

returns, and on the tax treatment of these payments at the corporate level. The international 

model thus has features in common with the 

portfolio allocation model presented above. 

The model takes into account the relationship 

among the three major components of the U.S. 

balance of payments: the balance of merchandise 

and services trade, the balance of capital inflows 

and outflows, and the balance of receipts and 

payments of investment income on cross-border 

holdings. One possibility is an increase in imports 

relative to exports in the long run, and a resulting 

fall in the output of the import-competing sector. 

The different tax treatment of resident and 

nonresident investors also plays an important role 

in the model. For example, under current law, 

foreign investors in U.S. equity are subject to the 

U.S. corporate level tax but not to the investor 

level taxes imposed on a U.S. resident. They pay 

only withholding taxes on dividends and these are 

very low on average because of treaty relief. 

Similarly, portfolio interest paid to foreigners is 

exempt from U.S. tax under current law. To the 

extent that integration prototypes alter the relative 

tax treatment of foreign and resident investors, 

they can lead to a reallocation of internationally 

mobile capital among countries. 

Three integration prototypes are modeled 

explicitly: the shareholder allocation prototype 

and the two distribution-relatedprototypes. While 

potential effects of CBIT are discussed, there is 

no explicit modeling of the prototype due to the 
143 

significant uncertainty surrounding the relative 

substitutability of U. S.exempt and taxable debt in 

the portfolios of U.S. and non-U.S. investors. As 

before, two means of financing revenue costs of 

integration are presented: lump-sum taxes and 

scaled-rate replacement taxes on capital income. 

Table 13.11 presents the percentage change in the 

U. S, and foreign capital stock, cross-border 

holdings of debt and equity, and after-tax returns. 

In addition, the thee rows at the bottom of the 

table present the absolute (constant) dollar changes (constrained to sum to zero) in trade, capital 

flows, and net international investment income. 

As with the closed economy models, simulation 

results refer to effects of integration prototypes on 

economic variables in the long run. 

Foreign Holdings of U.S. Capital 

The shareholderallocationprototype encourages foreign investors to reduce holdings of U.S. 

equity and increase holdings of U.S. debt. Pre-tax 

returns for foreign investors in U.S. equity, who 

concentrate their holdings in the U.S. corporate 

sector, decline as a result of the shift of capital 

into the corporate sector by U.S. residents. 

Because they would be denied the credit for the 

corporate level withholding tax, their after-tax 

returns decline as well. Accordingly, there is a 

decline in foreign investment in U.S. equity. The 

magnitude of the decline, of course, depends 

more generally on how responsive foreigners are 

to such price changes. With respect to debt, the 

shareholder allocation prototype raises slightly the 

U. S, interest rate because of the competition from 

nswly desirable equity. Foreign holdings of U.S. 

debt increase as a result. The overall effect on 

foreign holdings of U.S. capital depends on the 

relative mobility of debt and equity capital. In the 

simulations reported here, equity holdings fall, 

while debt holdings increase. Nonetheless, since 

debt is assumed to be more internationally mobile 

than equity,’l total foreign investment in the 

U.S. increases. 

The distribution-related prototypes have a 

similar effect on incentives for foreign investment 

in the United States. Foreign holdings of U.S. 

equity decline, while holdings of U.S. debt 

Economic Analyses 

increase. Because the separate corporate tax is 

maintained, however, corporations deduct interest 

at a higher rate than under the shareholder allocation prototype. Thus, the U.S. interest rate is 

higher and incentives for foreigners to shift into 

U.S. debt are larger. The calculations presented 

in Table 13.11 suggest that distribution-related 

prototypes increase (slightly) foreign investment 

in the United States. As with the shareholder 

allocation prototype, the change in the composition of foreign investment is more significant than 

the change in its total amount. 

We do not model CBIT’s effect on foreign 

investment in the United States. CBIT would shift 

the tax on business interest from the lender to the 

borrower. As a consequence, the market interest 

rate on business debt would fall below its current 

level. Since non-U.S. investors receive no credit 

for the tax that the borrower has paid on interest, 

their net return from U.S. lending would fall, 

giving them an incentive to shift out of business 

debt. To the extent that domestic investors shift 

capital into the corporate sector and, thereby, 

lower the pre-tax rate of return in that sector, 

foreign investors would have an incentive to 

reduce their holdings of U.S. equity. However, 

under CBIT, substantial amounts of government 

and home mortgage debt are taxed identically as 

under current law, offering pre-tax interest rates. 

Foreign investors may shift out of corporate 

bonds (and equity) and into these nonCBIT debt 

instruments, thereby mitigating any outflow of 

capital that might otherwise occur. 

U.S. Holdings of Foreign Capital 

The shareholder allocation prototype reduces 

incentives for U. S.taxpayers to hold foreign debt, 

and increases the incentive to hold foreign equity. 

For U.S. taxpayers, the shareholder allocation 

prototype raises the after-tax return to domestic 

investment. The after-tax return on domestic 

equity rises because of relief from the corporate 

tax, and the after-tax return on domestic debt rises 

because of the likely increase in U.S. interest 

rates. Consequently, foreign debt is less attractive 

relative to both domestic debt and domestic 

equity. Foreign equity is more attractive for U.S. 
Economic Analyses 

U.S.Capital Stock 

Rest of the World Capital Stock 

U.S.Holdings of Foreign Debt 

U.S.Holdings of Foreign Equity 

Foreign Holdings of U.S.Debt 

Foreign Holdings of U.S.Equity 

After-tax Return to U.S.Equity 

(U.S. Residents) 

After-tax Return to U.S.Equity 

(Rest of the World Residents) 

U.S.Interest Rate 

After-tax Real U.S.Interest Rate 

(U.S. Residents) 

Return to Foreign Equity 

(Rest of the World Residents) 

Return to Foreign Debt 

(Rest of the World Residents) 

144 

Table 13.11 

International Model 

of Tax Integration Alternatives 

Shareholder Allocation Dividend Credit Dividend Exclusion 

Financed by Financed by Financed by 

Lump Sum Tax on All Lump Tax on All Lump Tax on All 

Tax Capital SumTax Capital SumTax Capital 

Percentage Changes 

.6 1.9 1.2 2.7 .9 1.5 

-.3 -1.2 -.6 -1.3 -.4 -.9 

-10.9 -26.0 -11.9 -24.6 -9.2 -17.6 

10.6 43.7 10.7 30.2 8.6 24.8 

7.5 31.8 10.4 28.4 7.7 17.9 

-24.1 46.3 -17.1 -30.3 -12.9 -24.6 

20.1 1.8 13.7 7.7 10.1 2.6 

-13.8 -28.3 -8.2 -15.2 -6.1 -12.4 

.8 3.3 1.6 3.8 1.2 2.5 

2.0 -18.0 3.8 -6.9 2.8 -6.5 

.3 .1 .3 .4 .2 .2 

.4 1.1 .6 1.2 .4 .8 

Absolute Changes (in $ billions, 1988 base) 

Change in Annual Net Capital Flows -1.5 -.8 1.4 4.5 1.o 1.4 

Change in Net Trade Balance -20.7 48.8 -12.8 -25.6 -9.6 -21.7 

Change in Net Receipts of 

Investment Income 22.2 49.6 11.4 21.1 81.6 20.3 

Department of the Treasury 

Office of Tax Policy 

Note: Simulations assume all U.S.debt is exempt under CBIT. See discussion in text. 

investors because foreign tax credits are passed 

through to U.S. shareholders. 

Distribution-related integration also reduces 

incentives for U.S. investors to hold foreign debt. 

In contrastto the shareholder allocationprototype, 

however, distribution-related integration has an 

uncertain effect on incentives for U.S. investors 

to hold foreign equity. Under an imputation credit 

system, the dividends earned from equity investments overseas are not entitled to a credit to 

offset corporate level taxes, while dividends from 

domestic equity investments do receive such a 

credit. To the extent that this constraint limits the 

typical U.S. multinational’s ability to attach 

credits to dividends from foreign source income, 

there is a tax incentive for U.S. investors to 

switch out of foreign equity and into U.S. equity 

(and possibly debt). On the other hand, in practice, the typical U.S. multinational is likely to 

have a pool of available credits sufficiently large 

to attach a credit to dividends ultimately attributable to marginal investment income from abroad. 

As a result, U.S. investors might enjoy the benefits of integrationon their foreign equity holdings, 

so an increase in these investments might occur. 

An imputation credit system, thus, would have an 

ambiguous effect on total U.S. holdings of foreign 

assets. Debt holdings decline and equity holdings 

rise. Because of the greater international mobility 

of debt assumed in the simulations and the greater 

weight of debt in holdings of foreign assets, 

however, total U.S.investment overseas declines 

slightly. 
145 Economic Analyses 

The projected effects of the dividend exclusion 

prototypes are similar in character to the imputation credit, but somewhat smaller in magnitude 

because dividend exclusion provides a smaller 

benefit to U.S. equity investors. Under the dividend exclusion prototype, dividends originating 

form overseas investments are not eligible for 

exemptionat the shareholder level. As in the case 

of the imputation credit system, the simulationsin 

Table 13.11 assume that this limitation does not 

seriously restrict the typical U.S. multinational 

company’s ability to pay excludable dividends. As 

a result, U.S. holdings of foreign equity are projected to increase. U.S. investment in foreign debt 

declines because of the rise in U.S. interest rates. 

CBIT would be unlikely to change 

substantially the incentives for U.S. investors to 

hold foreign equity, but might reduce substantially 

incentives for them to hold foreign debt. In part 

because foreigners might shift out of U.S. debt, 

an increase in the after-tax return available to 

U.S. investors on U.S. debt could accompany 

CBIT. The higher return available domestically 

would offer an incentive for U.S. investors to 

shift out of foreign debt and into U.S. debt. The 

extent of the rise in the after-tax interest rate 

available to U.S. residents, however, is uncertain 

because the extent to which foreign investors 

would switch out of U.S. debt is uncertain. 

Components of the Balance of Payments 

This section discusses each prototype’s effects 

on the three major components of the balance of 

payments: net capital flows, net trade balance, 

and net receipt of investment income. These three 

components must balance (sum to zero) so a tax 

law change cannot affect just one; the other 

components must show an offsetting adjustment. 

Shareholder allocation and distribution-related 

prototypes have similar effects on the balance of 

payments in the model. Both would leave net 

capital flows largely unchanged. As the discussion 

above suggests, there is uncertainty about the size 

of the portfolio shifts that the prototypes would 

cause. Nonetheless, our results suggest that 

offsetting changes in incentives produce a small 

net effect on capital flows. The calculations 

indicate that on balance these prototypes lead to a 

very small change in the flow of capital into the 

United States. Both prototypes reduce net payments of investment income to foreigners. This 

effect arises primarily because of the decline in 

the pre-tax return on U.S. equity. Both prototypes 

reduce the net trade balance. With capital flows 

largely unchanged and reduced net investment 

income paid to foreigners, the trade balance must 

fall, so the overall balance sums to zero. 

Ascertaining effects of CBIT are again difficult. By reducing incentives for foreigners to hold 

CBIT debt, CBIT could encourage some flow of 

capital out of CBIT debt. Foreigners would likely 

shift their U.S. investment out of corporate bonds 

into nonCBIT government and home mortgage 

debt, however. The combination of a possible 

capital outflow under CBIT and the lower pre-tax 

returns available to foreigners on some of their 

U.S. investments implies that net payments of 

investment income to foreigners would fall, or 

US. net receipts rise. To the extent that CBIT 

shifts capital out of the United States, but raises 

U.S. net receipts of investment income, CBIT 

would have an ambiguous effect on the trade 

balance. 

Domestic U.S. Capital Stock 

Each prototype’s effect on the domestic capital 

stock depends on its effect on net capital flows, 

combined with its effect on saving out of changes 

in real income. Both shareholder allocation and 

distribution-related integration have a small, 

positive effect on the flow of capital into the 

United States in the model. These prototypes also 

increase U.S. real income as a result of efficiency 

gains from reduced net payments of investment 

income to foreigners. Consequently, these prototypes increase very modestly the U.S. capital 

stock. We have not attempted to model formally 

effects of CBIT on the size of the U.S. domestic 

capital stock. 
Economic Analyses 146 

13.6 DISTRIBUTIONAL EFFECTS 

OF INTEGRATION 

Incidence of the Corporate Tax: 

Theoretical Predictions 

Like most taxes, the corporate income tax 

alters the distribution of real income of individuals. This section discusses the evidence relating to 

who bears the burden of the corporate tax and 

issues to be resolved in analyzing distributional 

effects of integration. 

Issues 

A basic principle underlying proposals for 

integration is that because corporations are owned 

by shareholders, corporations have no taxpaying 

ability independentof their shareholders. Corporations pay taxes out of the incomes of their shareholder~.~*The economic burden of a tax, however, frequently does not rest with the person or 

business who has the statutory liability for paying 

the tax to the government. This burden, or incidence, of a tax refers to the change in real incomes that results from the imposition of a change 

in a tax. Importantly, the burden of the corporate 

tax may not fall on shareholders. A corporate tax 

change could induce responses that would alter 

other forms of income as well. For example, 

some of the burden may be shifted to workers 

through lower wages, to consumers of corporate 

products through higher prices, to owners of 

noncorporate capital through lower rates of return 

on their investments, or to landowners through 

lower rents. This shifting might not happen 

quickly, so the short-run incidence could well 

differ from the long-run incidence. 

Tax policy analysts have long been concerned 

with the incidence of the corporate tax.73 

Although there is no unanimous view, the most 

frequent finding is that, while shareholders are 

likely to bear the burden of the tax in the short 

run, much of the tax is probably shifted to owners 

of all capital in the long run. Some further shifting onto labor or consumers also may be possible, 

however, under certain circumstances. 

me Basic Harberger Model 

An early incidence analysis was offered by 

Harberger.74 

Suppose that investors always allocate capital 

so as to equalize its net return at the margin 

across sectors. Consider the imposition of an 

extra tax on corporate capital, starting from an 

equilibrium in which net rates of return are 

equalized. The immediate effect is to lower the 

net rate of return in the corporate sector by the 

amount of the tax. In the short run, therefore, the 

tax is borne by corporate shareholders. Over time, 

however, capital begins to shift out of the corporate sector as investors seek the higher (after-tax) 

rates of return available in the noncorporate 

sector. As capital moves into the noncorporate 

sector, its pre-tax rate of return in that sector 

falls, while the pre-tax return in the corporate 

sector rises. The migration of capital stops only 

when the pre-tax returns change enough that the 

after-tax rate of return in the corporate sector 

equals the rate of return in the noncorporate 

sector. Although the tax is levied only on corporate capital, noncorporate capital also suffers from 

the tax in the long run; owners of noncorporate 

capital receive a lower net rate of return. Indeed, 

Harberger found that under reasonable assumptions, the burden of the corporate income tax is 

borne equally by owners of all capital. 

As in any model, the outcome depends on 

initial assumptions. Much attention in the academic literature has been given to the consequences of 

changing various assumption^.^^ For example, if 

the marginal investment is financed by debt, the 

burden of the tax may fall on corporate 

shareholders.76 

Incidence in a Dynamic Economy 

In principle, the incidence of the corporate tax 

in a dynamic economy can be quite different from 

the Harberger approach, in which the supply of 

capital is fixed. Intuitively, to the extent that the 

corporate tax (and taxes on capital income 

generally) reduces saving, the capital stock can 
147 Economic Analyses 

diminish, thereby decreasing wage rates and 

shifting the burden to labor. 

Analyzing this point is difficult, however. In 

addition to addressing the controversy over the 

size of the sensitivity of saving to changes in the 

net return, one must specify an increase in some 

other tax to compensate for eliminating the corporate tax. For example, in a life-cycle context, 

fmancing the elimination of the corporate tax by 

increasing taxes on individual income could 

increase or decrease the capital stock and income. 

(There are offsetting effects here, since the redistribution of income from younger high-savers to 

older low-savers would reduce the incentive 

effects of the tax.) 

While the response of savings to the elimination of the corporate tax (holding total income 

taxes constant) is likely to be relatively small, 

there are important distributional effects across 

individuals within a generation with different 

mixes of labor and capital income and across 

generations. 

Incidence in an Open Economy 

Many authors have suggested that the incidence of the corporate tax can be dramatically 

different from Harberger’s early closed economy 

analy~is.’~With frictionless international capital 

markets for securities and real investment, a 

small, open economy is a price-taker in international capital markets. Imposing a corporate tax in 

such an economy would cause capital to flow 

abroad until net rates of return are once again 

equalized internationally. To the extent that labor 

cannot emigrate, the incidence of the tax falls on 

domestic labor. 

While correct, this argument is likely to have 

limited applicability to an analysis of the incidence of the corporate tax in the United States. 

First, the United States is not a small, open 

economy; it owns approximately 30 percent of the 

worldwide capital stock. Second, world capitalmarket integration, in practice, is substantially 

less than complete, particularly for equity capital.78 As a result, even if capital is mobile 

internationally, owners of domestic capital could 

be expected to bear a significant portion of the 

long-run burden of the tax.79 

Summary 

While there is no fm agreement on the 

incidence of the corporate income tax, the literature suggests the following assumptions on which 

distributional analyses are conventionally based: 

(1) the short-run incidence falls on owners of 

corporate stock in proportion to their corporate 

income or (2) the long-run burden falls either 

completely on owners of all capital, or partly on 

owners of capital and partly on workers.*o 

Assessing Distributional Impacts of 

Integration Prototypes 

Distribution of Efective Tax Rates 

The preceding discussion highlights the importance of assumptions about incidence for analyzing long-run distributional effects of corporate tax 

integration. Effects of integration on the distribution of the tax burden also depend on how integration would be financed (discussed below). 

Tables 13.12 and 13.13 summarize the distributional consequences of the dividend exclusion, 

imputation credit, shareholder allocation, and 

CBIT integration prototypes, consistent with our 

revenue estimates (see Section 13.H) and the 

incidence assumptionsdiscussed above. The tables 

describe the long-run distribution of tax burdens 

as measured by effective tax rates relative to 

current law, after taxpayers have adjusted their 

behavior in response to the new regimes. The 

calculations represent the combined effects of 

changes in individual and corporate taxes, as well 

as changes in fiduciary, employment, and excise 

taxes.81 

For each prototype, the estimated effective tax 

rates in Table 13.12reflect our preferred assumption about the long-run incidence of the corporate 

tax,that the taxburden is borne by the owners of 

all capital. Table 13.13 shows for each prototype 

the estimated effective tax rates under the alternative assumption that the corporate income tax is 
Economic Analyses 148 

Table 13.12 

Effective Tax Rates on Individuals: 

Current Law and Integration Prototypes

Standard Incidence Assumption' 

I Dividend I hputation 

(1991) I Exclusion I Credit 

Family 

Economic 

Income 

0- 10 

10- 20 

20- 30 

30- 50 

50- 75 

75-100 

100-200 

over 200 

Total Individual 

Shareholder 

Allocation 

With 

Prototype Capital 

Alone Tax2 

Income) 

10.0 10.4 

12.8 13.3 

16.0 16.5 

18.7 19.2 

20.4 20.9 

21.8 22.2 

22.6 23.3 

22.1 23.5 

20.1 20.7 

CBIT: No Tax CBIT: with Tax 

on CBIT on CBIT 

Capital Gains Capital Gains 

With With 

Prototype Capital Prototype Capital 

Alone Tax2 Alone Tax2 

10.5 10.4 10.6 10.1 

13.5 13.5 13.8 13.1 

16.8 16.7 17.1 16.4 

19.5 19.4 19.8 19.2 

21.3 21.2 21.6 21.1 

22.8 22.8 23.1 22.6 

23.9 23.8 24.6 23.8 

22.9 22.8 26.0 24.5 

20.9 20.9 21.8 21.0 

0.009 10.1 10.0 10.2 

0.037 13.0 12.9 13.1 

0.061 16.3 16.2 16.3 

0.155 19.1 18.9 19.1 

0.202 20.8 20.6 20.7 

0.162 22.3 22.0 22.1 

0.191 23.8 23.2 23.5 

0.183 24.1 23.9 24.4 

1.000 20.9 20.6 20.8 

10.0 10.2 

12.8 13.0 

16.0 16.2 

18.8 19.0 

20.6 20.8 

22.0 22.2 

23.4 23.7 

23.8 24.3 

20.5 20.8 

Department of the Treasury 

Office of Tax Policy 

'Corporate income tax assumed to be borne 100% by capital income. 

2Capitaltax change imposed to offset change in revenue from prototype. Capital tax assumed to be distributed uniformly 

across all capital income. 

Table 13.13 

Effective Tax Rates on Individuals: 

Current Law and Integration Prototypes Alternative Incidence Assumption 

Current Law: Dividend Imputation 

(1991) Exclusion Credit 

With With 

Income 

(Taxes Percentages of 1 

0- 10 0.009 10.6 10.6 10.8 10.6 10.9 

10- 20 0.038 13.3 13.3 13.5 13.2 13.4 

20- 30 0.062 16.6 16.5 16.7 16.3 16.6 

30- 50 0.156 19.5 19.3 19.5 19.1 19.4 

50- 75 0.205 21.3 21.1 21.3 21.1 21.3 

75-100 0.164 22.7 22.4 22.6 22.4 22.7 

100-200 0.190 23.8 23.3 23.6 23.5 23.8 

over 200 0.176 23.4 23.1 23.4 23.0 23.4 

Total Individual1 1.000 21.0 20.7 21.0 20.7 21.0 

Department of the Treasury 

Office of Tax Policy 

Shareholder on CBIT 

With With 

'rototypeCapital Prototype Capital 

Alone Tax2 Alone Tax' 

:ome) 

10.6 11.2 11.3 11.2 

13.2 13.9 14.0 14.0 

16.3 17.0 17.3 17.2 

19.1 19.7 20.0 20.0 

20.9 21.5 22.0 21.9 

22.2 22.8 23.4 23.4 

22.7 23.5 23.9 23.9 

21.3 22.4 21.5 21.4 

20.2 21.0 21.1 21.0 

CBIT: with Tax 

on CBIT 

Capital Gains 

With 

Prototype Capital 

Alone Tax2 

11.5 10.8 

14.3 13.5 

17.6 16.8 

20.3 19.6 

22.3 21.6 

23.8 23.1 

24.7 23.9 

24.5 23.3 

22.0 21.1 

'Corporate income taxes assumed to be borne 50% by labor, 50% by capital income. 

'Capital tax change imposed to offset change in revenue from prototype. Capital tax assumed to be distributed uniformly 

across all capital income. 
149 

borne half by capital income and half by labor 

income. 

The tables classify individuals according to 

their Family Economic Income (FEI). FEI is a 

broad concept of income that attempts to capture 

family income from all sources, taxed and untaxed, in the current year. The concept is designed to place families into income classes with 

others about equally well off, with those in higher 

income groups considered consistently better off 

than those in lower income groups.** 

When we presented estimates of integration on 

economic efficiency earlier in the chapter, we 

incorporated explicitly the requirement that revenues lost as a result of integration be compensated 

by offsetting tax increases. These we considered 

as replacement taxes lump-sum taxes and uniform 

increases in taxes on capital income. Since lumpsum taxes are not available to policymakers, we 

present distributional information in Tables 13.12 

and 13.13 assuming that tax rates on capital 

income are increased to finance integration. 

Dividend Exclusion 

The dividend exclusion prototype would 

reduce total revenues when fully phased in (see 

Section 13.H). All FEI groups would receive a 

slight reduction in effective tax rates. With the 

capital tax replacement, there would be very small 

differences in the effective tax rates under current 

law and the dividend exclusion prototype (including a slight increase in the effective tax rate for 

the highest income group). Hence, the efficiency 

gains made possible by this integration prototype

(see Section 13.F) could be obtained with no loss 

in revenue and with only slight changes in the 

distribution of tax burdens across income groups. 

This conclusion holds irrespective of underlying 

assumptions regarding the long-run incidence of 

the corporate tax (compare Tables 13.12 and 

13.13). 

Imputation Credit 

The distributional consequences of the imputation credit prototype are qualitatively similar to 

Economic Analyses 

those for dividend exclusion under both incidence 

assumptions. The imputation credit prototype, 

described in Chapter 11, would lose revenue 

when fully phased in. The revenue neutral version 

of the prototype decreases the reduction in effective tax rates for upper income groups, with a tax 

increase for the highest FEI group (with FEI 

exceeding $200,000 per year). 

Shareholder Allocation 

The third column of calculations in Tables 

13.12 and 13.13 presents the distribution of 

effective tax rates under the shareholder allocation 

prototype. There would be a significant annual 

revenue loss under shareholder allocation when 

fully phased in (see Section 13.H), leading to 

reductions in effective tax rates larger than under 

the distribution-related integration proposals, 

particularly for the top two income groups (with 

FEI of at least $100,000 per year). With an 

offsetting uniform increase in tax rates on capital 

income to finance the revenue loss, tax reductions 

for upper-income taxpayers are attenuated, with 

slight overall increases in tax burdens for middleincome groups. 

CBIT 

Unlike the other integrationprototypes considered in this Report, CBIT would not lose revenue. 

When fully phased iti, the CBIT prototype would 

raise a small amount of revenue with no taxation 

of capital gains from the sale of CBIT assets, and 

a substantial amount of revenue with current law 

treatment of capital gains (see Section 13.H). In 

the former case, the revenue neutral version 

amounts to a very small tax increase for lowerand middle-income groups and a reduction in the 

effective tax rate for the highest income group. 

The reduction for the highest FEI group more 

reflects the distributional implications of the 

elimination of the capital gains tax on the sale of 

CBIT assets than the characteristics of CBIT as an 

integration prototype. To see this, note that the 

revenue neutral version of CBIT with current law 

treatment of capital gains has only very small 

impacts on effective tax rates relative to current 

law. These patterns of effective tax rates are 
Economic Analyses 150 

qualitatively similar under the two incidence 

assumptions we considered. 

13.H REVENUE ESTIMATES FOR 

INTEGRATION PROTOTYPES 

This section presents revenue estimates for 

integration prototypes. Below we discuss: the 

revenue estimating procedures and the assumptions behind the revenue estimates, long-run 

revenue estimates for each prototype, and revenue 

estimates for a 5 year budget period under the 

assumption that the proposals would be adopted 

effective January 1, 1992, and phased in over a 5 

year period. While the prototypes are not legislative proposals and we do not contemplate that any 

would be proposed with so early an effective date, 

5 year estimates based on the economic assumptions used to estimate other items in the Fiscal 

Year 1992 Federal budget are useful to permit 

comparison with other proposals. 

Procedures and Assumptions 

We prepared revenue estimates for the integration prototypes using the Individual Income Tax 

Model and the Corporate Income Tax Model of 

the Office of Tax Policy. These models are based 

on large samples of individual and corporate tax 

returns. Detailed computer programs are used to 

calculate tax liabilities and simulate changes in tax 

law provisions. 

Earlier in this chapter, we examined economic 

effects of the adoption of the prototype integration 

proposals. The revenue estimates presented in this 

section are dynamic. That is, the revenue estimates use the changes in economic variables 

predicted by a computable general equilibrium 

model to adjust the levels of various components 

of income and deductions on the tax models. 

Among the important economic changes incorporated in the estimates for corporations are changes 

in dividend payout rates, debt to equity ratios, the 

share of capital in the corporate sector, and rates 

of return to capital in the corporate sector. 

Among the important changes in individual taxpayer behavior taken into account are those in 

levels of interest and dividend income, income 

from non-corporate businesses (sole proprietorships, partnerships, farms, and small business 

corporations), capital gains realizations, and 

interest deductions. Changes in interest rates 

affect the income and deductions of both corporations and individuals. The effects of the proposals 

on the incentives of foreigners and tax-exempt 

institutions to hold different types of assets in 

their portfolios are taken into account. 

Following the standard convention of revenue 

estimates produced by the Office of Tax Policy, 

Gross National Product (GNP) and the overall 

inflation rate are assumed to be unchanged as a 

result of the adoption of the prototype^.^^ Interest rates, relative prices, and the allocation of resources among sectors of the economy do change 

depending on the expected economic effects of the 

prototype. The allowance for changes in interest 

rates is not strictly in accord with conventional 

revenue estimating procedures because of the 

nature of the proposals estimated. The integration 

proposals are more likely to affect relative interest 

rates paid on different types of assets than tax 

changes commonly estimated. In particular, the 

significant changes introduced by some of the 

prototypes make it important to consider changes 

in interest rates. 

An important additional assumption for the 

revenue estimates is that tax provisions other than 

those included in the proposal remain the same as 

under current law. An actual legislative proposal 

would include other changes which could affect 

the estimates presented here. 

Effects of Integration on 

Federal Tax Revenue 

We estimated fully phased-in revenue effects 

for each of the prototypes (at the 1991 level of 

real GNP) incorporating behavioral changes that 

would occur in the long run. These behavioral 

changes are those which would be expected to 

occur after the economy has fully adjusted to the 

new tax regime. While these estimates are not 

necessarily correct for the short run or the 5 year 
151 Economic Analyses 

budget period, they are important for understanding the long-run effects of the integration 

prototypes. 

Dividend Exclusion 

The dividend exclusion prototype taxes corporate income (defined as under current law) at a 

rate of 34 percent. Dividends paid out of taxed 

corporate income, i.e., those qualified by an 

Excludable Distributions Account (EDA) as 

described in Section 2.B, are not taxed at the 

individual level.84The amount added to the EDA 

is based on U.S. corporate taxes paid.85 This 

excludes foreign taxes paid to the extent that they 

offset domestic taxes through the foreign tax 

credit.86Capital gains from the sale of corporate 

shares are treated the same as under current law. 

Outbound foreign investment is basically treated 

the same as under current law. For inbound 

investment, the withholding tax on dividends paid 

to foreigners is maintained. 

The basic principle of the dividend exclusion 

prototype is to reduce the double tax on distributed corporate income. We estimate that when fully 

phased in, integration through dividend exclusion 

loses $13.1 billion annually at 1991 levels of 

income. 

Dynamic changes in the economy would 

increase corporate income tax receipts under the 

dividend exclusion prototype. Increases in corporate tax receipts would result from the incentive to 

shift corporate financing from debt to equity. The 

reduction in corporate borrowing would decrease 

corporate interest deductions. Induced changes in 

interest rates also would affect corporate interest 

deductions and therefore affect corporate tax 

revenues. The increases in corporate tax revenues 

would be slightly more than offset by the decrease 

in individual income tax receipts from the dividend exclusion. The dividend exclusion, thus, 

provides incentives for corporations to increase 

excluded dividends. In closely-held corporations, 

the incentive under current law to pay out profits 

as managerial wages or interest would be largely 

eliminated, and there would therefore be some 

substitution of dividends for wages and interest 

payments to owners. 

CBIT 

The CBIT prototype for integration extends 

the logic of the dividend exclusion prototype to 

debt, Neither interest nor dividend payments 

would be deductible at the corporate level, but 

both interest and dividend payments from CBIT 

entities generally would be excludable at the 

investor level. The entity level CBIT tax rate of 

31 percent would apply to both corporate and 

noncorporate businesses (except for small businesses, which would be taxed as under current 

law). Unlike interest on CBIT debt, home mortgage interest would continue to be deductible by 

the borrower and taxable to the lender, as under 

current law. Interest on U.S. Government debt 

would be taxable to the recipient. Interest taxexempt under current law would remain taxexempt to recipients under CBIT. We considered 

two alternative assumptions for the taxation of 

capital gains on CBIT assets: (1) no taxation of 

capital gains on CBIT assets and (2) current law 

treatment of capital gains on CBIT assets. 

In contrast to the other integration prototypes, 

the CBIT prototype would increase tax receipts 

relative to those under current law. Once the 

behavioral changes are fully accounted for, the 

annual increase in revenues would be $3.2 billion 

with no taxation of capital gains on CBIT assets 

and $41.5 billion with current law treatment of 

capital gains. While overall tax receipts would be 

increased under the CBIT prototype, individual 

tax payments would be substantially reduced 

because dividends, noncorporate business income, 

most interest and some capital gains would no 

longer be taxable to individual recipients. The 

reduction in individual incometaxreceipts reflects 

the taxation of capital income at the entity level. 

Noncorporate entities subject to CBIT would now 

be taxed at the 31 percent CBIT rate. Much of 

this income is currently taxed under the individual 

income tax. 
Economic Analyses 152 

Shareholder Allocation 

The shareholder allocation prototype approximates passthrough integration more closely than 

the dividend exclusion or CBIT prototypes. The 

prototype would retain a corporate tax rate of 34 

percent. Taxable shareholders would receive a 31 

percent credit for corporate level taxes paid, while 

tax-exempt and foreign shareholders would receive no credit. The credit would accompany the 

allocation of corporate income to the shareholder. 

Intercorporate dividends would be granted a full 

dividends-received deduction in lieu of a credit. 

Under this prototype, corporate income tax is 

taxed at the individual level as part of corporate 

income rather than as a separate income item. 

Capital gains on corporate stock due to retained 

earnings would not be taxed, since undistributed 

corporate income would increase shareholders’ 

basis. Increases in corporate stock values from 

other sources would be taxed as under current 

law. For outbound investment, the foreign tax 

credit would be passed through at the taxable 

investor’s rate. For inbound investment, the 

withholding tax on dividends paid to foreign 

investors would be retained. 

Because shareholder allocation integration 

would extend distribution-related integration to 

retained earnings and shareholders would not be 

taxed on untaxed corporate preference income, it 

would lose significantly more revenue than would 

the dividend exclusion prototype. We estimate that 

when fully phased in, shareholder allocation 

integration would lose $36.8 billion annually at 

1991 levels of income. 

Most of the revenue loss would be in the 

individual income tax. While taxable income of 

individuals would be increased substantially by 

including all corporate income (rather than just 

dividends received), this would be more than 

offset by the revenue loss from the credit for 

corporate taxes paid. For taxpayers in the 31 

percent tax bracket, the tax on the additional 

income and the credit for corporate taxes paid 

would offset each other and leave taxes approximately unchanged. For taxpayers in lower tax 

brackets, however, the additional corporate 

income subject to tax would be taxed at a lower 

rate than the credit. For example, taxpayers in the 

15 percent bracket would be taxed at 15 percent 

on the additional income but receive a credit at a 

31 percent rate. For lower tax bracket taxpayers, 

the corporate credit can be used to offset taxes 

against wages and other income. 

The other major factor in the large revenue 

loss from the shareholder allocation prototype is 

the basis adjustment for corporate stock. 

Shareholders’ basis would rise to reflect income 

already taxed at the corporate level, and so revenues from the taxation of capital gains on sales of 

stock would be reduced. 

Corporate tax receipts would increase, since 

dynamic behavioral changes (including the expansion of the corporate sector) are taken into account. As with distribution-related integration, the 

increase in corporate tax receipts results primarily 

from the reduction in corporate debt and therefore 

in interest deductions. 

Imputation Credit System 

The final prototype we considered is distribution-related integration through an imputation 

credit system. Under this prototype, corporate 

taxes paid are credited to a shareholder credit 

account (SCA). Individual shareholders report 

dividends grossed-up (by one divided by one 

minus 0.31) to reflect corporate taxes paid and 

receive a credit for corporate taxes paid. The 

prototype calculates the credit and gross-up factor 

at the top individual 31 percent tax rate rather 

than the top 34 percent corporate tax rate to limit 

the credit to no more than the individual income 

tax paid by individuals in the highest tax bracket. 

We estimate that accomplishing distributionrelated integration through an imputation credit 

system would generate a fully phased-in revenue 

loss of $14.6 billion per year. 
APPENDICES 

APPENDIXA: 

THECORPORATE INCOME TAXINTHE UNITEDSTATES

A.1 BRIEF DESCRIPTION OF THE 

CORPORATE INCOME TAX 

The corporate income tax originally was 

enacted in 1909 as an excise tax on the privilege 

of doing business in the corporate form. An 

individual income tax on dividend income was 

enacted in 1916. 

The Corporate Income Tax Base 

Corporations are generally taxed at a 34 

percent marginal rate on their taxable income. To 

compute taxable income, a corporation deducts 

from gross income business expenses paid or 

incurred during the taxable year. These expenses 

include employee compensation, state and local 

taxes, depreciation, and interest expense, but not 

dividends paid. When deductions exceed income, 

a corporation has a net operating loss (NOL). 

Corporations generally can carry back net operating losses to offset taxable income for the 3 

preceding years and can carry forward any remaining net operating loss to offset taxable 

income for 15 years. 

Like individuals, corporations generally 

include gains on appreciated assets in income (and 

deduct losses on depreciated assets from income) 

only when the assets are sold or otherwise disposed of (when the gains or losses are realized). 

Corporations may deduct capital losses only 

against capital gains, and unused capital losses 

may be carried back for 3 years and forward for 

5 years. 

Because the double tax on corporate earnings 

distributed to shareholders might become a triple 

or quadruple tax if corporations were taxed in full 

on dividends received from other corporations, a 

corporate shareholder is entitled to a full or 

partial dividends received deduction (DRD), depending on its percentage ownership of the 

distributing corporation. 

U.S.corporations are subject to tax on foreign 

as well as domestic income. Although a U.S. 

corporation is required to pay U.S. tax currently 

on foreign income earned through a foreign 

branch, U.S. tax is generally not imposed on 

earnings of a foreign subsidiary until the subsidiary distributes its income to the parent corporation as a dividend. In computing U.S. tax 

liability, U.S. taxpayers (including corporations) 

are allowed a credit for foreign taxes paid, subject 

to certain restrictions. See Chapter 7. 

In addition to these general rules, special rules 

apply to specific types of businesses that conduct 

activity in corporate form, such as financial 

institutions and insurance companies. Other 

special rules apply to specific types of activities, 

such as the exploration, development, and production of natural resources. Certain types of corporations are granted full or partial relief from 

corporate level tax. 

Tax Rates 

Corporations are subject to tax at a rate of 15 

percent on the first $50,000 of taxable income, 25 

percent on the next $25,000 of taxable income, 

and 34 percent on mable income above $75,000. 

The marginal rate on a corporation’s taxable 

income between $100,000 and $335,000 is increased by 5 percent to phase out the benefit of 

the graduated rate structure. Thus, corporations 

with incomes in the phaseout range pay tax at a 

marginal rate of 39 percent. Corporations with 

taxable incomes in excess of $335,000 pay tax at 

153 
Appendices 154 

a flat 34percent rate. In 1989, over 90 percent of 

corporate taxable income was taxed at the 34 

percent rate. 

Corporations also are subject to an alternative 

minimum tax (AMT).Corporations pay AMT 

only if their minimum tax liability exceeds their 

regular tax liability. A corporation’s AMT base is 

its taxable income, adjusted to eliminate the 

benefit of certain deferrals of income, accelerations of deductions, and permanent exclusions. 

The resulting amount, alternative minimum taxable income (AMTI),is reduced by an exemption 

amount and is taxed at a 20 percent rate. The 

basic exemption amount is $40,000,which is 

reduced by 25 percent of the amount by which 

AMTI exceeds $150,000. A corporation’s minimum tax liability can generally be credited against 

future regular tax liability. 

Entities Subject to the Corporate Tax 

A business entity is taxable as a corporation if 

it is organized as a corporation under state law. In 

addition, Treasury Regulations treat an unincorporated entity as a corporation if it has more 

corporate characteristics than noncorporate 

characteristics. The four relevant corporate characteristics are: (1) continuity of life, (2) centralization of management, (3) limitation of liability 

for debts to property of the entity, and (4)free 

transferability of interests.’ Certain partnerships 

also are treated as corporations if their interests 

are traded on an established securities market or 

are readily tradable on a secondary market (or its 

equivalent) and the partnership is not engaged in 

a qualifying passive activity. 

Subchapter C refers to the provisions of the 

Code that apply to most corporations. In 1958, 

Congress enacted Subchapter S of the Code to 

enable certain corporations to elect exemption 

from the corporate level tax. S corporations, like 

partnerships, are generally treated like conduits 

for tax purposes. The income of S corporations is 

taxed directly to their shareholders. To qualify for 

this passthrough treatment, a corporation must 

have no more than 35 shareholders and only one 

class of stock, and all of its shareholders must be 

individuals who are U.S. citizens or residents or 

certain trusts and estates. There also are restrictions on an S corporation’s afffiations with other 

corporations. 

In addition to S corporations, other entities 

that meet certain restrictions on assets, type of 

business, and distributions to shareholders qualify 

as conduits for all or a portion of their income. A 

regulated investment company (RIC), a mutual 

fund that makes diversified investments for its 

shareholders, pays no tax on amounts distributed 

to its shareholders if it distributes currently at 

least 90 percent of its dividend and interest income and meets certain other condition^.^ A real 

estate investment trust (REIT), a corporation or 

association that specializes in investments in real 

estate and real estate mortgages, also may receive 

passthrough treatment if it meets certain conditions designed to ensure that its assets and income 

are primarily related to real estate! A real estate 

mortgage investment conduit (REMIC), an entity 

that holds a fixed pool of mortgages and issues 

multiple classes of interests to investors, also 

qualifies for passthrough treatment.5 Qualified 

distributions to members of cooperative organizations also are taxed directly to the members and 

are not taxed at the entity level. 

Treatment of Debt and Equity 

Under present law, the tax treatment of the 

returns to an investor in a corporation depends 

upon whether an investment is considered debt or 

equity. A corporation generally can deduct interest on corporate debt.6 Consequently, corporate 

earnings paid to debtholders as interest bear no 

tax at the corporate level. In contrast, because 

dividends are not deductible, corporate tax must 

be paid on the earnings attributable to equity 

investments, regardless of whether the earnings 

are retained or distributed. 

Individual debtholders are taxed on interest 

income when received or accrued, in accordance 

with their method of accounting. Individuals are 

taxed on corporate income when the income is 

distributed to them as dividends? Increases in the 

value of corporate stock held by individuals, 
155 

whether due to retained earnings, appreciation of 

the corporation’s assets, or other factors, are 

generally not taxed until the stock is sold.* Such 

gains are generally capital gains. Individuals also 

may not deduct losses on corporate stock until the 

stock is sold. Such losses are generally capital 

losses and may be deducted without limitation 

against capital gains. However, capital losses in 

excess of capital gains also may be used to offset 

only $3,000 of an individual’s ordinary income 

per year, with any excess carried forward 

indefinitely. 

Corporate debtholders also pay tax on interest 

income when received or accrued, in accordance 

with their method of accounting. A corporate 

shareholder must include all dividends in income 

but can deduct a portion of dividends received 

from other domestic corporations. The deduction 

for dividends received is 70 percent if the recipient corporation owns less than 20 percent of the 

stock of the payor, and 80 percent if the recipient 

corporation owns between 20 percent and 80 

percent of the stock of the payor.’ Intercorporate 

dividends among members of afffiated groups 

(each 80 percent or more owned, directly or 

indirectly, by a common parent) are generally 

fully deductible by the recipient. Thus, the maximum rate of tax on dividends received by corporate shareholders is generally 10.2 percent (30 

percent of dividends received multiplied by the 34 

percent corporate tax rate). Corporate capital 

gains are currently taxed at the same rate as 

ordinary income, and capital losses may offset 

capital gains, but not ordinary income, with a 

3 year carryback and 5 year carryforward. 

Although debt and equity are treated very 

differently by the tax system, distinguishing debt 

from equity is not straightforward. In 1969, 

Congress authorized the Department of the Treasury to issue regulations to determine whether an 

interest in a corporation should be treated as stock 

or debt for tax purposes. Congress suggested that 

Treasury consider the following factors in making 

this determination: (1) the existence of a written 

unconditional promise to pay on demand or on a 

specified date a sum certain in money at a fmed 

Appendices 

rate of interest, (2) whether the instrument is 

subordinated to or has preference over any debt of 

the corporation, (3) the issuer’s debt to equity 

ratio, (4) whether the instrument is convertible 

into stock, and (5) the relationship between 

holdings of the issuer’s stock and holdings of the 

instrument in question.lo 

Although Treasury issued three drafts of 

regulations attempting to distinguish debt from 

equity, the task of devising simple, workable rules 

for distinguishing between debt and equity proved 

elusive. Ultimately, Treasury withdrew all of 

these regulations. 

In the absence of regulations, taxpayers and 

the IRS look to judicial opinions and IRS rulings 

to determine whether an instrument will be treated 

as debt or equity for tax purposes. In addition to 

the factors listed in the 1969 statute, the following 

factors have been considered relevant: (1) the 

holder’s rights upon default, (2) the equity features of the instrument, such as voting rights or 

participation in earnings, (3) whether the corporation has sufficient projected cash flow to service 

the debt, (4) whether the holder has management 

rights, and (5) whether the holder acts like a 

reasonable creditor in protecting its rights. 

To summarize, it has not proved possible to 

develop simple and acceptable guidelines for 

distinguishing between debt and equity. As fmancial markets become more flexible and innovative, 

that task becomes more difficult. The administrative complexity and compliance costs associated 

with making the debt-equity distinction are serious 

problems in the current system of corporate 

taxation. 

Cross-Border Investment 

The tax treatment of cross-border investment 

is discussed in Chapter 7. 

Tax-Exempt Organizations 

The treatment of tax-exempt organizations is 

discussed in Chapter 6. 
Appendices 156 

A.2 OVERVIEW OF U.S. 

CORPORATE TAX RECEIPTS 

In 1990, the corporate tax generated Federal 

revenues of $93.5 billion. Federal corporate tax 

receipts have generally increased over the past 40 

years, but when adjusted for inflation, they have 

fallen since the late 1960s. In constant 1982 

dollars, corporate tax receipts averaged $85 

billion per year in the 1950s, $86 billion per year 

in the 1960s, $77 billion per year in the 1970s, 

and $56 billion per year from 1980 to 1986. Since 

1986, real coqorate tax receipts have averaged 

$76 billion per year in 1982 dollars. From the 

1950s to 1986, corporate receipts also fell as a 

percentage of Federal budget receipts and of gross 

national product (GNP). See Figure A.l. Since 

1986, however, the decline in the relative importance of the corporate tax has stopped and may 

have reversed. From 1987 through 1990, corporate receipts averaged 9.9 percent of total Federal 

budget receipts, above the average of 8.9 percent 

for the rest of the 1980s, but less than the 1970s 

average of 15.0 percent. From 1987 to 1990, 

estimated tax liabilities for nonfinancial corporations, relative to GNP or gross domestic product, 

also slightly exceeded the 

for example, rules requiring uniform capitalization 

of certain expenditures. As anticipated, the 1986 

Act increased corporate income tax receipts (and 

lowered individual income tax receipts) as a 

percentage of total income tax receipts. The 

percentage of income tax receipts accounted for 

by corporate taxes increased from 15 percent in 

1986 to 19 percent in 1989 and dropped back to 

17 percent in 1990. The percentage of income tax 

receipts accounted for by individual income taxes 

fell from 85 percent to 81 percent, rising to 83 

percent in 1990. Current estimates indicate that 

the 1986 Act increased corporate income tax 

receipts by approximately $130 billion from 1987 

to 1991. 

The level of corporate tax receipts depends 

heavily on economic conditions. When the U.S. 

economy is growing, corporate profits are strong, 

and corporate tax receipts increase, but when the 

economy is in recession, corporate profits tend to 

fall, and corporate taxes decrease. During the 

recession of the early 1980s, for example, 

corporate taxes as a percentage of total budget 

receipts fell from 10.2 percent in 1981 to 6.2 

percent in 1983. This decline was mostly 

Fipre A.l average for the early 1980s. Corporate Receipts as a Percentage of 

The Tax Reform Act of I 1940-1991 

1986 (the 1986 Act) adopted 

base-broadening measures 

designed to increase the 

overall level of corporate 50 1 

taxes, although it reduced the Corporate Receipts as a 

Total ReceiDts and Gross National Product 

maximum marginal corporate Percentage of Total Receipts tax rate from 46 percent to 

34 percent. The base broadening was accomplished 

primarily by repealing the 

investment tax credit, limiting 

depreciation deductions, re- Corporate Receipts as a 

stricting the use of net oper- Percentage of Gross National Product 

ating losses, strengthening the 

corporate alternative minimum tax, repealing the 

General Utilities doctrine, 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 

and adopting significant Year 

changes in accounting rules, 
157 Appendices 

attributable to the a decline in pre-tax corporate 

profits, from $202 billion in 1981 to an average 

of $178 billion in 1982 and 1983. 

Foreign countries have a wide variety of tax 

systems, which make it difficult to compare 

directly corporate tax burdens across countries, 

but some general observations can be made. In 

1988, corporate income taxes accounted for an 

average of 8 percent of total income tax receipts 

for the 22 countries in the OECD. The average in 

1988 was the same as in 1980. Although U.S. 

corporate income taxes were 8 percent of total tax 

receipts in 1988, the same as the average for the 

22 OECD countries, the U.S. percentage is 

expected to be higher in subsequent years if 

current trends continue. Countries with percentages higher than the OECD average in 1988 include 

Japan at 24 percent, the United Kingdom at 11 

percent, and Italy at 9 percent; countries with 

percentages below the OECD average include 

Germany at 5 percent, France at 5 percent, and 

Switzerland at 7 percent." 
APPENDIXB: EXPERIENCEOF OTHER COUNTRIES WITH 

DISTRIBUTION-RELATED INTEGRATION SYSTEMS

This appendix briefly describes the distribution-related integrated systems of six of the United 

States' major trading partners.' The Australian 

and New Zealand imputation credit systems most 

closely resemble the prototype discussed in Chapter 11. The United Kingdom system is a prominent example of a compensatory tax system. This 

appendix also discusses the Canadian, French and 

German distribution-related systems. This appendix does not describe the Japanese corporate tax 

system, because in 1989 Japan replaced its split 

rate tax system with a classical system. 

B.1 AUSTRALIA 

Introduction 

Australia's imputation credit system became 

effective July 1, 1987. Major changes to related 

tax laws have subsequently taken effect, most 

notably: 

0 a reduction in the top corporate rate from 49 

percent to 39 percent, 

0 the imposition of a 15 percent tax on the investment income of pension plans, and the extension to 

them of the imputation credit (at the full rate of 39 

percent), and 

the exemption of most foreign income from the 

corporate tax base. 

Description of Mechanics 

Imputation Credits 

Australia's imputation credit system makes 

imputation credits available to taxable shareholders (including pension plans) for distributions 

from the corporation's franking account. Imputation credits provide full relief from the corporate 

level tax paid with respect to distributed income. 

Distributions not paid from the franking account 

are considered to be paid from preference income 

and are taxed to the shareholder without gross-up 

and without credit. 

The shareholder receives an imputation credit 

equal to the amount of distributions from the 

franking account (franked distributions), grossedup at the corporate rate (currently, 39 percent), 

and then multiplied by that rate.2The shareholder 

includes this amount in his income and receives a 

credit in the same amount against his personal tax 

liability. Imputation credits generally are not 

refundable. 

The balance in the franking account represents 

the portion of the corporation's after-tax income 

that, in effect, has been taxed fully (taxed at the 

corporate rate). In general, the franking account 

balance derives from the amount of tax the corporation pays. At the current tax rate of 39 percent, 

for every AU$39 the corporation pays in tax, it 

adds AU$61 to the balance of the account. The 

calculation converts after-tax corporate income 

that is taxed at various rates into an equivalent 

combination of fully-taxed and fully exempt

amount^.^ Thus, Australia's system accords 

shareholders relief only from corporate level tax 

actually paid with respect to distributed income, 

and distributed preference income is subject to tax 

at the shareholder level. 

An Australian corporation must make entries 

in its franking account throughout the year upon 

the occurrence of specified events in the assessment, payment, and adjustment of tax. The 

franking account is credited when the corporation: 

carries forward a franking surplus from the 

previous year, pays tax, receives franked dividends from another company, is served with a 

determination reducing the amount of a "franking 

deficit tax offset," or has an "estimated debit 

determination" (see "Allocating Credits to Dividends," below) that lapses or substitutes a new 

estimated debit determination. 

The franking account is debited when the 

corporation: pays franked dividends, has tax 

refunded, is served with a determination (or 

increase) of a franking deficit tax offset, receives 

159 
Appendices 160 

(or is deemed to receive) notice of an estimated 

debit determination, e.g., appeals a tax assessment, makes on-market share buybacks; or underfranks a dividend (franks it by less than the 

required franking amount, if the required franking 

amount is 10 percent or more of the dividend). 

Compensatory or Withholding Ta 

The Australian system does not have a compensatory or withholding tax on distributions. 

Dividends Defined, Bonus Shares, 

Share Repurchases 

In general, dividends include all non-liquidating distributions of money or other property to 

shareholders out of profits (under corporate law, 

the corporation cannot pay dividends as a return 

of capital without a court order). Liquidating 

distributions generally are deemed to be dividends 

to the extent they represent profits. 

A corporation can issue bonus shares as a 

mechanism for extending the imputation system to 

retained earnings. An issue of bonus shares 

distributed to a shareholder is treated as a dividend unless it is paid out of the corporation's 

share premium account (whichrepresents amounts 

paid on issuance of shares in excess of par value). 

Thus, if the corporation has a sufficient balance in 

its share premium account, it can choose the tax 

treatment of the bonus issue by choosing whether 

or not to debit the account, subject to certain rules 

for dividend-streaming arrangements. See 

"Streaming" below. 

The tax treatment of a share repurchase (or 

"buyback") differs depending upon whether the 

transaction is an "on-market" or an "off-market" 

purchase. An on-market buyback occurs in the 

ordinary course of business on an official exchange; an off-market buyback (a buyback by an 

unlisted company or by a listed company not in 

the ordinary course) occurs otherwise . 

An off-market buyback is treated as a dividend 

to the extent it exceeds paid-up capital for the 

shares (share capital plus the amount, if any, 

allocated to the buyback from the share premium 

account). With respect to the dividend portion, the 

corporation debits its franking account as required 

under the general rules and the shareholder receives the imputation credit. The shareholder's 

basis in his stock is irrelevant for dividend purposes but is relevant for the portion treated as 

return of paid-up capital, so the shareholder could 

have a dividend and a capital gain or loss on the 

same transaction. 

An on-market buyback is treated as a capital 

transaction to the shareholder (because he does 

not know that his buyer is the corporation). The 

corporation has no gain, loss, or deductions. 

However, the corporation must treat the buyback 

as a dividend to the extent it would be a dividend 

if it were off-market and, with respect to such 

amount, must debit its franking account under the 

allocation rules. See "Allocating Credits to Dividends, below. (This notional dividend also might 

affect any provisional required franking amount 

for any actual frankable dividend.) No imputation 

credit is available to the shareholder to offset his 

capital gainB4 

Allocating Credits to.Dividends 

Australia has adopted allocation rules generally designed to assure that a corporation pays 

dividends first out of the franking account, and to 

prevent corporations from streaming franked 

dividends to resident shareholders, who can use 

imputation credits, and unfranked dividends to 

foreign shareholders (and tax-exempt shareholders), who cannot. The allocation rules impose a 

minimum "required franking amount" for a 

dividend and provide for adjustments and sometimes penalties if a dividend is overfranked or 

underfranked by more than a de minimis amount. 

The required franking amount ideally franks 

all dividends paid during the year to the extent of 

the corporation's after-tax income. To ensure that 

the corporation does not underfrank a dividend, 

the rules require the company: (1) to take into 

account all dividendst0 be paid on the same day, 

that have been declared but not yet paid, or that 

the corporation is committed to pay later in the 
161 

same year (a committed future dividend), such as 

dividends on preferred stock, in allocating franking credits to a given dividend, (2) to frank a 

dividend that was a committed future dividend at 

least to the same extent as the earlier dividend, 

and (3) to frank a dividend at least to the same 

extent as any other dividend on the same day.5 

These rules do not, however, prevent a corporation from franking an earlier dividend on one 

class of stock at one rate and franking a later 

dividend on another class of stock at a lower rate 

where the corporation was not committed to pay 

the later dividend or where the later dividend is 

paid in the succeeding year. An upper limit on 

franking is set by reference to the corporate tax 

rate; at current rates, a dividend of AU$61 can 

carry no more than AU$39 of imputation credits. 

The required franking amount could range 

from zero, for a corporation with no taxable 

income, to 39 percent of the dividend, for a 

corporation with sufficient after-tax income. 

However, the required franking amount might not 

be readily determinable when a dividend is distributed during the year, where it is not clear 

whether the corporation will have sufficient 

taxable income for that year. The situation also 

could be complicated by later events, such as a 

refund of previously paid tax. If, for such a 

reason, a year-end deficit were to result, the 

corporation would be subject to a franking deficit 

tax and possibly a penalty tax. An estimated debit 

determination is a procedure for resolving this 

problem; if the corporation expects such a later 

debit, so the dividends paid would turn out to 

have been overfranked, the corporation may 

notify the tax authorities and make an anticipatory 

debit to its franking account. 

If a corporationunderfranks a dividend (and if 

the required franking amount is 10 percent or 

more of the dividend), the corporation must debit 

its franking account to the extent of the underfranking. Thus, the corporation is treated as 

having franked the dividends to the required 

amount, but the shareholders forfeit the imputation credit attributable to the underfranking. 

Appendices 

Where overfranked dividends (or other adjustments) result in a deficit in the franking account 

at the end of the year, the corporation must pay a 

franking deficit tax.The franking deficit tax is the 

amount of tax sufficient to restore the franking 

account to zeroe6This tax does not result in a 

positive credit to the franking account, because it 

functions as a prepayment of corporate tax prematurely imputed to shareholders by the payment of 

overfranked dividends. The franking deficit tax is 

not a penalty, and therefore a corporation may 

offset a payment of franking deficit tax against its 

future tax liability. However, to discourage more 

than de minimis overfranking, a penalty equal to 

30 percent of the franking deficit tax is payable 

where the franking deficit exceeds 10 percent of 

the total of the franking credits arising during the 

year and any dividend paid during the year was 

overfranked. 

Tcu:Rates 

The corporate tax.rate currently is 39 percent. 

Marginal tax rates for individuals range from 0 

percent to 47percent. The 47percent rate applies 

to taxpayers with taxable income exceeding 

AU$50,000. Capital gains on assets acquired after 

September 19, 1985 are taxed at ordinary income 

rates. However, to determine the amount of gain 

recognized on disposition of a capital asset, basis 

in the asset is indexed for inflation if the asset 

was held for more than 1 year. 

Treatment of Preference Income 

Dividends paid out of preference income 

(when the franking account balance is zero) are 

taxable when received by shareholders and thus 

corporate preferences are not extended to shareholders. 

The Australian system currently provides 

corporations few preferences. In 1988 Australia 

reformed its depreciation system and other tax 

concessions. For example, depreciation rates for 

"plant" were based on 5 or 3 year lives; now they 

are based on effective lives (using a 150 percent 
Appendices 162 

declining balance or "prime cost") plus a 20 

percent "loading.I' The 150 percent deduction for 

research and development expenditures is scheduled to be scaled back to 125 percent in the 

mid-1990s. 

Treatment of Domestic 

Intercorporate Dividends 

Dividends received by an Australian corporation from another Australian corporation generally 

are free of tax because tax is rebated. In addition, 

credits attached to intercorporate dividends are 

credited to the recipient corporation's franking 

account. However, unfranked dividends to private 

corporations (generally, unlisted corporations) are 

taxed without refund. This exception is designed 

to prevent the use of private corporations to defer 

tax on distributed preference income. Australia 

does not permit consolidation of affiliated corporations for purposes of its imputation system (or 

for its corporate tax generally, although there is 

loss transfer for 100percent related corporations). 

Treatment of Foreign Source Income 

BeginningJuly 1, 1990,foreign source income 

derived from comparable tax countries through a 

branch is generally excludable from corporate 

income. An exemption from corporate tax also 

applies to dividends received from a corporation 

resident in a comparable tax country if the Australian corporation owns at least a 10 percent interest 

in that corporation. Dividends received from 

portfolio investments (i.e., less than 10 percent) 

in corporations resident in comparable tax countries are taxable with a credit allowed for foreign 

withholding taxes. However, because foreign 

taxes paid with respect to foreign source income 

derived from comparable tax countries do not 

generate credits to the franking account, dividends 

paid by an Australian corporation out of such 

income do not carry credits in respect of such 

foreign taxes and are exposed to shareholder level 

tax. Thus, this foreign source corporate income is 

still double-taxed, once when earned in the foreign country and once when the after-foreign-tax 

amount is distributed to domestic individual 

shareholders. 

Income derived from low-tax countries 

through a branch or a nonresident corporation 

generally is subject to full taxation at the corporate level with a credit for foreign taxes paid on 

such income. Where an Australian corporation 

owns a 10 percent or more interest in a corporation residing in, or deriving substantial income 

from, a low-tax country, the Australian corporation is taxed currently on its share of the nonresident corporation's income and may credit its 

share of foreign taxes paid by the nonresident 

corporation on an "accruals" basis, provided that 

the foreign corporation is a controlled foreign 

company (that is, 5 or fewer Australian residents 

control 50 percent or more of the company). Such 

a 10percent shareholder maintains an "Attribution 

Tax Account" (ATA) for every entity in the 

chain, in which income is attributed to that entity; 

when a dividend is paid between entities, a debit 

is made to the ATA of the paying corporation and 

a credit is recorded in the ATA of the receiving 

corporation.' Where the Australian corporation 

owns a lesser percentage, the accruals tax does 

not apply, but dividends received are subject to 

Australian tax (with a tax credit for foreign 

withholding taxes paid on the dividend). Because 

foreign taxes paid do not generate credits to the 

franking account, dividends paid out of such 

income to the shareholders of the Australian 

corporation are exposed to shareholder level tax. 

The net effect of this system is the equivalent of 

allowing a deduction for foreign taxes on distributed foreign source .income earned through an 

Australian corporation. 

Treatment of Tax-Exempt

Shareholders 

Excess imputation credits are not refundable to 

any shareholder, including tax-exempt shareholders. Accordingly, income taxed at the corporate 

level is subject to one level of tax even where it 

is distributed to tax-exempt shareholders. 

Until 1988, pension funds were tax-exempt, 

although distributions were taxable to beneficiaries. The new statute imposes a tax at a 15 percent rate on the investment income of pension 

funds, but allows pension funds an imputation 
163 

credit for franked dividends at the full 39 percent 

rate. Thus, a pension fund can use the excess 

imputation credits (a 24 percent credit) to shelter 

the tax on a large amount of other investment 

income (such as interest, rents, royalties, foreign 

income, capital gains, and unfranked dividends). 

Pension funds also may utilize imputation credits 

to reduce tax imposed on contributions. These 

changes are designed in part to encourage pension 

funds to invest in domestic corporations having 

Australian tax liability, thus reducing the tax 

arbitrage gains to pension funds from investing in 

bonds or in corporations paying unfranked 

dividends. 

Treatment of Foreign Shareholders 

Australia generally imposes a withholding 

tax on dividends from Australian corporations to 

nonresident shareholders. No distinction is made 

between portfolio and nonportfolio investment. 

The normal withholding rate is 30 percent, but 

treaties may reduce this rate to 15 percent. The 

gross-up and imputation credit procedure does not 

apply to nonresident shareholders. However, the 

franked portion of a dividend is exempt from the 

withholding tax. Thus, the franked portion of a 

dividend bears Australian tax at the 39 percent 

corporate rate. Unfranked dividends are subject to 

withholding tax and, thus, bear Australian tax at 

the applicable withholding rate. 

Treatment of Low-Bracket 

Shareholders 

Although a shareholder may use excess credits 

to offset any other tax liability he may have, 

excess credits are not refundable. Unused credits 

may not be carried forward or back. The imputation credit (aggregated with other nonrefundable 

credits) is stacked so refunds from other sources 

cannot impair use of the credit. 

Streaming 

In addition to the allocation rules described 

above, Australia has adopted several anti-streaming provisions. First, where a dividend is paid to 

a corporate shareholder as part of a dividend 

Appendices 

stripping operation, imputation credits attached to 

the dividend and the tax rebate for intercorporate 

dividends may be denied. One effect of the dividend stripping rule is to discourage sales of shares 

by tax-exempt or nonresident shareholders in 

anticipation of the payment of a franked dividend. 

Second, to inhibit streaming through partnerships 

and trusts, imputation credits received by a partnership or trust are generally allocated in accordance with a partner’s or beneficiary’s share of 

partnership or trust income. Third, a special debit 

to the franking account is required when a 

corporation distributes an unfranked dividend or 

tax-exempt bonus share to a shareholder in substitution for a franked dividend as part of a dividend 

streaming arrangement. Generally, the franking 

debit is calculated as if the franked dividend had 

been franked to the same extent as the dividend 

for which it substituted, thus ensuring equal 

franking for all dividends paid on a particular 

class of stock as part of the same distribution. 

Treatment of Interest 

Interest paid by an Australian corporation 

generally is deductible. Interest paid to a resident 

lender is includable in the lender’s income. 

Interest paid to a foreign lender (whether or not 

resident in a treaty country) is subject to a 10 

percent withholding tax. Australia has a thin 

capitalization rule that denies a resident corporation a deduction for interest paid to foreign 

shareholders where the foreign shareholders own 

at least 15 percent of the resident corporation and 

the resident corporation’s debt to equity ratio with 

respect to the nonresident shareholders’ investment is in greater than 3 to 1 (6 to 1for fmancial 

institutions). Beginning July 1, 1990, this rule 

applies even if the foreign controlling shareholder 

is in turn controlled by Australian residents. 

B.2 CANADA 

Introduction 

Canada introduced distribution-related integration in 1971 with the adoption of a straight credit 

system that grants a credit to resident individual 

Canadian shareholders with respect to dividends 
Appendices 164 

received from Canadian corporations. The credit 

is not required to be funded at the corporate level. 

That is, the amount of the shareholder credit does 

not depend on the payment of tax by the corporation. Excess credits are not refundable. 

Description of Mechanics 

Credits 

Where a Canadian resident individual shareholder receives a taxable dividend (described 

below) from a Canadian corporation, the shareholder grosses up the dividend by 25 percent (Le., 

includes 125 percent of the dividend in income) 

and takes a credit against his Federal individual 

income tax for 66.7 percent of the amount of the 

gross-up. Provincial individual taxes are calculated as approximately 50 percent of the shareholder’s Federal tax liability (after the reduction 

for the shareholder tax credit). Thus, the provincial tax is reduced by approximately 33.3 percent 

of the amount of the gross-up, and the total value 

of the shareholder credit against the combined 

Federal and provincial liability of the shareholder 

is approximately equal to the amount of the 

gross-up.a 

The gross-up and credit are not dependent on 

the payment of Canadian tax at the corporate 

level. Thus, the shareholder credit may provide 

full or partial relief from corporate level tax, 

depending upon the tax rate applicable to the 

corporation paying the dividend. If no tax is paid 

at the corporate level, the shareholder credit 

completely or partially offsets the shareholder 

level tax, which is the only level of tax that would 

otherwise apply to the distributed income. For 

example, a dividend that is paid exclusively out of 

preference income would carry the full credit, the 

same as a dividepd paid out of Canadian source 

sales income. In the former case, the corporation 

pays no Canadian corporate tax and, in the latter 

case, it pays a net Federal tax of more than 28 

percent. 

The degree to which the Canadian system 

integrates corporate and shareholder tax depends 

on the rate at which distributed income has been 

taxed at the corporate level under the Federal and 

provincial tax systems. See “TaxRates,” below. 

Combining Federal and Ontario provincial tax,the 

system integrates 32 percent of a regular corporation’s tax, 41 percent of a manufacturing corporation’s tax, and 86 percent of a small business 

corporation’s tax.’ 

Compensatory or Withholding Tax 

Canada does not impose a compensatory or 

withholding tax on dividends to resident shareholders. 

Dividends Defined, Bonus Shares, 

Share Repurchases 

In general, a taxable dividend includes any 

nonliquidating distribution with respect to shares 

out of surplus funds. Accordingly, a return of 

contributed surplus that has not been converted 

into paid-up capital is a taxable dividend. A 

liquidating distribution constitutes a taxable 

dividend to the extent it exceeds paid-up capital 

(defined to exclude contributed surplus). 

A stock dividend is generally treated as a 

taxable dividend. However, subject to certain 

exceptions, the amount of the dividend is limited 

to the increase in paid-up capital in respect of the 

stock dividend. 

A share repurchase generally is treated as a 

taxable dividend to the extent that the amount paid 

exceeds the paid-up capital on the shares repurchased. The amount so treated is excluded in 

determining the shareholder’s capital gain or loss. 

These rules, however, do not apply to a corporation’s open market purchases of its shares. 

Allocating Credits to Dividends 

Because the shareholder credit is not dependent on the actual payment of corporate tax, the 

Canadian system does not require rules allocating 

credits to dividends. 
165 Appendices 

Tu Rates 

The Federal basic corporate rate is 38 percent. 

Provincial basic corporate rates generally range 

from 14 percent to 17 percent. However, an 

abatement of Federal corporate tax is allowed in 

respect of provincial tax equal to 10 percent of 

taxable income earned in a province. In addition, 

a surtax currently is imposed on corporations 

equal to 3 percent of a corporation's Federal tax 

liability. Thus, effective combined Federal and 

provincial corporate tax rates vary from 42.8 

percent to 45.8 percent. 

For individuals, Federal tax rates are 17 

percent for taxable income up to $28,784, 26 

percent for taxable income of $28,784 to $57,578, 

and 29 percent for taxable income in excess of 

$57,578.'' A Federal surtax of 5 percent is currently in place. Provincial tax is imposed as a 

percentage of Federal tax, varying from 46.5 

percent to 62 percent. Some provinces impose a 

surtax on high-income individuals. 

Corporate and individual taxpayers are taxed 

at ordinary income rates on 75 percent of their net 

capital gain in a taxable year. For individuals, a 

lifetime exemption of $100,000 of gain applies. 

The lifetime exemption is $500,000 for small 

business shares and farm property. For individuals, in addition to actual realized gain, gain is 

deemed to be realized with respect to many kinds 

of assets at death, at the time of transfer by gift 

or at the time the owner gives up Canadian 

residence. 

Treatment of Preference Income 

Because the shareholder credit is not dependent on the payment of tax at the corporate level, 

the Canadian system can be described as extending preferences to shareholders. However, because the Canadian system may provide less than 

100 percent integration of the corporate and 

shareholder taxes on distributed income, the 

extension of preferences may be more than offset 

by the remaining double tax on taxable income. 

For example, for regular corporations the credit 

generally equals half of Federal corporate tax. 

Thus, preferences are not extended to shareholders until preference income exceeds half of total 

corporate income.l1 

A 5 percentage point reduction in the basic 

rate of corporate tax (from 38 percent to 33 

percent) applies to manufacturing and processing 

income of a resident corporation. For Canadian 

small business corporations, a deduction applies 

that effectively reduces the basic rate by 16 

percentage points (from 38 percent to 22 percent). 

Except for a 35 percent research and development 

credit, investment tax credits apply only in selected geographic areas. A more generalized investment tax credit was phased out in 1988 as part of 

tax reform. As discussed above, only 75 percent 

of net realized capital gains are included in income. Certain assets are eligible for accelerated 

depreciation. 

Treatment of Domestic Intercorporate Dividends 

The gross-up and shareholder credit mechanism does not apply to dividends paid by a 

Canadian corporation to a Canadian corporate 

shareholder. In general, however, domestic 

intercorporate dividends are deductible in computing the income of the Canadian shareholder corporation.12 Thus, preferences generally are not 

recaptured when preference income is distributed 

to corporate shareholders. However, for Canadian 

portfolio dividends received by a private or 

privately-controlled Canadian corporation, a tax of 

25 percent is payable by the recipient corporation 

and is refunded to the corporation when the 

dividends are redistributed to shareholders. 

Treatment of Foreign Source Income 

Resident corporations are taxed on their 

worldwide income. This includes current taxation 

on an accrual basis of passive income earned 

through a controlled foreign affiliate. However, 

Canada provides exemptions for certain types of 

foreign source income and a foreign tax credit 

with respect to certain other types of foreign 

source income. For example, dividends received 

from a foreign afffiate resident in a prescribed 
Appendices 166 

country out of its active business income in that 

country or another prescribed country generally 

are exempt from Canadian corporate tax. Tax 

credits are allowed with respect to portfolio 

dividends received from a nonresident corporation, but not for underlying foreign taxes paid by 

that corporation on the income distributed. The 

effect of these exemptions and credits is to relieve, in whole or in part, corporate level Canadian tax on foreign source income. Because the 

shareholder credit does not depend on the extent 

to which the underlying corporate income has 

been taxed, the Canadian system extends the 

benefits of integration to foreign source income to 

the extent of the shareholder credit. 

Treatment of Tax-Exempt

Shareholders 

Certain persons are excluded from Canadian 

tax, including charities and pension funds. However, because the shareholder credit is nonrefundable, tax-exempt shareholders do not receive the 

benefit of Canadian integration. 

Treatment of Foreign Shareholders 

The Canadian integration system generally is 

not extended to nonresident shareholders because 

the gross-up and shareholder credit mechanism 

does not apply to dividends paid to nonresident 

shareholders. Dividendspaid to foreign shareholders are subject to a withholding tax at a statutory 

rate of 25 percent. By treaty, Canada typically 

reduces the rate to 10 percent for direct investment dividends and to 15 percent for portfolio 

dividends. The 1980 U.S. treaty, reflecting this 

policy, was the first in which Canada reduced its 

dividend withholding rate below 15 percent. This 

concession for direct investment dividends in the 

U.S. treaty was seen as extending to U.S. direct 

investors in Canadian corporations some of the 

benefit of Canadian integration. 

Low-Bracket Shareholders 

Excess shareholder credits are available to 

offset income tax liability with respect to other 

income. Credits not used in the year received may 

not be refunded or carried forward. 

Streaming 

The Canadian system includes stop-loss rules 

that inhibit dividend stripping by requiring that, in 

certain circumstances, the amount of a loss 

recognized on a sale of shares be reduced by 

dividends received on the shares. 

In addition, the gross-up and credit mechanism 

does not apply where a "dividend rental arrangement" exists. A dividend rental arrangement 

essentially is a transfer of shares where the transferee receives the dividend but the transferor 

retains the risk of loss and opportunity for gain 

with respect to the shares. Finally, under a general anti-abuse rule, Canadian tax authorities may 

deny a tax benefit where there is an avoidance 

transaction and a misuse of provisions of tax 

laws. An avoidance transaction is a transaction 

resulting in a tax benefit unless the transaction 

reasonably could be considered to have been 

undertaken primarily for non-tax reasons. 

Treatment of Interest 

Interest paid by a Canadian corporation is 

deductible if the interest relates to borrowed 

money used for the purpose of earning income 

from a business or property or for acquiring 

property for gain upon resale. A thin capitalization rule prohibits the deduction of interest paid 

by a thinly capitalized corporation to nonresident 

shareholders owning 25 percent or more of any 

class of the corporation's stock. 

Interest income generally is taxable to resident 

lenders. A withholding tax generally is imposed 

on interest paid by Canadian corporations to nonresident lenders at the statutory rate of 25 percent. 

No withholding tax is imposed with respect to interest paid on corporate bonds or debentures to an 

arm's-length lender if no more than 25 percent of 

the principal amount is repayable within 5 years 

of issuance. In addition, the withholding rate may 

be reduced by treaty to 10 or 15 percent. 
167 Appendices 

B.3 FRANCE 

Introduction 

The French distribution-related integration 

system combines three elements: (1) an imputation 

credit (avoir fiscal), (2) a compensatory tax 

@recompte mobilier), and (3) for 1989 through 

1991, a "split" tax rate on corporate profits. 

The avoir fiscal credit was enacted in 1965 

and, simultaneously, a 24 percent withholding tax 

on dividends was repealed. The new system 

became fully effective in 1967. 

In 1989, the French introduced a split rate 

system, which applies a higher tax rate to distributed profits. The split rate system was designed to 

provide an incentive for corporate financing 

through retained earnings and balance the incentive, created by the avoir fiscal, to distribute 

earnings and to finance through new equity capital. This system has been eliminated, however, 

beginning in 1992. 

Description of Mechanics 

Imputation Credits 

Upon receipt of an eligible dividend (described 

below), a French resident individual or corporate 

shareholder is dlowed a tax credit (the avoir 

fiscal) equal to 50 percent of the amount of the 

dividend, or 33.3 percent of the amount of the 

dividend plus the avoir fiscal. A shareholder must 

include in income both the amount of a dividend 

payment and the amount of the avoir fiscal. 

The gross-up and avoir fiscal partially integrate corporate tax paid on distributed income. 

For 1991, distributed income is subject to a tax 

rate of 42 percent at the corporate level. The 

avoir fiscal, thus, equals 69 percent of the tax 

paid by the corporation on distributed income and 

29 percent of the pre-tax amount of such income. 

For example, profits of FlOO are subject to 

corporate tax of F42 prior to distribution, leaving 

a net amount for distribution of F58. A shareholder would include a total of F87 (F58+F29) in 

income. The avoir fiscal associated with this F87 

dividend is F29. For 1992, distributed income 

will be subject to corporate level tax at the rate of 

34 percent. The avoir fiscal will thus equal 97 

percent of the tax paid by the corporation on 

distributed income and 33 percent of the pre-tax 

amount of such income.13 

In order to encourage corporate distributions, 

the avoir fiscal is not allowed to shareholders in 

respect of dividends paid out of profits realized 

more than 5 years prior to distribution. In addition, the avoir fiscal is not available to foreign 

shareholders, unless specific provision is made in 

an income tax treaty: If the amount of the avoir 

fiscal exceeds the tax liability of an individual 

shareholder, the excess is refunded. The same is 

true for some tax-exempt shareholders. No refund 

is available to a corporate shareholder. 

Split Rate Tax and Compensatory Tax 

(Precompte Mobilier) 

The French split rate tax system, in effect for 

1989 through 1991, is unusual in that it applies a 

higher tax rate to distributed profits than to 

retained profits. For fiscal years beginning on or 

after January 1, 1991and before January 1, 1992, 

retained corporate profits are taxed at a rate of 34 

percent, and distributed corporate profits are taxed 

at a higher rate of 42 percent. The additional 8 

percent is imposed as a surtax in the year of 

distribution. The application of a higher tax rate 

to distributed profits was instituted for 1989 

through 1991 to encourage corporate saving and 

investment. Taking into account the avoir fiscal 

credit allowed to shareholders, the effective 

corporate level tax rate on distributed taxable 

income is 13 percent for 1991. Consistent with 

recent corporate tax rate reductions in the United 

States and other EC countries, however, the 

French government recently eliminated the 8 

percent surtax on distributed income. 

The precompte mobilier is imposed on a 

distributing corporation in respect of dividends 

distributed (1) out of profits that have not borne 

regular corporate income tax at the 34 percent 

rate, e.g., foreign source income, preference 
Appendices 168 

income, and dividends received by a parent 

company from a 10 percent owned subsidiary or 

(2) from fully-taxed profits earned more than 5 

years before the distribution.l4 The precompte 

mobilier is imposed at a rate of 50 percent of the 

amount of the dividend, or 33.3 percent of the 

dividend plus the precompte mobilier. Thus, the 

amount of the precompte mobilier is equal to the 

amount of the avoir fiscal associated with the 

dividend. No distinction is made in calculating 

precompte mobilier liability between income that 

is not taxed and income that is taxed at a rate 

lower than 34 percent.I5 

French corporations are required to segregate 

fully-taxed income from income potentially subject to the precompte mobilier for tax accounting 

purposes. In general, dividends eligible for avoir 

fiscal are deemed to be distributed first out of 

current fully-taxed income, and then out of fullytaxed retained income of each of the immediately 

preceding 5 years. Once fully-taxed income for 

this 5 year period has been exhausted, a corporation may choose to allocate a dividend distribution 

to (1) dividends received from foreign subsidiaries, (2) the long-term capital gains reserve, or (3) 

other miscellaneous preference income in any 

order. France thus allows stacking of dividends 

last against preference income. 

A French corporation may elect, alternatively, 

to allocate part or all of a distribution eligible for 

the avoir fiscal first against dividends received 

from a French subsidiary within the last 5 years 

(rather than to current taxable income). Dividends 

received from French subsidiaries are subject, in 

principle, to the precompte mobilier. On redistribution, however, the avoir fiscal associated with 

such dividends may be credited against the 

precompte mobilier liability. 

Dividends Defined, Bonus Shares, 

Share Repurchases 

Distributions are eligible for the avoir fiscal if 

they are made from corporate income, are made 

pro rata to shareholders, and are based on a 

regular decision of the corporation. Repayments 

of share capital are not taxable, but payments to 

shareholders are considered to be repayments of 

share capital only if all of the corporation’s 

earnings and reserves previously have been 

distributed. 

Distributions in liquidation are taxed as ordinary dividends to the extent the distribution 

exceeds the greater of contributed capital or share 

basis, and are eligible for the avoir fiscal. To the 

extent that liquidating distributions are deemed 

made from preference income, they are subject to 

the precompte mobilier. 

Stock dividends generally are not subject to 

tax in the hands of a recipient. However, if the 

distribution of new shares is the result of a reinvestment of cash dividends at the election of the 

shareholder, the distribution is taxed as an 

ordinary dividend distribution. 

Proceeds from share repurchases are treated as 

distributions,although only the difference between 

the value of consideration received and the shareholder’s basis in the shares is subject to tax at the 

shareholder level. The amount distributed does 

not qualify for the avoir fiscal or trigger the 

precompte mobilier unless it is paid on a pro rata 

basis to all shareholders in accordance with a 

regular decision made by the corporation. 

Allocation of Credits’to Dividends 

The avoir fiscal applies regardless of the rate 

of corporate level tax actually borne by distributed 

income. 

Tax Rates 

For the 1991 tax year, individual marginal 

income tax rates range from 5 percent to 56.8 

percent. France also imposes a net wealth tax at 

rates, for 1991, ranging from 0.5 percent to 1.5 

percent. 

For fiscal years beginning on or after January 1, 1991but before January 1, 1992, undistributed profits are taxed at a flat rate of 34 percent 

and distributed profits at a flat rate of 42 percent. 

The higher rate applicable to distributed profits 
169 

does not apply to profits distributed in the form of 

a stock dividend. For fiscal years beginning on or 

after January 1, 1992, all corporate profits (distributed and undistributed) will be taxed at a flat 

rate of 34 percent. 

Net short-term capital gains (generally, gains 

on the sale of assets held less than 2 years) are 

included in taxable income and taxed at regular 

rates in the year realized (subject to certain 

exceptions that allow gains arising from mergers 

or similar reorganizations to be spread over 

periods from 5 to 15 years). Net short-term 

capital losses are either deductible from operating 

profits in the year realized or, for a loss corporation, added to the net operating loss (and thereby 

made available for 5 year carryforward or an 

elective 3 year carryback). 

For dispositions occurring prior to July 1, 

1991, net long-term capital gains generally are 

taxed at a rate of 25 percent. Long-term capital 

gains on property other than buildings, land and 

financial instruments are taxed at 19 percent and 

long-term capital gains on industrial property 

(e.g., patents) are taxed at 15 percent. Net longterm capital losses may not be used to offset 

operating profits, but may be carried forward for 

10 years to offset future long-term capital gains. 

The after-tax amount of net long-term capital gain 

is credited to a special capital gain reserve. When 

a dividend is deemed distributed out of the capital 

gain reserve, a compensatory tax is imposed at a 

rate of 17percent, equal to the differencebetween 

the long-term capital gains tax rate (25 percent) 

and the tax rate applicable to distributed profits 

(42 percent). For dispositions occurring on or 

after July 1, 1991, the French government has 

replaced the multiple rates on capital gains with a 

single 18 percent rate. Compensatory tax will thus 

be imposed at a rate of 16percent for 1992, equal 

to the difference between 18 percent and the 34 

percent rate applicable to distributed profits. 

Treatment of Preference Income 

Tax preferences available at the corporate 

level include special accelerated depreciation for 

new construction in depressed areas, shares in 

Appendices 

certain building companies, software acquired 

from third parties, research installations, and air 

and water purification installations. Corporations 

also may be entitled to a tax credit for research 

and development expenditures, a tax holiday for 

start-up businesses, &d a reduced rate of tax on 

French headquarters of multinationalcorporations. 

Preferences are not passed through to shareholders, since the precompte mobilier is imposed 

on distributions of preference income. However, 

as described above, French law allows preference 

income to be stacked last. 

Treatment of Domestic 

Intercorporate Dividends 

Nonparent Companies 

"Nonparentcompanies" are defined as companies that own less than 10 percent of the issued 

share capital of the distributing corporation. 

Nonparent companies are eligible for the avoir 

fiscal. Like an individual shareholder, a nonparent 

company must include in income the entire 

amount of a dividend received from another 

French company and may use the avoir fiscal 

associated with the dividend as a credit against its 

income tax liability. If, however, the nonparent 

company's income tax liability for the year in 

which a dividend is received is less than the 

amount of the avoir fiscal, no refund or carryforward is allowed. 

Parent Companies 

"Parent companies" are defined as companies 

that own 10 percent or more of the shares of the 

distributing corporation. Parent companies are 

eligible for a "participationexemption" as well as 

the avoir fiscal. Under the participation exemption, 95 percent of the amount of a dividend 

received from a 10 percent-owned subsidiary 

(including the amount of the avoir fiscal) is 

excludable from taxable income.l6 

The avoir fiscal associated with dividends 

received by a parent company from its subsidiaries is passed on to the parent's shareholders when 
Appendices 170 

the dividends are redistributed. In principle, the 

precompte mobilier applies to such redistribution, 

because the subsidiary dividends are almost 

entirely exempt from tax. The parent company is 

permitted a deduction, however, for the avoir 

fiscal associated with the subsidiary dividends and 

this deduction exactly offsets the parent's 

precompte mobilier liability. Any available credit 

for foreign withholding tax paid on the subsidiary 

dividends also may be used to offset the 

precompte mobilier. As a result, the shareholders 

of the parent company are placed in the same 

position as if they had owned shares in the subsidiaries directly. 

Consolidated Groups 

A French parent company may consolidate for 

tax purposes with its direct and indirect 95 percent-owned French subsidiaries. Dividends paid 

within the consolidated group are subject neither 

to precompte mobilier nor to corporate income 

tax. 

Treatment of Foreign Source Income 

In general, the French integration system does 

not extend the benefits of integration with respect 

to foreign income taxes imposed on foreign source 

income. 

Profits earned by a French company through 

a foreign branch or other permanent establishment 

generally are excluded from taxable income until 

they are repatriated to France and distributed to 

shareholders. Upon distribution of these profits, 

the precompte mobilier is imposed. However, if 

a branch profits tax is imposed on the branch 

income in addition to foreign income tax, and 

provided the branch is located in a treaty country, 

the French corporation may credit the branch 

profits tax against the precompte mobilier." 

A French nonparent company is taxed on the 

net amount of a dividend received from a foreign 

corporation (after deduction of foreign withholding tax) resident in a nontreaty country and may 

not credit any foreign withholding tax against its 

corporate tax liability. Where the foreign 

corporation is resident in a treaty country, the 

dividend is grossed up for any foreign withholding 

tax, which is then allowed as a credit against 

French corporate tax. Dividends paid by the 

nonparent company out of foreign source dividend 

income are subject to the precompte mobilier and 

qualify for the avoir fiscal. 

Under the participation exemption, 95 percent 

of the amount of a dividend received by a French 

parent company from a 10 percent-owned foreign 

subsidiary (including the amount of the avoir 

fiscal) is excludable from taxable income. Foreign 

withholding tax is not allowed as a credit against 

French corporate tax on the foreign source dividend. The precompte mobilier is imposed on, and 

the avoir fiscal applies to, dividends paid by the 

French parent company out of foreign source 

dividends. However, where the foreign subsidiary 

is resident in a treaty country, the amount of the 

dividend received by the French parent company 

is grossed up by the amount of any foreign withholding tax, which may then be credited against 

the precompte mobilier due upon the redistribution of the foreign source dividend (provided the 

redistribution occurs within 5 years of the receipt 

of the foreign source dividend). 

As of January 1, 1990, special rules apply to 

French holding companies. A French holding 

company is exempt from the precompte mobilier 

upon redistribution of dividend income received 

from foreign subsidiaries to its shareholders, if 

the holding company satisfies three requirements: 

(1) the exclusive purpose of the holding company 

is to hold shares in other companies, (2) at least 

two-thirds of the capital assets of the holding 

company consist of interests in foreign subsidiaries, and (3) the holding company derives at least 

two-thirds of its accounting profit (excluding 

capital gains) from such foreign interests. Generally, the French holding company must hold at 

least a 10 percent interest in a foreign subsidiary. 

Dividends distributed by a qualifying French 

holding company out of dividends received from 

foreign subsidiaries are not eligible for the avoir 

fiscal, but give rise to a tax credit equal to any 

foreign withholding tax imposed on the foreign 
171 Appendices 

subsidiary dividends. If such dividends are redistributed to a holding company shareholder residing in a nontreaty jurisdiction, the standard 25 

percent withholding tax imposed on dividends is 

increased to 50 percent." 

Treatment of Tax-Exempt Shareholders 

Pension funds, charities, and other tax-exempt 

organizations are not taxed on dividends received 

from French corporations, but are subject to tax 

at a reduced rate of 24 percent with respect to 

certain types of investment income, including 

dividends received from foreign corporations. 

Tax-exempt organizations generally are not 

eligible for the avoir fiscal. However, retirement 

and disability benefit funds, as well as certain 

foundations and associations of "public utility, I' 

are granted a refundable avoir fiscal with respect 

to dividends received from French corporations. 

Treatment of Foreign Shareholders 

Dividends paid by a French company to a 

foreign shareholder are subject to French withholding tax at a rate of 25 percent, subject to 

reduction by treaty. The avoir fiscal is not generally available to foreign shareholders (whether 

individuals or corporations). This is the case even 

if a French corporation distributes income subject 

to, and pays, the precompte mobilier. 

France has extended the avoir fiscal (by means 

of a cash refund) to shareholders of a French 

corporation who are resident in some treaty 

countries and who (1) are subject to income tax in 

their residence country on dividends received 

from the French corporation and (2) do not 

qualify for exemption or foreign tax credit relief 

in respect of deemed-paidforeign corporate taxes, 

i.e., individuals and corporate portfolio investors. 

The avoir fiscal refund is subject to French 

withholding tax at a rate of 25 percent, subject to 

reduction by treaty. Under some treaties, 10 

percent corporate shareholders (nonportfolio 

shareholders) and other nonresident shareholders 

not entitled to the avoir fiscal refund are allowed 

a refund (subject to withholding tax) of any 

precompte mobilier imposed in respect of 

dividends received. 

Under the United States treaty, for example, 

the avoir fiscal is refunded to shareholders who 

are either (1)United States resident individuals or 

(2) United States corporations that own less than 

10 percent of the issued share capital of the 

distributing corporation and that do not qualify for 

the indirect foreign tax credit under IRC 0 902 

(corporate portfolio shareholders). The avoir 

fiscal is treated as an additional dividend amount 

and is subject to a 15 percent withholding tax. 

United States corporations that are 10 percent 

shareholders of the distributing corporation (nonportfolio shareholders) are not eligible for an 

avoir fiscal refund, but are entitled to a reduced 5 

percent withholding rate on dividends and to a 

refund of the precompte mobilier. 

Treatment of Low-Bracket 

Shareholders 

The avoir fiscal is refundable to low-bracket 

shareholders. 

Streaming 

France does not have specific rules to prevent 

streaming, although the avoir fiscal is available 

only with respect to a distribution made pro rata 

to all shareholders. 

Treatment of Interest 

Interest paid to third parties who are not 

shareholders and who do not have legal or effective control over the payor is deductible at the 

corporate level. 

Interest from corporate indebtedness is generally included in the taxable income of a resident 

lender (collected in part by Withholding). Resident 

individuals holding certain fixed income securities 

may elect to have interest taxed at a flat rate 

collected by withholding. For 1991, the flat rate 

is 27 percent for income from bonds. 
Appendices 172 

Interest from corporate indebtedness generally 

is subject to a withholding tax imposed at statutory rates from 25 percent to 51 percent. However, 

interest on bonds paid abroad is exempt. Reduced 

treaty rates also may apply. 

B.4 GERMANY 

Introduction 

The German integration system has both a 

split rate tax and an imputation credit system with 

a compensatory tax. The split rate tax applies a 

"statutory"rate (currently 50 percent) to retained 

income and a lower "distribution" rate (currently 

36 percent) to distributed income. The imputation 

credit mechanism imputes to shareholders the 

corporate level income tax paid on distributed 

income. In general, the shareholder receives a 

credit based on the distribution rate regardless of 

the corporation's actual tax liability. However, as 

discussed more fully below, the corporation may 

become liable for compensatory tax if it has not 

paid tax on distributed income at the full 

distribution rate. 

Description of Mechanics 

Imputation Credits 

Imputation credits are available to any shareholder subject to German tax on his worldwide 

income. This generally excludes nonresident 

aliens, foreign corporations, and domestic entities 

not subject to German tax (although imputation 

credits are available to a foreign corporation or 

nonresident that holds the shares as part of a 

permanent establishment in Germany). 

In general, dividends are subject at the corporate level to a creditable 36 percent distribution 

tax (described below) and to a 25 percent withholding tax at the corporate level. The withholding tax is imposed on the amount of the declared 

distribution. Thus, a distribution of DM64 is 

reduced by DMf6 of withholding tax, leaving a 

cash distribution of DM48. The withholding tax 

applies without regard to whether the stock of the 

distributing corporation is held publicly or privately, or by domestic or foreign shareholders. 

(The effect of tax treaties on withholding is 

discussed below.) In some circumstances the 

government will grant an exemption certificate to 

the shareholder which, when provided to the 

withholding agent, will exempt the shareholder 

from withholding. 

The shareholder must gross up the amount of 

the dividend by the amount of the withholdingtax 

plus the imputation credit (equal to 36/64 of the 

declared distribution). Thus, a cash dividend of 

DM48 (net of withholding tax) is grossed up to 

DM64 (for the withholdingtax), and the resulting 

DM64 is then grossed up to DM100. The shareholder reports the grossed-up distribution as 

income and claims a credit equal to the amount of 

the total gross-up, If the credit exceeds the shareholder's tax liability, the shareholder receives a 

full refund of the excess; if the shareholder's tax 

liability exceeds the credit, the shareholder must 

pay the excess. 

Compensatory Tm 

The German system uses an "available net 

equity" account to track taxable and preference 

income with both thesplit rate tax and the imputation credit mechanisms. Available net equity 

represents after-tax corporate income and certain 

other balance sheet items available for distribution. Available net equity is divided into baskets 

representing the rate at which the income was 

taxed. These "Eigenkapital" (equity capital) 

baskets, abbreviated "E,I' are:

EK 56, containing available net equity from income 

taxed at the pre-1990 statutory rate of 56 percent. 

(As of January 1, 1995, the balance in this basket 

will be "emptied" into the EK 50 basket at a rate 

equal to 56/44 of the amount in the EK 56 basket.) 

EK 50, containing available net equity from income 

taxed at the post-1989 statutory rate of 50 percent. 

EK 36, containing available net equity from lesser 

taxed income that has been converted into an 

equivalent amount of income taxed at 36 percent, 

and thus matches the distribution rate of 36 percent 

(see discussion below). 
173 Appendices 

0 EK 0, containing available net equity from income 

subject to no corporate tax. EK 0 is further divided 

into four categories: EK 01, containing foreign 

source income realized after 1976 (the imputation 

credit became effective in 1977), EK 02, containing items not included in EK 01, 03 or 04, for 

example net operating losses (discussed below) and 

distributions made when there is no available net 

equity in any category (in the latter case, the 

corporation pays the 36 percent compensatory tax 

and includes the distributionin EK 02 as a negative 

item, permitting the corporation to later distribute 

an offsetting amount of EK 0 without a compensatory tax), EK 03, containing available net equity 

from years before 1977, and EK 04, containing 

shareholder contributions to capital in years after 

1976. 

Fully-taxed income (EK 56 or 50 income) is 

considered distributed first, followed next by EK 

36 income, and last by EK 0 income. 

Germany implements its split rate tax by 

refunding to corporations the excess tax paid on 

distributions out of EK 50 and EK 56.19 Distributions out of EK 36 generate neither a refund 

nor extra corporate tax.Distributions out of EK 0 

(other than EK 04) are subject to a compensatory 

tax of 36 percent, If the corporation has DMlOO 

in its EK 01 account, for example, it may pay the 

shareholder only DM64-the original DMlOO in 

the account net of a 36 percent distribution tax. 

The additional tax is added to the corporation's 

total tax liability for the year to which the distribution is assigned, Distributions out of EK 04 

(contributions to capital) generate no tax to the 

corporation and are excluded from the shareholder's income (as a return of capital).2o 

There are generally no time limits on relief. 

Thus, a distribution from EK 56 earned in 1977 

produces the same credit for corporate tax paid as 

a distribution from EK 56 earned in 1989. This 

means that the available net equity accounts need 

not be segregated into vintage accounts, and 

instead may be kept as "pools." Income earned 

prior to 1977, however, is placed in the EK 03 

category, and thus there is no imputation relief at 

the shareholder level for German corporate taxes 

paid on such income. 

A corporation might actually pay tax on 

certain income at rates other than those for which 

corresponding EK categories exist. (A substantial 

portion of such income is foreign source income, 

discussed below .) The German imputation system 

converts income subject to some other effective 

tax rate into appropriate amounts of EK 50, EK 

36, and EK 0 income. The conversion formula 

maximizes the amount of pre-tax income converted into income taxed at the 36 percent distribution 

rate, since distributions from EK 36 neither entitle 

the corporation to a refund nor require the payment of compensatory tax. If the corporation's 

effective tax rate exceeds 36 percent, the remainder of its income is converted to EK 50 income; 

but if the corporation's effective tax rate falls 

short of 36 percent, the remainder of its income 

is converted to EK 0 income.21For example, if 

the corporation has pre-tax income of DMlOO on 

which it pays German tax of DM40, then the 

effective tax rate is greater than .36 (40/100 = 

.40), and so a portion of the income will be 

converted into income taxed at the 50 percent 

statutory rate.22By contrast, if the corporation 

has pre-tax income of DMlOO on which it pays 

German tax of DM25, then the effective tax rate 

is less than .36 (25/100 = .25), and so a portion 

of the income will be converted into income taxed 

at a zero rate.23 

The EK accounts are determined at the end of 

the taxable year.= A distribution is classified 

according to the accounts for the year preceding 

the year of the dividend declaration. 

Dividends Defined, Bonus Shares, 

Share Repurchases 

Any distribution of cash or property (whether 

liquidating or nonliquidating) is a taxable dividend 

for German tax purposes unless it is a distribution 

out of EK 04 or otherwise is a repayment of share 

capital. 

Stock dividends are not subject to the distributions tax and are not taxable to shareholders. 

However, in certain circumstances, distributions 
Appendices 174 

in reduction of share capital within 5 years of the 

stock dividend (to the extent not in excess of the 

increase in share capital resulting from the stock 

dividend) are taxable as dividends and are subject 

to a penalty tax. 

Stock corporations generally are prohibited 

from making share repurchases under German 

corporate law. A GmbH is permitted to make 

share repurchases but is effectively required to 

finance them out of retained earnings (as opposed, 

for example, to borrowing against unrealized 

appreciation in its assets). Share repurchases are 

not subject to distribution tax at the corporate 

level and are capital gains transactions at the 

shareholder level. 

Allocation of Credits to Dividends 

As discussed above, Germany applies a uniform rate for purposes-of determining the shareholder credit regardless of the rate of corporate 

tax that the distributed income has actually borne. 

Tax Rates 

Before 1990, individual marginal rates ranged 

from approximately 22 percent to 56 percent 

(effective for income exceeding DM130,OOO). 

Beginning in 1990, marginal rates range from 

approximately 19 percent to 53 percent (effective 

for income exceeding DM120,OOO). 

There is a flat rate of 50 percent for retained 

profits (before 1990, the rate was 56 percent). 

This rate is reduced to 36 percent for distributed 

profits. Certain German "public banks" (banks 

generally owned by municipal or other public 

bodies) and German branches of foreign corporations are subject to a flat rate of 46 percent (pre1990, 50 percent). (See below for a discussion of 

German branches.) Income sourced in the former 

western sector of Berlin is subject to a special tax 

rate of 38.75 percent (pre-1990, 43.4 percent). 

West Berlin branches of foreign corporations are 

subject to a special tax rate of 35.65 percent (pre1990, 38.75 percent). The special tax rate for 

such income, however, is being phased out over 

a number of years as a result of unification.25 

Gains from sales of stock by individuals are 

exempt unless (1) the sale is connected with a 

business, (2) the stock is held 6 months or less, or 

(3) the shareholder owned more than 25 percent 

of the company's stock at some time during the 

preceding 5 years. Business and short-term gains 

are taxable to individuals at normal rates, except 

that short-term gains are exempt up to DM1,000 

each year. Short-term losses may be netted against 

short-term gains. Gains by substantial individual 

shareholders are taxed at one-half the normal rate 

up to the fEst DM30 million of net gain and at 

the normal rate thereafter. Gains from exchanges 

of stock in a liquidation or redemption are treated 

as sales (except for any portion that is taxed as a 

dividend distribution). 

Gains from sales of stock by corporations are 

taxable as ordinary income. 

Effective for the period July 1, 1991, through 

June 30, 1992, Germany has imposed a tax on 

each taxpayer equal to 7.5 percent of the tax that 

such person would otherwise pay. The surtax 

applies to all individual and corporate taxpayers, 

foreign shareholders subject to dividend withholding tax, and German branches of nonresident 

corporations. For taxpayers using a calendar 

taxable year, the surtax has the effect of a 3.75 

percent surtax in each of the 1991 and 1992 

taxable years. 

Treatment of Preference Income 

Investment incentives in Germany generally 

take the form of accelerated depreciation for 

zertain industries or regions of the country; there 

is no investment tax credit. There are special low 

corporate rates for income derived from the 

former western sector of Berlin (these rates, 

described above, are being phased out). Government "incentive grants" (in the form of cash 

awards) are awarded in certain cases (usually 

related to research and development and energy 

production), 

The benefit of preferences that take the form 

of accelerated depreciation is not extended to 

shareholders. The benefit is eliminated through 
175 Appendices 

the 36 percent compensatory tax applied to distributions out of EK 0. Preferences are stacked 

according to the EK accounts, as indicated. Thus, 

fully-taxed income (EK56 or 50) is distributed 

first, and EK 0 is distributed last. 

The benefit of the current reduced tax rate for 

West Berlin income is extended to shareholders. 

Such income is deemed to have borne the full 

imputation burden (EK 50 or EK 56). 

Treatment of Domestic 

Intercorporate Dividends 

Dividends paid to domestic corporations are 

treated exactly the same as dividends paid to 

resident individuals. The dividends are subject to 

the 36 percent distributions tax. The recipient 

corporation must include the grossed-up distribution in income and is entitled to claim the imputation credit. Therefore, preferences are recaptured 

at the corporate level on intercorporate dividends. 

No exemption from these rules is provided even 

where the distributing corporation is a subsidiary 

of the recipient corporation. 

Treatment of Foreign Source Income 

German corporations are subject to German 

corporate tax on their worldwide income. However, Germany has two methods for relieving double 

taxation with respect to foreign profits: by statute, 

it gives a foreign tax credit and, by treaty, it 

exempts foreign business profits earned by a 

domestic corporation (and gives no credit). 

The foreign tax credit is not treated as tax 

paid for purposes of the imputation credit. In 

effect, foreign taxes are treated as deductib�e 

expenses for purposes of applying the imputation 

system. If the profits are covered by a treaty 

exemption, then the profits (net of foreign tax) are 

simply placed in EK 01 and are subject to the 36 

percent distribution taxwhen paid to shareholders. 

If the profits are not covered by a treaty exemption, they are subject to a residual German corporate tax, as in the United States. In applying the 

imputation system to this latter class of profits, it 

is assumed that the profits (net of foreign tax) 

were subject to a rate of German tax equal to the 

residual tax divided by the net profits. 

Treatment of Tax-Exempt

Shareholders 

In Germany, the tax-exempt sector is divided 

into two separate groups for tax purposes: (1) 

public law corporations or bodies, e.g., the 

government and certain central banks, and (2) 

charitable organizations, including religious 

groups. Charitable organizations are exempt at the 

shareholder level, but public corporations are 

subject to one-half of the normal withholding tax 

of 25 percent. 

In general, neither group is entitled to the 

imputation credit. However, the imputation credits 

are refunded where the dividend is paid out of EK 

01 (foreign source income that has not borne 

German tax) or EK 03 @re-1977 profits). In 

addition, all shareholders (except shareholders of 

foreign corporations with German branches) 

benefit from the 36 percent distribution rate on 

distributed profits. 

Treatment of Foreign Shareholders 

Income distributed to foreign shareholders, 

like all other income, is taxed at the corporate 

level at the distribution rate rather than at the 

statutory rate. No distinction is made, for this 

purpose, between portfolio and direct 

shareholders. 

Dividends to direct and portfolio foreign 

shareholders are subject to the statutory withholding tax of 25 percent, except where reduced by 

treaty. Treaties frequently reduce the rate from 25 

percent to 15 percent for direct corporate shareholders that are residents of the treaty partner. In 

some cases, the reduction applies to all residents 

of the treaty partner. (This was, for example, the 

treatment provided in the 1954 U.S.-Germany 

treaty).26 Foreign shareholders also will be 

subject to the 7.5 percent surtax previously described. The surtax will be refunded to shareholders entitled to limited withholding under a tax 

treaty. 
Appendices 176 

In general, foreign shareholders are not entitled to the imputation credit, and the withholding 

tax applies to the dividend without gross-up. 

Although Germany has not extended the imputation credit to foreign shareholders, it has been 

willing to reduce withholding rates by treaty, in 

part in recognition of the benefits of its imputation 

system to resident shareholders. In the new U.S.-

Germany treaty that entered into force on August 

21, 1991 (generally effective retroactive to January 1, 1990), Germany grants a 5 percent withholding rate for direct corporate shareholders (10 

percent prior to 1992) and a 10 percent withholding rate for U.S. portfolio shareholders. Under 

the treaty, the United States agreed to treat the 

additional relief for portfolio investors as a dividend resulting from a refund of German corporate 

tax equal to 5.88 percent of the declared dividend; 

the entire amount (declared dividend plus refund) 

is considered to have been subject to a 15percent 

German withholding tax. Thus, for U.S. tax 

purposes, if a German corporation declares a 

dividend of DMlOO payable to a U.S. individual 

shareholder, the dividend will, in effect, be 

grossed up to DM105.88. After application of a 

15 percent withholding rate, the shareholder will 

receive a net amount of DM90 and be eligible for 

a foreign tax credit of DM15.88. 

Foreign shareholders are entitled to a refund 

(subject to withholding tax) of the 36 percent 

distribution tax imposed on two types of distributions: (1) distributions out of foreign source 

income and (2) distributions out of domestic 

source income earned prior to the adoption of 

integration in 1977. The refund is only for the 36 

percent distribution tax, not for the foreign or 

pre-1977 taxes. Refunds paid to foreign shareholders with respect to such distributions are 

subject to 25 percent withholding unless a treaty 

provides for a reduced rate. In the latter case, the 

reduction is granted directly by the government, 

eliminating the need to apply for a refund of 

excess withholding. 

German branches of foreign corporations are 

subject to a corporate tax rate of 46 percent @re1990, 50 percent). There is no reduction in the 

corporate rate when the profits are remitted to the 

home office or distributed to the foreign corporation’s shareholders (nor is there imposed a 

branch tax, as under IRC 9 884); the distribution 

of the profits to the shareholders is not subject to 

German withholding; and the shareholders are not 

entitled to any imputation credit with respect to 

the German corporate tax.” 

Treatment of Low-Bracket 

Shareholders 

As discussed above, excess credits are fully 

refundable to low-bracket shareholders. 

Streaming 

An anti-streaming rule applies where (1) a 

shareholder sells a substantial interest in a German corporation @e., shares with a value of more 

than DMlOO,OOO), (2) the shareholder is not 

entitled to the shareholder credit (i.e., a taxexempt or foreign shareholder), (3) the shareholder sells the shares to a person entitled to the credit 

(i.e., a German resident), and (4) the gain realized on the sale is not subject to German tax. In 

such case, the acquiror is not allowed to recognize 

loss on disposition of shares within 10 years to 

the extent the loss is attributable to dividends paid 

by the German corporation. 

Treatment of Interest 

Interest paid by German corporations on 

indebtedness incurred for business purposes 

generally is deductible. However, interest paid by 

an undercapitalized subsidiary to a related party 

may be recharacterized as a hidden dividend. 

Interest paid by German corporations to 

resident lenders is includable in income. Interest 

paid by German corporations to nonresident 

lenders generally is not subject to any German 

withholding tax. Interest paid on participatory or 

convertible bonds, however, is subject to withholding at a statutory rate of 25 percent rate. 

Lower treaty rates or treaty exemptions may 

apply* 
177 Appendices 

B.5 NEWZEALAND 

Introduction 

New Zealand adopted an imputation credit 

system beginning with the tax year starting 

April 1, 1988. 

Description of General Mechanics 

Imputation Credits 

For purposes of shareholder level taxation, the 

amount of a dividend includes the amount of 

imputation credits that the corporation allocates to 

the dividend (see "Allocating Credits to Dividends, 'I below) from its Ymputation credit account" (ICA). The imputation credits are then 

creditable against shareholder tax liability. Excess 

credits are not refundable but do convert into an 

equivalent loss carryforward. 

The New Zealand system requires every 

taxable domestic corporation to maintain an ICA. 

The ICA is a memorandum account that runs 

from April 1 to March 31, regardless of the 

corporation's fiscal year. The first imputation year 

ran from April 1, 1988, to March 31, 1989. 

Unlike Australia's year-to-year franking account, 

the ICA is a continuing account, and so a negative 

year-end balance in the ICA results in a tax levy. 

The ICA is credited when the corporation pays 

New Zealand income tax or receives imputation 

credits attached to dividends paid by another 

corporation. Where a refund of tax becomes due 

because of a revised tax assessment, the amount 

of the refund available is limited to the closing 

balance of the ICA for the previous year. The 

amount of a refund in excess of the balance is 

carried forward and may be used to reduce future 

tax liability of the corporation. 

The ICA is debited when the corporation 

attaches imputation credits to dividends paid to 

shareholders, receives refunds of New Zealand 

income tax, or alters its credit ratio without 

making a ratio change declaration. See 

"Allocating Credits to Dividends," below. A 

closing debit must be cleared within two months 

by making a "further income tax" paymentavailable to offset future income tax liabilities, but 

not arrears-and also results in a 10 percent 

penalty.*' See also "Streaming" below. 

Compensatory or Withholding Tax 

New Zealand does not impose a compensatory 

tax. Recently, New Zealand introduced a withholding tax for dividends paid to residents that do 

not carry imputation credits. Technically, the 

resident withholding tax is imposed on all dividends at a rate of 33 percent (the higher individual marginal rate), but an offset is allowed to the 

extent the corporation is passing through imputation and foreign source dividend withholding 

payment credits allocated to the dividend. (See 

"Treatment of Foreign Source Income" below for 

a discussion of the "dividend withholding payment" relating to foreign source dividends.) As 

with imputation credits, the amount of the dividend includes the resident withholding tax paid 

and the withholding tax is creditable against 

shareholder tax liability. However, excess resident 

withholding tax credits are refundable. 

Dividends Defined, Bonus Shares, 

Share Repurchases 

In general, all nonliquidating distributions to 

shareholders are treated as taxable dividends 

(under corporate law, the corporation cannot pay 

dividends as a return of capital without a court 

order); on liquidation, the amount in excess of 

paid-up capital is a dividend. 

A taxable bonus issue, although technically not 

a dividend, may carry imputation credits. A 

corporation with profits essentially may elect 

whether to treat a bonus issue as taxable. In 

addition, a bonus issue is taxable if shareholders 

may elect to receive cash in lieu of stock. However, the importance of bonus issues as a mechanism for extending the imputation system to 

retained earnings is reduced, because, as 

described under "Tax Rates," below, New 
Appendices 178 

Zealand does not impose tax on capital gains 

(includinggains on sales of stock of New Zealand 

corporations). 

In the case of share repurchases, the amount 

treated as a dividend is limited to the excess of 

the amount paid over the sum of the stated capital 

and qualifyingpremium with respect to the share. 

The qualifying premium is qual to the proportionate share of the subscription premium paid on 

issuance of the class. The limitation applies, 

however, only if the Inland Revenue Department 

is satisfied that the shares are not being redeemed 

pursuant to an arrangement to redeem shares in 

lieu of the payment of dividends. 

Allocating Credits to Dividends 

New Zealand's imputation statute does not 

require a corporation to allocate any credit to a 

dividend, but certain allocation rules significantly 

limit a corporation's flexibility to reduce opportunities to stream imputation credits to shareholders 

who can best use them. The maximum amount 

that can be allocated to a dividend is determined 

by multiplying the dividend by a fraction, the 

numerator of which is the corporate tax rate and 

the denominator of which is one minus the corporate tax rate. Once the corporation allocates 

credits to a dividend, the corporation has established the "benchmark" imputation ratio, and the 

corporation must generally use the same ratio in 

allocating credits to any other dividendpaid in the 

same imputation year on any class of stock. The 

corporation may change its ratio, if it files with 

the Inland Revenue Department a "ratio change 

declaration" showing that the change is made for 

commercial reasons and not to convey an imputation credit benefit to one group of shareholders 

over another. If the corporation uses a ratio 

different from the benchmark and has not filed a 

ratio change declaration, it must debit its ICA by 

the amount by which the account would have been 

debited if all dividendsthat year had been credited 

at the highest rate used that year. Additional tax 

and penalties are due if, as a result, the closing 

balance is negative. 

Tax Rates 

The corporate tax rate is currently 33 percent. Individualspay tax at two marginal rates: 24 

and 33 percent. The 33 percent rate applies to 

individuals with taxable incomes exceeding NZ 

$30,875, adjusted for inflation. New Zealand 

currently imposes no tax on capital gains. 

Treatment of Preference Income 

Because a corporation may attach credits to 

dividends only to the extent of taxes actually paid 

by it, corporate tax preferences generally are not 

extended to shareholders. When preference 

income is distributed as an uncredited dividend, 

the amount of the dividend, in general, is subject 

to resident withholding tax. However, subject to 

the credit allocation limitations described above, 

a corporation may choose the order in which 

taxable income and preference income are considered distributed. In addition, New Zealand recently attempted to eradicate most tax preferences. 

Various concessions remain for certain industries, 

most relating to timber, livestock, farming and 

fishing. New Zealand also offers certain export 

incentives. The research and development deduction is 100 percent, with special rules for 

depreciable property. 

Treatment of Domestic 

Intercorporate Dividends 

Until April 1, 1992, corporations are exempt 

from tax on the receipt of domestic source dividends. Any imputatipn credits attached to such 

dividends are credited to the recipient's ICA and 

may be used to frank dividends to its shareholders. The effect of this system is preserve corporate tax preferences until preference income is 

distributed out of corporate solution. 

Under a recent decision of the New Zealand 

Government, domestic source dividends are not 

exempt from tax when received by a corporate 

shareholder on or after April 1, 1992. Instead, the 

normal gross-up and credit rules apply and a 
179 

corporate shareholder thus will be taxed on the 

receipt of an unfranked, domestic source dividend. The reason for this change is to prevent 

corporations with tax losses from effectively 

transferring the losses to corporate shareholders 

through the issuance of redeemable preference 

shares and using the proceeds to invest in interestbearing securities. Another effect of the change is 

to recapture preferences on the distribution of 

preference income to a corporate shareholder. 

To mitigate the effect of the repeal on afffiated groups of corporations and for other reasons, 

a group of corporations with 100percent common 

ownership is allowed to consolidate for tax purposes. A consolidated group would maintain a 

single ICA and intercorporate dividends would be 

ignored. 

Treatment of Foreign Source Income 

Foreign source income other than dividends is 

includable in income, and New Zealand allows a 

cre& for foreign taxes paid. Because a corporation credits its ICA only with any additional New 

Zealand corporate tax paid, foreign taxes do not 

give rise to imputation credits, and dividends to 

shareholders of a New Zealand corporation paid 

out of foreign source nondividend income are 

exposed to a second level of tax. Foreign source 

dividends received by New Zealand corporations 

are exempt from tax but are subject to a "dividend 

withholding payment" as described below. Foreign taxes paid on the dividend generally are not 

added to the ICA and, accordingly, dividends paid 

to shareholders of the New Zealand corporation 

out of foreign source dividend income also are 

subject to shareholder level tax. Special rules 

apply to income derived from controlled foreign 

corporations (CFCs). The net effect of the New 

Zealand system is the equivalent of allowing a 

deduction for foreign taxes on distributed foreign 

source income earned through a New Zealand 

corporation. 

Dividend Withholding Payment Account (WPA) 

New Zealand enacted a withholding payment 

system (at the 33 percent corporate rate) that 

Appendices 

applies to all foreign source dividends received by 

New Zealand resident corporations. The payment 

is designed to approximate the income tax that a 

New Zealand individual shareholder would pay on 

a dividend from a nonresident company. The 

corporationmakes dividend withholdingpayments 

only to the extent the New Zealand corporate tax 

rate exceeds the foreign withholding tax rate. 

Although styled a withholding payment, the 

payment is imposed when the corporation receives 

the foreign dividend, regardless of whether it 

makes a distribution to its own shareholders. 

However, the corporation records the dividend 

withholding payments in its ICA, and thus can 

pass through a credit to its shareholders when it 

pays dividends. Alternatively,the corporation may 

establish a separateWithholding Payment Account 

(WPA) and allocatedividend withholdingpayment 

credits from the WPA to its shareholders. A WPA 

might be desirable because the imputation credit 

is nonrefundable and can only be converted into 

a loss, but the dividend withholding payment 

credit is refundable to shareholders. In addition, 

only dividend withholding credits are creditable 

against the withhold@g tax that applies to dividends paid to nonresident shareholders. Accordingly, a corporationthat owns significantinterests 

in nonresident companies and that is owned in 

significant part by tax-exempt or foreign shareholders will find the additional paperwork of a 

separate WPA worthwhile. 

The WPA is maintained under rules similar to 

the ICA rules. The WPA is credited when the 

corporation pays dividend withholding payments, 

and when it receives dividends bearing dividend 

withholding payment credits. The WPA is debited 

when dividendwithholding payment credits attach 

to dividends paid to shareholders, and when the 

corporation chooses to transfer any part of a WPA 

closing credit balance to its ICA. If the corporation has an income tax loss carryforward, or 

expects to generate one, it may reduce that loss to 

satisfy all or part of the dividend withholding 

mount payable (or obtain a refund of payments). 

A closing negative balance in the WPA must be 

satisfied with a "further" dividend withholding 

payment (which may be credited against future 
Appendices 180 

dividend withholding payments due, but cannot be 

refunded). A debit closing balance, in addition, 

automatically incurs a 10 percent penalty. 

Dividend withholding payment credits may be 

allocated to dividends paid to shareholders under 

rules similar to and coordinated with the allocation rules for imputation credits. 

Branch Equivalent Tax Account (BETA) 

The Branch Equivalent Tax Account (BETA) 

regime is designed to reduce the potential for 

deferring New Zealand tax by accumulating 

income in low-tax countries. A CFC is a foreign 

corporation (not resident in Australia, the United 

States, the United Kingdom, Japan, France, 

Germany or Canada) in which five or fewer New 

Zealand residents have a controlling (50 percent 

or more) intere~t.~'Any New Zealand resident 

with a 10 percent interest in a CFC must include 

in income its proportionate share of the CFC's 

income and receives credit for its proportionate 

share of foreign income taxes paid by the CFC. 

Any New Zealand taxpaid is then credited to the 

BETA (or to the ICA if the corporation does not 

elect to maintain a separate BETA). Credits from 

a BETA can be used to satisfy the dividend 

withholding payment liability on later dividends 

actually received from the CFC. When BETA 

credits are so used to satisfy the WPA liability, a 

corresponding credit to the ICA is made. 

Treatment of Tax-Exempt

Shareholders 

New Zealand has a small tax-favored investor 

sector. Under recent reforms, New Zealand fully 

taxes pension plans. At the same time the new 

imputation scheme went into effect, New Zealand 

conformed the treatment of Maori authorities to 

that of corporations (or, in appropriate cases, to 

that of trusts). In addition, New Zealand repealed 

the income tax exemption on "qualifying activities" enjoyed by certain cooperatives dealing in 

primary products. 

For tax-exempt charitable and governmental 

shareholders, imputation credits in excess of tax 

liability are not refundable. However, such taxexempt shareholders are exempt from resident 

withholding tax so preferences are not recaptured 

where preference income is distributed to them. 

Treatment of Foreign Shareholders 

In general, the benefits of the imputation 

credit system generally are not extended to foreign shareholders. New Zealand imposes a nonresident withholding tax at the rate of 30 percent 

for dividends, with no difference in treatment of 

portfolio and nonportfolio investors. In some 

cases, treaties reduce that rate, but to no less than 

15 percent. Imputation credits are not creditable 

against nonresident withholding tax (although 

dividend withholding payment credits are 

creditable against such tax). 

Low-Bracket Shareholders 

Excess imputation credits are available to 

offset any other tax liability of the taxpayer, but 

are not refundable. Imputation credits not us@ in 

the year that they are received convert into a loss, 

which carries forward indefmitely. Excess dividend withholding payment credits and resident 

withholding tax credits are refundable. 

Streaming 

In addition to the allocation rules discussed 

above, New Zealand's imputation system contains 

several anti-streaming provisions. The ICA, 

WPA, and BETA must be debited to reverse a 

credit where, after the credit arises, the corporation undergoes a change of beneficial ownership 

of more than 25 percent (34 percent after April 1, 

1992).30 In addition, the ICA and WPA are 

debited if there is a "shareholder or company tax 

advantage arrangement" (a streaming arrangement). The use of credits by shareholders is 

denied if the shareholders are party to such an 

arrangement of if there is an arrangement for the 

shareholder to be paid a dividend by another 

company. The latter provision applies, for example, where streaming is accomplished through 

stapled share arrangements. 
181 

Treatment of Interest 

Interest paid by a New Zealand corporation is 

generally deductible. Interest paid to a resident 

lender is includable in the lender's income and, 

with certain exceptions, is subject to a withholding tax imposed at a rate of 24 percent. Withholding tax at a statutory rate of 15 percent is imposed 

on interest paid to a foreign lender. The New 

Zealand Government recently announced its 

decision to exempt from withholding tax interest 

paid on debt issued on or after August 1, 1991by 

"Approved Issuers" (issuers that agree to pay a 

levy equal to 2 percent of the amount of the 

interest paid for the right to pay exempt interest). 

In addition, in some cases, treaties reduce the 

withholding rate, but to no less than 10 percent. 

B.6 UNITED KINGDOM 

Introduction 

The United Kingdomprovides for distributionrelated integration of the individual and corporate 

income tax systems by allowing a credit for 

corporate tax paid with respect to distributed 

earnings. The amount of the credit is determined 

as though the corporation had paid tax at the 

"basic" individual rate, currently 25 percent, 

rather than at the corporate rate, currently 33 

percent (except for small corporations, which may 

be taxable at a 25 percent rate). Thus, the credit 

provides only partial relief (except for small 

corporations) from corporate level tax because 

actual corporate tax paid with respect to distributed earnings is not fully creditable at the shareholder level. 

Description of Mechanics 

Imputation Credit 

When a corporation makes a "qualifying 

distribution"(described below) to its shareholders, 

the distribution carries with it an imputation 

credit. The shareholder includes the amount of the 

credit in his taxable income in addition to the 

amount of the distribution and may use the credit 

against his income tax liability. The amount of the 

Appendices 

imputation credit equals the amount of net qualifying distributions, grossed up at the basic personal 

rate (25 percent), and then multiplied by that 

rate.31Accordingly, if the shareholder's actual 

marginal tax rate equals the basic rate, then the 

shareholder owes no tax on the distribution. 

Generally, the imputation credit is refundable to 

all resident, non-corporate shareholders, including 

tax-exempt shareholders. 

Compensatory or Withholding Tax 

The United Kingdom imposes an "Advance 

Corporation Tax" (ACT) on qualifying distributions equal to the amount of corporate tax imputed 

to shareholders (at a 25 percent grossed-up rate). 

The corporationmay apply ACT payments against 

its regular taxliability (mainstream tax) subject to 

the limitations described below. Because preference income generates no mainstream tax, ACT 

effectively recaptures preferences at the corporate 

level on the distribution of preference income, 

thereby assuring that preference income ultimately 

is taxed at shareholder rates. 

The amount of ACT that may be applied 

against mainstream tax is limited to an amount 

that equals 25 percent of the corporation's taxable 

income for the year. Excess ACT may be carried 

back for up to 6 years and may be carried forward indefinitely. Alternatively, current year and 

surplus ACT can be surrendered to a more than 

50 percent-owned subsidiary. Because excess 

ACT is not refundable, uncredited ACT represents an additional tax liability to the corporation 

until the corporation earns sufficient additional 

taxable income to absorb it. In practice, because 

of the numerous tax preferences provided by U.K. 

law, many corporations carry excess ACT credits 

on their books.32 

Dividends Defined, Bonus Shares, 

Share Repurchases 

The U.K. system generally defines a qualifying distribution to include any non-liquidating 

distribution of cash or property made by a corporation with respect to its shares, other than a 

repayment of share capital. Liquidating 
Appendices 182 

distributions are not treated as qualifying distributions, and thus neither the ACT nor the gross-up 

and credit mechanism applies. 

Bonus issues are not qualifying distributions. 

This rule prevents corporations from having to 

pay ACT on bonus issues. However, cash distributions on bonus issues of redeemable shares 

made within 10 years of their issuance generally 

are qualifying distributions even if paid out of 

share capital. 

Share repurchases are generally treated as 

qualifying distributions to the extent that the 

amount paid exceeds share capital, and the corporation must pay ACT on the amount so treated. 

Allocation of Credits to Dividends 

Because the gross-up and credit mechanism 

described above applies to each qualifying distribution at the assumed 25 percent rate, no allocation rules are necessary. 

Tcrx Rates 

The corporate rate, until recently, was 25 

percent for income up to �100,000 and 35 percent 

for income greater than �500,000. (The U.K. 

system phases out the reduced corporate rate, 

which resulted in a marginal rate of 37.5 percent 

for corporate income between �100,000 and 

f500,OOO.)On March 29,1991, the Chancellor of 

the Exchequer introduced a budget that (1) reduces the 35 percent corporate rate to 34 percent 

retroactive for profits med in frnancial year 

1990, and to 33 percent for profits earned in 

1991, and (2) raises the ceiling on the 25 percent 

rate to f250,OOO. 

The individual rate is 25 percent for income 

up to �20,700 and 40 percent for income over this 

level. 

Capital gains are taxed at the same rate as 

ordinary income. In calculating the amount of 

gain on disposition of a capital asset, the basis in 

the asset is indexed for inflation. In addition, 

individuals are eligible for an annual capital gains 

exclusion of C5,000,also indexed for inflation. 

Treatment of Preference Income 

As discussed above, the ACT generally 

prevents corporate preferences from being extended to shareholders (preference income is taxed at 

shareholder rates when distributed). However, 

crediting ACT against mainstream tax has the 

effect of treating distributions as made first from 

taxable income. 

The U.K. system provides corporations with 

a variety of tax preferences. The most significant 

is accelerated capitdl allowances or "writing 

down" allowances (equivalent to accelerated 

depreciation or amortization). To provide investment incentives, accelerated cost recovery is 

allowed for certain types of capital expenditures. 

Generally, all investments in business machinery 

and equipment are "pooled," Le., treated as a 

mass asset. In lieu of depreciation, taxpayers are 

permitted to recover 25 percent of the pool each 

year, on a declining balance basis. Scientific 

research expenditures and certain oil exploration 

costs in the U.K. can be fully deducted in the 

year incurred even if they create an asset. Capital 

expenditures on industrial and commercial buildings in enterprise zones are deductible in full 

when incurred. Additional preferences are available for mineral extraction operations, industrial 

buildings, and patents and know-how. 

Treatment of Domestic 

Intercorporate Dividends 

A U.K. corporation paying a qualifying 

distribution to another U.K. corporation generally 

must pay ACT on the distribution, but the recipient corporation is exempt from tax on the distribution. A U.K. corporation receiving a dividend 

generally cannot claim a refund or credit of ACT 

paid on that dividend. However, the recipient 

corporation can redistribute a dividend that has 

been subject to ACT (franked investment income) 

without incurring further ACT, and its shareholders are entitled to a credit for the ACT paid 
183 

by the original distributing company. The effect 

of imposing ACT on intercorporate dividends is to 

recapture preferences prior to distribution of 

preference income out of corporate solution. 

If a recipient corporation receives more 

franked investment income than it distributes, it 

can carry forward the excess franked investment 

income indefinitely. Alternatively, the recipient 

corporation may claim a refund of ACT paid on 

the excess franked investment income by offsetting the excess against any losses for the year. If, 

in a subsequent year, payments by the corporation 

of franked investment income exceed receipts of 

franked investment income, any refund of ACT 

received in the earlier year is recaptured. 

Qualifying distributions between U.K. corporations are not subject to ACT if a group dividend 

election has been made. Such an election may be 

made with respect to dividends from a more than 

50 percent owned subsidiary. If a group dividend 

election is made, the distribution is not treated as 

franked investment income and thus is subject to 

ACT when redistributed. 

Treatment of Foreign Source Income 

U.K. corporations are taxed on their worldwide income, with relief from double taxation 

provided through a foreign tax credit system. 

U.K. corporations are allowed a credit for foreign 

taxes paid subject to the following limits.33First, 

the foreign tax credit is allowed only against U.K. 

tax payable on foreign source income from the 

particular source with respect to which the foreign 

tax was paid. Second, unused foreign tax credits 

may not be carried forward or back. 

Foreign tax credits cannot be used to satisfy 

liability for ACT where qualifying distributions 

are paid out of foreign source income. Thus, the 

benefit of the foreign tax credit is washed out 

with respect to distributed foreign source income. 

The amount of ACT that may be applied 

against mainstream tax imposed on foreign source 

income effectively is the lesser of (1) the mainstream tax on foreign source income and (2) 25 

Appendices 

percent of foreign source taxable income. The 

effect is that foreign tax credits are allowed before 

the ACT and ACT that is unused because of 

foreign tax credits is carried back or forward. 

This ordering rule favors taxpayers because 

surplus ACT, unlike surplus foreign tax credits, 

can be carried 

Treatment of Tax-Exempt

Shareholders 

A tax-exempt shareholder is entitled to a 

refund of the shareholder credit. The primary 

entities exempt from tax on investment income are 

charities, pension plans (called “exempt approved 

schemes”), and building societies. 

Treatment of Foreign Shareholders 

The treatment of dividends paid by U.K. 

corporations to foreign shareholders varies depending on whether they are entitled to treaty 

benefits. Except as provided by treaty, only 

shareholders that are U.K. residents are entitled to 

imputation credits on dividends received from 

U.K. corporations. On the receipt of such dividends, a foreign shareholder not entitled to treaty 

benefits is treated as having income equal only to 

the amount of the distribution (rather than the 

distribution plus the imputation credit), the rate of 

tax applicable is the same as for residents (25 or 

40 percent for individuals), the foreign shareholder is treated as having paid tax at the 25 percent 

rate on the distribution, and the foreign shareholder generally is not entitled to the imputation 

credit. 

Under tax treaties, foreign shareholders 

generally are entitled to some or all of the imputation credits otherwise allowable to resident shareholders with respect to a dividend from a U.K. 

corporation, and the rate of tax is reduced (the 

amount of the reduction may vary depending on 

whether the shareholder is a portfolio or nonportfolio investor). For example, for a U.S. shareholder owning less than 10 percent of the stock of 

the distributing corporation, the U.S. treaty 

entitles the shareholder to the full imputation 

credit and reduces the tax to 15 percent of the 
Appendices 184 

amount of the dividend grossed up for the credit 

(imposed as a withholding tax). For a U.S. 

shareholder owning at least 10 percent, the shareholder is entitled to one-half of the imputation 

credit and the rate of tax is reduced to 5 percent 

of the dividend grossed up for the amount of the 

credit allowed (also imposed as a withholding 

tax).35 

Streaming 

The U.K. system contains severalanti-streaming provisions. For example, tax-exempt shareholders purchasing at least 10 percent of a corporation are subject to tax at a 10 percent rate on 

dividends made out of pre-acquisition earnings 

(but may use attached credits to offset the tax). 

Restrictions on entitlement to imputation credits 

apply where there is an arrangement to channel 

credits to shareholders of a close investment 

holding company. 

In addition, the United Kingdom has adopted 

measures to prevent trafficking in excess ACT. 

The principal limitation is triggered where, following a major change in share ownership (a 

more than 50 percent increase by one or more 

5 percent shareholders over a 3 year period), 

there is a major change in nature or conduct of 

the corporation’s business or a considerable 

revival of business that had been negligible prior 

to the ownership change. In such a case, prechange surplus ACT cannot be used to offset postchange mainstream tax. 

Treatment of Interest 

Interest paid by U.K. corporations generally is 

deductible if the indebtedness is incurred for 

business purposes. Interest received by a resident 

lender generally is includable in the lender’s 

income. Foreign lenders are taxed on U.K. source 

interest at the same rate as residents, but this tax 

may be reduced or eliminated under treaties. For 

example, U.K. source interest received by a U.S. 

resident is exempt from U.K. tax under the U.S. 

treaty. 
APPENDIXc:EQUIVALENCEOF 

DISTRIBUTION-RELATED INTEGRATION SYSTEMS

The dividend exclusion, imputation credit and 

dividend deduction systems produce equivalent 

results if corporate and shareholder tax rates are 

the same, all shareholders are taxable, and no 

corporate tax preferences exist. This appendix 

illustrates that equivalence and shows how the 

three systems diverge when each of these 

assumptions is relaxed. 

C.1 EQUIVALENCE OF SYSTEMS 

IF TAX RATES WERE EQUAL 

Table C.l illustrates the equivalence of the 

three different types of systems when individual 

and corporate tax rates are equal (34 percent in 

the example), all shareholders are subject to tax, 

and no corporate tax preferences exist. For 

simplicity, all examples assume that corporations 

distribute all income when earned. 

It might appear counterintuitive that the 

dividend deduction and imputation credit systems 

lead to exactly the same result. Nevertheless, 

from an economic perspective, the two systems 

are equivalent under these assumptions. This 

equivalence depends on the assumption that 

shareholders are indifferent between receiving a 

certain amount of money as a cash dividend or the 

Table C.l 

same amount split between a cash dividend and a 

tax credit. Under either the dividend deduction or 

the imputation credit system, the shareholder has 

the same after-tax income and pays the same 

amount of tax.Thus, the corporation's behavior 

should be the same economically under both 

systems. To achieve equivalence under the three 

systems, in the example above, the corporation 

must adjust its cash dividends to leave its shareholders in identical after-tax positions. This 

assumptionprobably better reflects long-term than 

short-term behavioral responses to the various 

integration mechanisms. 

C.2 EFFECTS OF RATE 

DIFFERENCES, PREFERENCE 

INCOME, AND EXEMPT 

SHAREHOLDERS 

Rate Differences 

If corporate and shareholder tax rates differ, 

the three systems no longer produce equivalent 

results. A dividend exclusion system eliminates 

whatever shareholder level tax would otherwise be 

imposed. A dividend deduction system eliminates 

the corporate level tax and retains the shareholder 

level tax. 

Equivalence of Distribution-Related Integration Systems 

Classical Dividend Dividend Imputation 

System Exclusion Deduction Credit 

Corporate income 100 100 100 100 

Distribution 66 66 100 66 

Corporate tax 34 34 0 34 

Shareholder credit 0 0 0 34 

Cash received 66 66 100 66 

Shareholder income 66 0 100 100 

Shareholder tax' 22 0 34 0 

Total tax paid 56 34 34 34 

'Taxdue after credits, if any. 

An imputation credit 

system can be structured to 

tax distributed earnings at 

either the corporate or individual rate. To tax distributions at the individual rate, a 

credit would be allowed to 

shareholders for the full 

amount of corporate tax paid 

with respect to a distribution. 

This credit would be allowable against tax on other 

income, or, if there were no 

such tax, fully refundable. To 

tax distributions at the corporate rate, a credit would be 

185 
Appendices 186 

allowed only for tax at the shareholder rate on the 

sum of the cash distribution and the credit ($95.65 

in the second to last column in the example 

below). 

Table C.2 assumes a shareholder rate of 31 

percent and a corporate rate of 34 percent. 

Preference Income 

If some corporate income is not taxed, or is 

taxed at a lower rate, the alternative systems also 

do not produce equivalent results. Without modification of the sort described in Section 2.B, a 

dividend exclusion would automatically extend 

corporate tax preferences to shareholders, because 

preference income would not be taxed (or would 

be taxed at a lower rate) at the corporate level 

and, with an exclusion for all dividends received, 

would not be taxed at the shareholder level. A 

dividend deduction system would not extend 

preferences to shareholders because shareholders 

would include dividends in income. 

An imputation credit system can be designed 

to achieve either result. If, as this Report recommends, the policy choice is not to extend preferences to shareholders, a system can be designed 

to limit the shareholder credit to the corporate tax 

actually paid with respect to the distribution. If 

the policy choice is to extend preferences, where 

corporate and shareholder rates are equal, the 

system could determine the shareholder credit as 

though the corporation had paid taxat the full rate 

on all income, Le., by grossing up the cash 

distribution at the full corporate rate.' Passing 

through preferences where there are rate differences is somewhat more diffic~lt.~ 

To illustrate the effects of preferences, holding 

tax rates equal, Table C.3 assumes that the corporate rate and the shareholder rate are both 34 

percent, 

Tax-Exempt and Foreign Shareholders 

If certain shareholders are wholly or partially 

exempt from U.S. tax, the alternative distributionrelated integrated systems do not produce equivalent results, even if corporate preferences are not 

taken into account. A dividend exclusion system 

replicates the current treatment of tax-exempt 

shareholders, because corporate income is taxed 

at the corporate level, and a tax-exempt shareholder would receive no additional benefit from a 

shareholder level exclu~ion.~In contrast, a dividend deduction system produces an absolute 

benefit to tax-exempt shareholders because corporations could reduce or eliminate the corporate 

level tax that applies to income from equity 

Table C.2 

Effect of Rate Differences 

Imputation Credit 

Classical

System 

Dividend

Exclusion 

Dividend

Deduction At Shareholder At Corporate 

Rate Rate 

Corporate income 100 100 100 100 100 

Distribution 66 66 100 66 66 

Corporatetax 34 34 0 34 34 

Shareholder credit 0 0 0 29.65 34 

Cash received 66 66 100 66 66 

Shareholder income 66 0 100 95.65 100 

Shareholder tax' 20.46 0 31 0 0 

Total tax paid 54.46 34 31 34 31' 

'Tax due after credits, if any. 

'The shareholder would have an excess credit of $3 that would be refunded or could be used to 

offset other tax liability. 
187 

Table C.3 

Effect of Preferences 

Classical Dividend Dividend 

System Exclusion Deduction 

Appendices 

Imputation Credit 

Preferences Preferences Not 

Passed Through - Passed ThroughI

100 100 

40 40 

60 60 

79.6' 79.6' 

20.4 20.4 

41 20.4 

79.6 79.6 

120.6 100 

0 13.6 

20.4 34 

Corporate income 

Preference income 

Taxable income 

Distribution 

Corporate tax 

Shareholder credit 

Cash received 

Shareholder income 

Shareholder tax2 

Totaltax paid 

100 100 100 

40 40 40 

60 60 0 

79.6' 79.6' 100 

20.4 20.4 0 

0 0 0 

79.6 79.6 100 

79.6 0 100 

27.06 0 34 

47.46 20.4 34 

'This is the maximum amount the corporation can distribute after payment of the corporate level tax. 

'Tax due after credits, if any. 

supplied by tax-exempt shareholders by deducting 

paymentsof dividendsto tax-exempt shareholders. 

A dividend deduction system also would maintain 

the same benefit relative to taxable investors that 

tax-exempt shareholders enjoy under current law. 

An imputation credit system with full refundability would have the same effect as a dividend 

deduction system. An imputation credit system 

that does not permit credits to be refunded to taxexempt shareholders would have the same effect 

as a dividend exclusion system. 

Table C.4 assumes that all shareholders are 

fully exempt from tax and that the corporation 

pays tax on all of its income at a 34 percent rate. 

The treatment of foreign shareholders under 

each system is similar. A dividend deduction 

system would extend automatically the benefits of 

Table C.4 

Effect of Tax-Exempt Shareholders 

Effect of Tax-Exempt Shareholders 

Imputation Credit 

Classical Dividend Dividend Not System Exclusion Deduction' Refundable Refundable 

100 100 100 100 100 

66 66 100 66 66 

34 34 0 34 34 

0 0 0 34 34 

66 66 100 66 66 

66 0 100 100 100 

0 0 0 03 0 

34 34 0 0 34 

Corporate income 

Distribution 

Corporate tax 

Shareholder credit 

Cash received 

Shareholder income 

Shareholder tax' 

Total tax paid 

'No withholding on dividends. (A dividend deduction system with a nonrefundable "withholding" tax of 34 percent would duplicate the results under a dividend exclusion system or an 

imputation credit system with nonrefundable credits.) 

'Tax due after credits, if any. 

3The tax-exempt shareholder would receive a $34 refund. 
Appendices 188 

integration to foreign shareholders, because only shareholders (assuming, again, that the current 

one level of tax (the current withholding tax on withholding tax remains in place). In contrast, an 

dividends) would be collected on corporate in- imputation credit system would extend benefits to 

come distributed to foreign shareholders. A foreign shareholders if the imputation credit is 

dividend exclusion system would automatically refundable and would deny benefits if the credit is 

deny the benefits of integration to foreign not refundable to foreign shareholders. 
189 

NOTES 

Notes 

PART I 

Chapter 1 

1. If corporate income were not subject to tax until distributed to shareholders, retained earnings would be taxed under the 

individual income tax system only when shareholders realize capital gains on the sale of stock. Shareholders could defer or 

avoid individual income tax simply by retaining earnings in corporations. See Pechman (1987) and Warren (1981). While 

this argument counsels against repeal of the corporate income tax, it does not apply to the integration proposals discussed 

in this Report, none of which permit such indefinite deferral of tax on corporate income. 

Some have suggested that a mark-to-market regime for corporate stock would remove the potential deferral associated 

with investment in corporations and, thus, the need for the corporate tax. Under a mark-to-market regime, shareholders 

would recognize each year the change in the value of the corporation, including corporate income. See Shakow (1986) and 

Thuronyi (1983). While marking to market corporate stock could be considered a method of integrating the corporate and 

shareholder tax systems, it also would tax shareholderson income that is unrealized at the corporate level. We do not explore 

that approach in this Report, because abandoning the realization requirement goes well beyond the changes necessary to 

achieve integration. 

2. Tax Reform Act of 1986, P.L.99-514, 100 Stat. 2085, Oct. 22, 1986. 

3. General Utilities & Operating Co. v. Helvering, 296 U.S. 200 (1935). 

4. This increase in welfare compares favorably to that estimated for the 1986 Tax Reform Act at the time of its adoption. 

See Fullerton, Henderson, and Mackie (1987). 

5. Appendix A contains a more detailed discussion of the taxation of corporations under current law. 

6. Characterizing the corporate income tax as a double tax rests on the assumption that the corporate level tax reduces 

corporate income available to shareholders. If the corporate tax does not reduce profits but instead increases prices charged 

to consumers or lowers wages paid to workers, little or no additional tax may be paid on dividends. Section 13.G discusses 

the incidence of the corporate tax. In addition, not all income earned by corporations is taxed when earned, and not all 

shareholders are subject to taxation. Chapter 5 discusses tax preferences and Chapters 6 and 7 examine the issues of taxexempt and foreign investors. 

7. The Omnibus Budget Reconciliation Act of 1990, Pub. L. 101-508, 104 Stat. 1388 (the 1990 Act) made three changes 

in the individual income tax rate structure. First, the 1990 Act increased the top marginal tax rate for individuals to 31 

percent from 28 percent. A number of other statutory provisions may affect statutory marginal rates. For example, the 1990 

Act created an explicit phaseout of personal exemptions for taxpayers with adjusted gross income (AGI) above certain 

thresholds. For a married couple filing jointly, for example, the deduction for personal exemptions phases out at a rate of 

2 percent for each $2,500 of AGI above $150,000. The 1990 Act also enacted a rule disallowing a portion of itemized 

deductions otherwise allowable to high-income taxpayers. Itemized deductions (other than medical, casualty and theft, and 

investment interest deductions) are generally reduced by 3 percent of AGI in excess of $100,000, except that the disallowance 

cannot exceed 80 percent of the affected itemized deductions. 

8. Interest received by foreign lenders that are related to the borrower or by foreign banks on loans made in the ordinary 

course of business, is, however, subject to withholding tax at 30 percent or a lower treaty rate. 

9. In addition to the distortions created by the two-tier tax, distortions may result from the rules used to measure business 

income. For example, the Code generally fails to correct for distortions in the tax base attributable to inflation or to the 

requirement that a capital gain be realized before being subject to tax. These measurement problems affect both corporate 

and unincorporatedbusiness income. Because the general reform of business income measurement rules is beyond the scope 

of this Report, we take the existing system of income measurement rules as given. 

10. See Harberger (1962 and 1966) and the subsequent studies cited in Chapter 13, note 1. 
Notes 190 

11. This simple example abstracts from other factors affecting the cost of capital, including: (i) differences between tax and 

economic depreciation; (ii) differences in tax rates among investors; and (iii) inflation. 

12. See Gravelle (1991). These calculations assume (i) a rate of inflation of 4 percent; (ii) an average holding period of 7 

years; and (iii) that two-thirds of capital gains are deferred until death. 

13. Data for the past few years (some of it preliminary) shows a reduction in the size of the corporate sector relative to the 

noncorporate sector and the overall economy. Particularly since 1986, S corporationshave accounted for an increased share 

of corporate profits. Long-term comparisons of corporate activity with general economic activity, however, present no clear 

trend toward disincorporation. See Chapter 13. 

14. See Gravelle (1991). 

15. Inflation adds a complication here. Because the tax system taxes nominal rather than real returns, the deductibility of 

interest expense under current law offers an even greater tax advantage to corporate debt financed investments (relative to 

corporate equity financed or noncorporate investments) in the presence of inflation, since corporations typically deduct 

nominal interest payments at a higher tax rate than the rate at which lenders are taxed on these payments. See Fullerton, 

Gillette, and Mackie (1987) and Gertler and Hubbard (1990). 

16. While both book-value and market-value measures are subject to criticism, market-value measures of debt burdens are 

generally superior for measuring bankruptcy risks because they reflect inflation and other factors that influence the value of 

alternative claims on the firm. See,e.g., Bemanke and Campbell (1988) and Warshawsky (1991). 

During inflationary periods, book-value measures tend to overstate the burden of debt and to understate the value of a 

firm’s assets. The debt burden may be overstated because with inflation part of the interest rate reflects a return of principal, 

not a real cost to the firm. As a result of inflation, new debt can be issued without increasing the effective debt burden of 

the firm; some new debt would merely represent a rollover of the portion of the real principal that must be repaid, rather 

than a net issuance of new debt. In addition, to the extent that inflation is higher than anticipated, the burden of a given 

amount of debt falls because real income is transferred from bondholders to shareholders. Book-value ratios also understate 

the value of the firm’s assets because traditional accounting measures of asset values are based on the historical price of the 

asset, not on its current market (replacement) price. In addition, because book-value debt to asset ratios do not reflect 

changes in equity values, they may be misleading indicators of the true burden of debt, especially during periods (such as 

the 1980s) with large increases in stock prices. 

While market-value measures of the firm’s debt and equity reflect adjustments for inflation and for other changes in the 

market value of the firm and its securities, they also may be criticized. First, market-value measures generally are estimated 

rather than directly observed. One approach for estimating the market value of equity and debt, for example, is to capitalize 

dividend and interest payments, respectively. The Federal Reserve market value ratio shown in Figure 1.5 is a more 

sophisticated measure, but it also relies on estimates of equity and debt values. Second, market-value ratios are inaccurate 

if stock market prices do not reflect fundamental values. 

17. See, e.g., Shoven (1987) md Auerbach (1989). Share repurchases are discussed further in Chapters 8 and 13. 

18. See the evidence in Shoven (1987) and Auerbach (1989). 

19. Estimates are based on data for dividends and buybacks from the COMPUSTAT II database, Standard and Poor’s 

COMPUSTAT Services, Inc. Assuming the corporate AAA bond interest rate for all years, the figures represent the 

maximum interest properly attributable to the increase in share repurchases because they assume that (1) repurchases were 

financed completely by debt, and (2) the additional debt remains outstanding during the 1980s. The eliminationof the capital 

gains exclusion by the 1986 Act reduced the attraction for investors of share repurchases, since the gain component of the 

distributionis no longer generally taxed at preferential rates. Share repurchases continued strong through 1989, but declined 

in 1990. 

20. Similarly, leveraged buyouts (LBOs), which replace substantial equity with debt, also may have contributed to the 

increase in corporate debt during the 1980s. The dollar value of completed mergers and acquisitions in the United States rose 

at an annual rate of 14.3 percent between 1981 and 1989. The LBO share of this activity rose 8.6 percent in 1983 to 22.7 

percent in 1986, but receded to 18.4 percent in 1989 (excluding RJR Nabisco), dropping sharply to 9.3 percent in 1990. 

(Source: Mergers and Acauisitions, Almanac and Index, May-June 1985-1991).By the end of 1988, outstanding LBO debt 

was estimated to be about 20 percent of the (book) value of outstandingcorporate bonds or more than 9 percent of the (book) 

value of total nonfinancial corporate debt (based on data from the Federal Reserve Board’s Flow of Funds Accounts, 
191 Notes 

Financial Assets and Liabilities, Year End (1967-1990), hereinafter cited as Flow of Funds Accounts). See Gertler and 

Hubbard (1990)). 

21. See, e.g., Warshawsky (1991). 

22. See Friedman (1990) and Gertler and Hubbard (1990). 

23. Potential nontax benefits of debt finance are discussed in Chapter 13. See also Jensen (1986) and Gertler and Hubbard 

(1990). 

24. See Chapter 13 and Gordon and Mallciel (1981). 

25. The Congressional Research Service estimates that the shareholder level effectiveFederal income tax rate on dividends 

is 32 percent, compared to 11 percent or less on capital gains attributable to retained egs. See Gravelle (1991). 

26. This assumption is controversial, since not all economic models of the effects of taxation on dividendpayments maintain 

that nontax benefits are associated with dividend payments. There are two leading explanations of why corporations continue 

to pay dividends in spite of the greater investor level tax burden on dividends than on capital gains attributable to retained 

earnings or share repurchases: the "traditionalview" and the "new view. I' The "traditionalview" asserts that dividends offer 

nontax benefits to shareholders that offset their tax advantage. Accordingly, dividend taxes distort payout decisions and raise 

the cost of capital. The "new view" assumes that dividend payments offer no nontax advantages to shareholders and that 

corporations have no alternative to dividends for distributing funds to shareholders. Under this assumption, dividend taxes 

reduce the value of the firm, but do not affect firms' dividend or investment decisions. This Report adopts the framework 

suggested by the "traditional view." The two approaches are discussed in more detail in Chapter 13. 

27. These studies are discussed in Section 13.B. 

28. The 1970 data in the text are from Shoven (1987). The 1989 and 1990 data are from Department of the Treasury 

calculations based on tabulations of the Standard and Poor's COMPUSTAT Industrial and Research files. 

29. The effect of taxation on savings is uncertain because changes in the after-tax rate of return have an ambiguous effect 

on savings. A higher after-tax return makes future consumption cheaper than foregonepresent consumption. This substitution 

effect encourages households to reduce present consumption and increase savings. However, a higher after-tax return also 

allows a given level of future consumption to be reached with less savings today. This second effect, called the income effect, 

reduces saving. Because the substitution effect of a rise in the after-tax retum increases saving, while the income effect 

reduces saving, the net effect of a rise in the after-tax return is an empirical question. 

30. As noted in note 29, the net effect of changes in the after-tax rate of retum on saving is difficult to determine because 

it depends on opposing income and substitutioneffects. There is less theoretical uncertainty about the direction of the effect 

of capital taxation on investment. The distinction between saving and investment is an important one in an analysis of 

corporate taxation. In an economy without international trade and investment flows, national saving equals national 

investment, and the average cost of capital summarizes tax incentives to save as well as to invest. International capital flows 

break the equivalence of domestic saving and investment, however. In a world with perfect international capital mobility, 

incentives for domestic investment would be governed by the pre-tax retum needed to cover taxes and the worldwide 

opportunity cost of funds. At the same time, domestic saving would depend on the after-tax return earned by savers from 

investing at the worldwide rate of return. Hence, domestic investment depends on domestic corporate level taxes, while 

domestic saving depends on domestic individual level taxes. 

3 1. U.S. Department of the Treasury, Tax Reform for Fairness. Simdicitv, and Growth (1984) (hereinafter cited as Treasurv

I>, Vol. 2, pp. 135-144 and The White House, The President's Tax Proposals to the Congress for Fairness. Growth, and 

Simplicity (1985) (hereinafter cited as The President's 1985 ProDosals), pp. 120-129. See also U.S. Department of the 

Treasury, Blueprints for Basic Tax Reform (1977) (hereinafter cited as Blueurints). 

32. See Appendix B. 

33. See, e.g., McLure (1979). 

34. So-called partial integration (referred to in this Report as distribution-related integration) has been viewed as a 

compromisebetween the passthroughideal and considerationsof administrability.A conventionaldefinitionof full integration 
Notes 192 

is given in McLure (1979), p.3: “...income earned at the corporate level, whether distributed or not, would be attributed 

to shareholders, as in a partnership, and taxed only at the rates applicable to the incomes of the various shareholders.” 

35. Appendix C discusses the effect of rate relationships on integration proposals. 

36. For general discussion of economic benefits of neutrality in the taxation of capital income, see Institute for Fiscal Studies 

(1978) and Bradford (1986). 

37. See Sections 2.D and 4.F. 

38. This Report also does not generally address tax distortions created by inflation. 

39. Under a corporate cash-flow tax, corporations would be taxed on the net cash flow from their business activities. 

Corporate cash-flow taxes have generally been advanced as part of an overall restructuring of the tax system that would 

replace the individual income tax with a consumption or cash-flow individual tax. See Institute for Fiscal Studies (1978), 

Aaron and Galper (1985), and Bradford (1986). Recently, however, some economists have proposed cash-flow taxes on 

businesses, while the current income tax rules would be maintained at the individuallevel. See, e.g., King (1987), Feldstein 

(1989), and Hubbard (1989). 

Under one corporate cash-flow tax proposal, a corporation would determine its tax base by subtracting from its receipts 

from sales of goods or services its cost of purchasing real goods and services for production. No deductions for financing 

investments would be allowed; that is, neither dividends nor interest payments would be deductible. Several significant 

changes would be required to convert the current corporate income tax base to a cash-flow tax base, including replacing 

depreciation deductions with a deduction for the cost of capital assets in the year of acquisition (expensing), and eliminating 

corporate investment interest deductions. Other ways to define the base of a corporate cash-flow tax are discussed in Institute 

for Fiscal Studies (1978) and King (1987). 

Proponents of a cash-flow tax emphasize that, because the initial purchase of assets would be deductible, the system 

would generate a zero marginal effective tax rate on investment. In effect, the tax system would not distort the cost of capital 

investment decisions. Income generated in the corporate sector, however, would continue to bear a tax at the individuallevel. 

In contrast, noncorporate business income would face no tax at the margin if it were taxed on a cash-flow basis. Hence, a 

bias against investment in the corporate sector would still exist. 

Because interest payments would not be deductible, the tax advantage that debt enjoys under the current system would 

be eliminated, but a cash-flow tax would not achieve neutrality with respect to choice of finance. Rather, under the 

reasonable assumption that the marginal individual tax rate on dividends exceeds the marginal effective accrual tax rate on 

capital gains, retained earnings would have an advantage over either debt or new equity as a source of corporate finance. 

40.See generally Treasurv I. 

Part II 

Introduction 

1. While the prototypes discussed in this Part and in Part IV contain considerable technical detail, they do not provide a 

comprehensive summary of technical changes that would be required. For example, the prototypes do not address the effect 

of an integration system on groups of corporations filing consolidated returns. We concluded, consistent with the approach 

to consolidated return matters under the current corporate tax system, that consolidated return issues are better addressed 

after a basic integration approach is selected. 

2. The distribution-relatedintegration systems of several major U.S.trading partners are described in Appendix B. 

Chapter 2 

1. Peel (1985) also proposes a dividend exclusion system. While Peel’s proposed system resembles the dividend exclusion 

prototype discussed here (e.g., in allowing shareholders to exclude dividends only to the extent of income that has been taxed 

fully at the corporate level), there are significant differences. For example, Peel’s proposed system would track taxable 
193 Notes 

income rather than taxes paid, would extend the benefits of integration to foreign shareholders by statute, and would treat 

foreign taxes like U.S. taxes in determining the extent to which a corporation’s income has borne tax. 

From 1954 to 1986, the Code provided a very small exclusion for dividends received by individuals. Immediately 

preceding repeal, IRC 0 116 provided an exclusion of up to $100 of dividends received ($200 on a joint return). 

2. Although a detailed treatment of the financial accounting consequences of adopting an integrated system is beyond the 

scope of this Report, and the financial accounting authorities have never addressed the integration prototypes developed in 

this Report, a few preliminary observations can be made. Because the dividend exclusion prototype generally retains the 

current rate structure and rules for calculating corporate income subject to tax, adoption of the prototype should not 

significantlychange corporations’provision for income tax expense or the determination of taxes currently payable or payable 

at a future date. Of course, the economic effects of moving to an integrated tax system, e.g., changes in corporations’ 

distribution policies and capital structures, would be reflected in financial statements. 

3. This is similar to an imputation credit system that taxes corporate income at a 34 percent rate and allows shareholders 

imputation credits at the individual shareholder rates. 

4. An imputation credit system that denies refundability of imputation credits to tax-exempt shareholders achieves the same 

results. See Section ll.E. 

5. An imputation credit system that relies on a shareholder credit limitation rather than a compensatory tax reaches the same 

result. See Section ll.B. 

6. An imputation credit system reaches the same result if foreign taxes are not added to the shareholder credit account. See 

Section ll.D. 

7. In an imputation credit system, this result can be achieved by denying refundability of imputation credits to foreign 

shareholders and continuing to impose withholding tax. See Section 11 .E. 

8. For simplicity, Table 2.1 (and the corresponding tables in Chapters 3, 4, and 11) refer to the tax imposed on a foreign 

investor’s noncorporate equity income as a withholding tax, fwN, although the method and rate of taxation actually vary 

depending on the type of income. Very generally, a foreign investor is taxed on income from an equity investment in a 

noncorporate business as if the foreign investor had earned directly the income earned by the business. A foreign investor 

is generally subject to tax at rates applicable to U.S. persons on income that is “effectivelyconnected“with a U.S. trade or 

business. A partnership generally must withhold tax from a foreign partner’s distributive share of effectively connected 

income under IRC 0 1446. A partnership also withholds tax on a foreign partner’s distributive share of dividends, interest, 

and other income to the extent required by IRC 8 1441. 

9. A compensatory tax is used in some foreign imputation credit systems, e.g., the United Kingdom, France, and Germany, 

to ensure that corporate level preferences are not extended to shareholders. See Appendix B. 

10. Because the prototype treats AMT as corporate taxes paid, it does not treat as taxes paid the portion of a later year’s 

regular taxes that are offset by the AMT credit allowed by IRC 0 53. 

Examde. A corporation earns $100 of preference income. The corporation’s regular tax is $0, and its AMT is $20. 

The addition to the EDA is $38.82 (($20/.34)-$20). This is the amount of hypothetical income that would be left 

for distribution if the corporation had earned taxable income of $58.82 and paid $20 of regular tax at the 34 percent 

rate (58.82X.34 = 20). 

11. In mathematical terms, for each dollar of taxes paid, the corporation can add (Ut)-1 to its EDA, where t is the 

corporate tax rate. This formula also can be expressed as (1 -t)/t. 

The graduated rates set forth in IRC 9 ll@) for corporations with incomes of less than $75,000 would continue to be 

available. Converting the entire amount of taxes paid at a 34 percent rate provides a simple rule and should not harm most 

corporations, because the benefit of graduated rates begin to phase out for corporations with taxable incomes greater than 

$l00,OOO.It would, however, be possible to modify the EDA conversion formula to reflect graduated rates. One possibility 

is to build the graduated rate structure into the EDA formula for corporations with taxable incomes of less than $100,000 

by permitting conversion of the first $7,500 of taxes paid at the 15 percent rate (into $42,500 of EDA) and conversion of 
Notes 194 

the second $6,250 of taxes paid at the 25 percent rate (into $18,750 of EDA). These amounts would be reduced for 

corporations in the phaseout range. 

12. Example. In year one, a corporation reports $100 of income and pays $34 of tax. The corporation’s EDA 

balance is $66, and it pays an excludable dividend of $66. In year two, the corporation incurs a net 

operating loss of $50 and files a claim for refund of $17. Making that adjustment retroactive to year one 

would require adjusting shareholders’ incomes to reflect a taxable dividend of $33. Because this is 

impractical, the prototype requires that the refund in the year of the adjustment be carried forward to be 

applied against future corporate taxes. 

13. Payment of a refund when the EDA balance is exhausted would, in effect, refund corporate taxes that have already been 

used to qualify distributions as excludable by shareholders; only by requiring a negative balance in the EDA could this be 

compensated for in later years. 

14. We rejected the alternative of permitting refunds and NOL carrybacks to create a negative EDA. If such an approach 

were adopted, a negative EDA would be increased by subsequent payments of corporate tax. In addition, a corporation with 

a negative EDA would be required to pay additional tax to increase its EDA to zero upon certain events, e.g., upon 

liquidation. 

15. While a 100 percent dividends received deduction could be extended to all corporate shareholders to defer completely 

taxation of corporate preference income until it is distributed out of corporate solution, it would add approximately $400 

million to the revenue cost of the dividend exclusion prototype. Because of the additional complexity that would arise from 

a partial dividends received deduction under an imputation credit system, we make a different recommendation under that 

system. See Section ll.B. 

16. As under current law, hybrid instruments and derivative products (e.g., convertible debt and options may allow a taxexempt or foreign investor to capture the portfolio benefits of holding stock while avoiding corporate level tax. 

17. One anti-streaming mechanism is inherent in the prototype. Because all dividends paid reduce any positive balance in 

the EDA, a corporation cannot simultaneously pay excludable dividends on one class of stock and taxable dividends on 

another. The imputation credit system, described in Chapter 11, allows greater flexibility in attaching shareholder level tax 

credits to dividends and, as a result, demands additional anti-streaming restrictions. 

Requiring dividends to reduce the EDA does not prevent all streaming, however. For example, excludable dividends 

can be paid to taxable shareholders to the extent of the EDA and thereafter all taxable dividends can be paid to tax-exempt 

shareholders. Further, complex corporate structures and corporate reorganintion (either acquisitive or divisive) also might 

be used to stream excludable dividends by isolating or shifting shareholders’ interest in a corporation’s EDA. If necessary, 

anti-abuse rules can be formulated to prevent such arrangements. 

18. IRC 0 246 (which governs corporations’ eligibility for the dividends received deduction) may provide a model for 

developing related rules. 

19. IRC 0 1059 limits the ability of corporate shareholders to strip dividendsby claiming the dividends received deduction 

with respect to distributions more properly treated as a return of capital. It does so by requiring stock basis to be reduced 

to the extent of the dividendsreceived deductionwith respect to extraordinary dividendspaid within 2 years of an acquisition 

of stock. The appropriate scope of an IRC 8 1059-typebasis adjustment will depend on the treatment of capital gains under 

integration. See Chapter 8. 

As discussed in the text under ‘‘Corporate Shareholders,I‘ an excludable dividend received by a corporate shareholder 

increases the recipient’s EDA. Consideration should be given to whether additional anti-streaming rules are necessary to 

prevent streaming through the shifting of EDA balances among corporations. 

20. Under IRC 9 305(b)(2), a distribution (including a deemed distribution) by a corporation of its stock is treated as a 

dividend if the distribution (or a series of distributions of which distribution is a part) has the result of (1) the receipt of 

money or other property by some shareholders, and (2) an increase in the proportionate interests of other shareholders in 

the assets or earnings and profits of the corporation. For example, assume a corporation issues two classes of common stock 

in an attempt to stream excludable dividendsto certain shareholders. The first class pays excludable dividends and is intended 

to be held by taxable persons. The second class pays stock dividends (or receives an increased interest in the corporation’s 

assets) and is intended to be held by tax-exempt persons. In such a case, IRC 0 305 would impute dividends on the second 

class of stock and the corporation’s EDA would be reduced accordingly. 
195 Notes 

Similarly, IRC 0 305(c) authorizes the Department of the Treasury to issue regulations treating a wide variety of 

transactions as constructive distributions to any shareholder whose proportionate interest in the corporation’s assets or 

earnings and profits is increased thereby. For example, IRC 8 305(c) would prevent a corporation from issuing preferred 

stock on which a redemption premium substitutes for dividends. 

21. Example. Corporation X is owned by a tax-exempt shareholder, and its only asset is a $100 EDA balance, 

e.g., because it previously distributed preference income and retained only enough cash to pay the tax 

liability when the preference subsequently turned around. CorporationY is owned by taxable shareholders 

and has substantialpreference income and cash but a $0 EDA balance. Corporation Y acquires corporation 

X in a tax-free merger described in IRC 0 368(a)(a)(A), and subsequently uses X’s EDA balance to 

distribute $100 of Y’scash as excludable dividends. If Y’s$0 EDA balance is attributable to deferral 

preferences, it will ultimately owe tax when the preferences turn around. However, the acquisition of X’s 

EDA enables Y to defer tax on the preference income that otherwise would have resulted from Y’scurrent 

distribution of dividends. 

22. The American Law Institute, Reporter’s Memorandum No. 3, (1991), pp. 7-8, makes a similar recommendation in 

discussing an integration proposal involving maintenance of a “taxes paid account” at the corporate level. 

23. In the interim, the rules of IRC 0 269 could be applied to prevent the most obvious tax-motivated acquisitions. 

24. Similar issues arise under the shareholder allocation and imputation credit prototypes, but we do not discuss them 

separately in Chapters 3 and 11. The dividend exclusion prototype taxes corporate equity income once at a 34 percent rate, 

regardless of the tax rate of the shareholder. Thus, if an interest disallowance rule applied, it should apply regardless of 

whether the dividends paid on the stock are excludable or taxable. While excludable dividends bear a superficial similarity 

to tax-exempt interest under IRC 0 103, one level of tax on the earnings used to pay the dividend has been collected. 

Similarly, taxable dividendspaid, for example out of preference income, to a taxable shareholder also bear one level of tax, 

although at the shareholder’s rate. Thus, if an interest disallowance rule were adopted, it would be inappropriate to apply 

it only to the extent of excludable dividends. On balance, this Report does not recommend developing rules to deal with the 

potential rate arbitrage of equity holders borrowing from low rate or tax-exempt lenders for either excludable or taxable 

dividends. See note 25. 

25. As under current law, the general deductibilityof interest permits significantrate arbitrage through the issuance of debt 

by taxable issuers to tax-exempt and foreign lenders. the relative importance of the rate arbitrage potential of borrowing to 

purchase corporate stock may be less in an integrated system that does not change the treatment of interest generally. In 

contrast, CBIT generally eliminates businesses’ ability to pay interest to tax-exempt and foreign lenders without the payment 

of one level of tax. Thus, in CBIT, we found it appropriate to eliminate investor level rate arbitrage through borrowing as 

well. Compare IRC 0 246A. 

26. No other country with an integrated system has adopted this approach, however. 

27. If such treatment of foreign taxes were permitted, special rules would be required to ensure that appropriate amounts 

are added to the EDA when foreign tax rates exceed the U.S. rate. If the foreign tax rate is less than the U.S. rate, foreign 

taxes paid could be converted into the appropriate EDA balance by applying the formula set forth in Section 2.B. 

Example 1. A corporation has $100 of foreign source income and pays $20 in foreign taxes. After applying the IRC 

0 904 limitation, the corporation would be entitled to credit all $20 of foreign taxes against its U.S. taxliability of $34. 

The U.S. residual liability would be $14, which would convert into a $27 ($14/.34-$14) addition to the EDA. The $20 

of foreign taxes paid would convert into a $39 ($201.34-$20) addition to the EDA. The total EDA would be $66, which 

would enable the corporation to distribute its after-tax earnings of $66 as excludable dividends. 

However, if foreign tax rates exceed U.S. tax rates, the foreign taxes cannot be converted into an EDA balance using 

the formula set forth in Section 2.B. In that case, the foreign taxes must be converted using the higher foreign tax rate. 

Example 2. A corporation has $100 of foreign source income and pays $40 in foreign taxes. After applying the IRC 

9 904 limitation, the corporation would be entitled to credit $34 against its U.S. tax liability of $34. The U.S. residual 

liability would be $0.It would be inappropriate, however, to add $66 to the EDA, because the corporation has only $60 

($100 income-$40 foreign taxes) of after-tax earnings to distribute. Adding $66 rather than $60 would permit the 

distribution of $6 of U.S. source preference income without shareholder level tax. Thus, the amount to be added to the 
Notes 196 

EDA should be limited to $60, which can be accomplished by applying the EDA formula to actual foreign taxes paid 

using the higher foreign rate ($40/.4-$40). 

This approach would create some complexity at the corporate level, because it would require separate tracking of foreign 

taxes paid and foreign tax rates. The alternative of tracing foreign income and adding to the EDA foreign income less foreign 

taxes is likely to be at least as complex. 

28. A low taxable income is not necessarily inconsistentwith wealth. For example, a low-bracket individual may have large 

amounts of income from tax-exempt sources, e.g., tax-exempt bond interest. Alternatively, a low-bracket individual who 

is retired may have a small income but a large accumulation of wealth. That is, individuals may prefer to maintain a level 

of consumption over their lifetime, and thus reduce consumption during high-income working years in order to be able to 

maintain consumption during low-income retirement years. See, e.g., Ando and Modigliani (1963). 

29. The credit formula is: Credit = (DIV/.66) X (.34-t), where DIV is the dividend and t is the shareholder’smarginal rate. 

This credit formula is designed to replicate the excess credit under an imputation credit system, Le., the difference between 

the imputation credit (.34 X(DIVl.66)) and the amount of shareholder tax due on the grossed up dividend at the shareholder 

rate (t X (DIV/.66)). 

30. Alternatively, relief for low-bracket shareholders also might take the form of a deduction. The credit formula could be 

converted into a deduction formula by dividing the credit by the shareholder tax rate: [(DIV/.66)x(.34-t)]/t, where DIV 

is the net dividend and t is the shareholder’s marginal rate. Thus, a shareholder in the 15 percent bracket would be entitled 

to a deduction of $127 (($66/.66) X. 19/.15). 

31. A corporation’s EDA would be allocated among shareholders in proportion to the amount of other assets distributed to 

them. 

32. The policy underlying the reorganization provisions is that impositionof tax is inappropriate if a corporate reorganization 

merely effects a readjustment of shareholders’ continuing interests in corporate property under modified corporate forms. 

This policy applies equally under the prototype, because it reflects a judgment about when income should be recognized under 

a realization-based tax system that does not require corporate assets or stock to be marked to market, not a judgment about 

whether two levels of tax should be imposed on recognized corporate income. 

33. Under current law, earnings and profits of the distributing corporation in a divisive reorganization that qualifies as a 

reorganizationunder IRC 0 368(a)(1)(D)are dividedbetween the distributingcorporationagd the controlled corporationbased 

on the relative fair market value of their assets. 

34. Under current law, nonliquidating distributions to shareholders are treated as dividends to the extent paid out of the 

corporation’s post-February 28, 1913, accumulated earnings and profits or its earnings and profits for the current taxable 

year. The earnings and profits rules may be viewed as serving two principal functions with respect to dividend taxation. First, 

the earnings and profits rules may be seen as a mechanism to assure that corporate preferences are not extended when 

preference income is distributed to shareholders. Second, the rules may be seen as a mechanism to distinguish whether a 

distribution represents a distribution of income earned on the shareholder’s investment or a return of that investment. 

35. IRC 9 301(c). 

36. See, e.g., Andrews (1956), Blum (1975), and American Bar Association (1986). 

37. Earnings and profits also are relevant in contexts other than determining dividend taxation. Earnings and profits are 

relevant, for example, in determining the extent to which gain on a dispositionof IRC 0 306 stock is recaptured as ordinary 

income, whether certain corporate divisions qualify for tax-free treatment under IRC 0 355, the amount of taxes paid by a 

foreign corporation that under IRC 9 902 are credited to its 10 percent corporate shareholder upon receipt of a dividend, 

the amount of Subpart F income that must be currently included in income by a United States shareholder of a controlled 

foreign corporation, whether an S corporation with substantialpassive income is subject to entity level tax on such income 

under IRC 0 1375or whether such income causes the termination of S corporation statusunder IRC 0 1362(d)(3);the amount 

of any basis adjustments in the stock of consolidated subsidiaries pursuant to the consolidated retum regulations, and the 

amount of the adjusted current earnings adjustment for AMT purposes. In some contexts, it is possible to eliminatereferences 

to earnings and profits or to devise alternatives that are simpler. Nevertheless, in other contexts-especially in the rules 

governing the taxation of foreign incomAeveloping simple alternatives may prove more difficult. The benefit of 
197 Notes 

eliminating the earnings and profits rules for purposes of dividend taxation is considerably reduced if alternatives are not 

found for the rules in other contexts. 

38. Recently, the American Law Institute Reporter circulated a draft memorandum that would eliminateearnings and profits 

as part of its distribution-related integration proposal. American Law Institute, Re~orter’sMemorandum No. 3 (1991), p. 

5. 

39. Just as under current law, however, the connection between earnings and profits and the economics of shareholder 

investmentis severed, however, by sales of stock and other transactions or events increasing or decreasing shareholder basis 

without adjusting earnings and profits. Preserving the connection would require earnings and profits accounts to be 

maintained and adjusted on a per share basis. Thus, for example, a seller of stock in a corporation with retained earnings 

would recognize dividend income to the extent of the earnings and profits attributable to such stock and the earnings and 

profits account for the stock would be reduced to zero. This system would not be feasible for actively traded stock. 

Accordingly, the earnings and profits rules may yield arbitrary and incorrect results from the shareholder’sperspective. The 

alternative rules are likely to be no more accurate in distinguishing between income distributions and returns of capital 

because they also do not take into account changes at the shareholder level. Indeed, by eliminating earnings and profits as 

a limitation on dividend taxation, the alternative rules would tend to increase the likelihood of imposing dividend taxation 

on a distribution that economically is a return of shareholder investment. 

40.For a discussion of the equivalence of deducting the cost of an investment and exempting investment income from tax, 

see Graetz (1979)’ Warren (1975)’ Andrews (1974), and Brown (1948). 

Chapter 3 

1. If income is not taxed at the corporate level (because of tax preferences or foreign tax credits), there is no additional tax 

burden on retained earnings, and therefore corporationswill tend to retain preference income. Under the dividend exclusion 

prototype, as well as under the current system, retained preference income is taxed at the shareholder level only when the 

stock is sold. To the extent that retaining preference income increases the value of stock, it also increases the capital gain 

realized on the sale. Thus, distribution-relatedintegration treats retained corporate preference income more favorably than 

distributed preference income. 

2. Because the shareholder allocationprototype would generally continue to tax the corporation in the same manner as under 

current law, it should not significantly change a corporation’s financial statement provision for income tax expense, taxes 

currently payable, and taxes payable at a future date. The prototype’s denial of carrybacks for net operating losses and 

removal of the corporate AMT will, however, be reflected in the reporting of corporate tax liability for financial accounting 

purposes. 

The denial of carryback treatment for net operating losses may increase the provision for income tax expense in certain 

circumstances. For financial accounting purposes, when a operating loss can and will be carried back, the tax effects of such 

carryback generally increase net income, or reduce the net loss, during the loss period. See Accounting Principles Board, 

minion No. 11 (1967), paragraph 44 and Financial Accounting Standards Board, Statement No. 96 (1987), paragraph 52. 

The tax effect of the NOL carryback (which is included in the determination of net income or loss) is based on income, or 

loss, reported for financial accounting purposes rather than for tax purposes. The refund of taxes expected as a result of the 

carryback is recorded as a current asset. Any difference between the tax loss and financial accounting loss carryback benefit 

is recorded in the deferred tax account. The shareholder allocation prototype would preclude corporations from recognizing 

the benefits of NOL carrybacks. 

Because the shareholder allocation prototype eliminates the corporate AMT, it would reduce the provision for tax 

expense in those limited situations in which a corporation would otherwise calculate a hypothetical AMT liability. For 

financial accounting purposes additional tax expense is only provided with respect to the corporate AMT when the application 

of the AMT rules to financial accounting income would result in a hypotheticalAMT liability, Le., to the extent AMT relates 

to deferral items no additional tax expense is recorded for financial statement purposes. The corporate AMT also affects the 

financial statement allocation of tax expense among taxes currently payable and taxes payable at a future date. Accordingly, 

the shareholder allocation prototype also could affect these allocations. 

3. Because both the dividend exclusion and shareholder allocation prototypes retain the corporate interest deduction, interest 

paid to tax-exempt organizationsand foreign investors generally escapes U.S. tax, while corporate equity income distributed 

to such investors is subject to at least one level of U.S. tax. Achieving equal treatment of debt and equity under a shareholder 

allocation system would require a corporation to allocate its taxable income to both bondholders and shareholders each year, 
Notes 198 

whether or not interest or dividends were paid. A bondholder, like a shareholder, would be entitled to a credit for the 

corporate level tax on the income allocated, and the bondholder’sbasis would increase by the after-corporate tax amount of 

income allocated. Tax-exempt and foreign bondholders would not be entitled to claim refunds of tax credits. Unlike current 

law, which requires accrual-basis bondholders to include interest in income whether paid or not, a shareholder and 

bondholder allocation system might limit bondholders’ interest income to the amount of the corporation’s earnings. 

Such a system would require rules for allocating corporate earnings to classes of debt as well as stock. The allocation 

rules in such a system should provide that earnings would be allocated first to interest payable or accrued on debt, and any 

remaining income would then be allocated to equity. One method for allocating income to traditional debt instruments would 

determine the maximum amount of income to be allocated to a given class of debt based on the current law rules for accrualbasis taxpayers (or for holders of bonds with original issue discount). Available earnings could then be allocated to each class 

of debt according to its priority, i.e., first to senior debt, then to senior subordinated debt, and then to subordinated debt, 

For example, assume that a corporation has $100 of earnings and three classes of debt. The first class of debt is bank debt, 

senior to the other two classes. The second and third classes are of equal priority. The interest accruing on the bank debt 

is $80; the interest accruing on the second class is $30; and the interest accruing on the third class is $10. Of the 

corporation’s $100 of earnings, $80 would be allocated to the bank debt. The remaining $20 would be allocated 

proportionately between two classes of junior debt, so that $15 (or $20 multiplied by $30/$40) would be allocated to the 

second class, and $5 (or $20 multiplied by $30/$40) would be allocated to the third class. No earnings would be allocated 

to equity. 

4. For a more detailed examination of problems involved in administering a widely held passthrough entity, including 

reporting issues, allocating items (such as built-in gain on contributed property) to members, and collection issues, see 

Department of the Treasury, Widelv Held Partnershim (1990). Proposals are pending in the Congress to modify the conduit 

treatment of certain large partnerships. Under H.R. 2777 and S. 1394, 102d Congress, 2d Session (1991) the income of 

partnerships with at least 250 partners would be consolidated at the partnership level, resulting in a reduction in the number 

of separate items that would be reported to partners. Audit adjustments would result ina single, current year adjustment to 

partnership income, rather than adjustments to the returns of prior year partners. Under these bills, the tax administration 

of large partnerships would move toward an entity approach and away from the aggregate approach that dominates current 

law partnership rules. 

In 1966, Canada’s Carter Commission recommended a modified shareholder allocation integration system, but Canada 

did not adopt the recommendation. See Royal Commission on Taxation (1966). Similarly, the United States did not adopt 

the Bluelxints proposal for a shareholder allocation integration system. In 1971, the Federal Republic of Germany’s Tax 

Reform Commission rejected a shareholder allocation integration system because of administrative complexity. See 

Gourevitch, (1977), pp. 48-54. In addition, other countries have implicitly rejected shareholder allocation integration by 

adopting distribution-relatedintegration systems, although most countries have passthrough entities that are taxed under a 

shareholder allocation integration approach. 

5. For ease of computation,the discussionand examples in this chapter use a 31 percent corporate tax rate. The shareholder 

allocation prototype could retain the current 34 percent corporate tax rate but provide credits to shareholders at a 31 percent 

rate if maintaining the credit rate differential were desirable or necessary. The revenue estimates set forth in Chapter 13 

assume a 34 percent corporate rate. Maintaining the corporate tax rate at 34 percent would require an adjustment in the 

amount of tax passed through to shareholders to allow shareholders a tax credit no greater than the maximum 31 percent 

individual rate. For example, if a corporation reported $100 of taxable income and owed $34 of tax, only $31 of tax would 

be passed through to shareholders. Retaining the rate differential would necessitate numerous calculations to transform 

corporate level preferences into shareholder level preferences; for example, if a corporation also had a $10 low-income 

housing credit, the shareholders should be entitled only to 31/34 of the credit. 

6. The additional economic income sheltered by the credit, absent an upward adjustment of the shareholder’s basis, will be 

taxed upon distribution by the corporation or sale of the shareholder’s stock. 

If the corporation had a $40 credit, shareholders would be allocated $31 of tax credits, and the $9 excess credit would 

be carried forward at the corporate level to the extent permitted under the Code. As discussed above, a shareholder with tax 

liability less than the amount of credit allocated to him could use excess credits against other income. As in the imputation 

credit prototype discussed in Chapter 11, considerationmight be given to providing a carryforward at the shareholder level 

for unused credits. See Chapter 11, note 33. 

7. Examr.de. A corporationeams $100 of taxable income and pays $31 of corporate tax. The corporation’s shareholders 

increase their basis in their stock by $69, the after-tax income of the corporation. This achieves the same result as 

a partnership that eams $100 of taxable income and distributes $31 in cash to partners to pay the tax. 
199 Notes 

8. Because the shareholder allocation prototype treats distributions first as a nontaxable return of capital to the extent of 

shareholder basis and second as capital gain to the extent of any excess over basis, the earnings and profits rules are not 

needed. Compare note 14, below. 

9. To mitigate somewhat the effect of eliminating loss carrybacks, considerationmight be given to extending somewhat the 

carryforward period, for example, from 15 to 18 years, so the total period in which corporate losses could be used would 

not be reduced under shareholder allocation. 

10. Corporations with more complicated capital structures may require more complicated allocation provisions. See 

Section 3.F. 

11. While noting that corporate level payment would facilitate payment of tax, Blueprints did not include such payment in 

its model system. See Blueurints, pp. 73-74. Compare IRC 0 1446, which requires withholdingby partnerships on income 

that is effectively connected with a trade or business in the United States and that is allocable to a foreign partner. 

12. If passthrough of losses were permitted, corporate losses, like partnership and S corporation losses, could be used by 

shareholders to the extent of share basis. Losses in excess of share basis might be carried forward at the shareholder level. 

See IRC 0 704(d). 

13. One method for eliminating most preferences would require corporations to allocate AMTI,rather than taxable income, 

to shareholders. Each corporation would thus impute to shareholders the full amount of both taxable and preference income 

(at least to the extent preference items are included in AMTI),regardless of whether the corporationwas subject to the AMT. 

Examule. Assume that a corporation has $100 of taxable income and $30 of tax-exempt interest as its only 

preference item. The corporation would not be subject to the AMT,because the tentative AMT ($26) would not 

exceed the regular corporate level tax ($31). Nevertheless, the corporation would allocate $120 of income among 

its shareholders. 

Under this approach, corporationswould continue to pay corporate level tax as under current law, at either the regular 

or AMT rate, whichever is applicable. Shareholders would be entitled to credit both corporate level tax and Ah4T but would 

not be entitled to credit corporate tax to the extent it was offset in later years by the AMT credit. 

The following example illustrates this method. The example assumes a 31 percent corporate and shareholder rate and 

a 20 percent corporate AMT rate. 

Corporate Level Tax Calculation 

Corporate taxable income 

Corporate preference income 

AMTI 

Tentative AMT 

Regular tax 

AMT 

AMT credit 

Net corporate tax payable 

ShareholderLevel Tax Calculation 

Shareholderincome 

Shareholder tax 

Year1 Year2 Year3 

$100 $100 $164 

200 0 0 

300 100 164 

60 20 33 

31 31 51 

29 0 0 

0 11 18 

60 20 33 

$300 $100 $164 

93 31 51 

Credit for corporate taxes paid 60 20 33 

Net shareholder tax payable 33 11 18 

In this case, a total of $175 of tax has been paid on $564 of economic income (a 31 percent rate). 

This approach would effectively eliminate corporate level preferences, whether or not distributed, by taxing corporate 

preference income currently at shareholder rates. A shareholder in the 31 percent bracket would generally be liable for 

additional shareholder level tax to the extent that corporate AMTI exceeded corporate taxable income. Thus, corporate level 

preferences essentially would be taxed the same as corporate level taxable income, unless the absence of a corporate level 
Notes 200 

tax were significant. For example, a tax-exempt shareholder would not owe additional shareholder level tax, with the 

consequence that allocated preference income would be tax-exempt (except to the extent of the corporate AMT). 

14. The following approach would tax preference income to shareholders only upon B distribution or a sale of stock. 

Corporations would track taxes paid, which would include payments of regular tax and AMT, as well as any AMT credits 

for AMT paid in prior years. An amount of deemed income equal to the amount of income that would give rise to the actual 

amount of corporate tax paid if tax had been imposed at a 31 percent rate would be allocated among shareholders. Thus, 

each $1 of regular tax or AMT would give rise to $3.23 of deemed income ($1/.31),Shareholders would report the deemed 

income and would be entitled to a credit for corporate taxes paid. Because this approach treats the amount of income that 

would be allocated to shareholders as if it had been taxed at the maximum corporate rate, no shareholder would owe 

additional tax on corporate level preferences currently and lower bracket shareholderscould use excess credits to offset other 

tax liability. Share basis would increase by the amount of deemed income reported to the shareholder, net of the credit for 

taxes paid. 

The following example compares the treatment of two corporations, only one of which, corporation B, is an AMT 

taxpayer. It assumes a 31 percent corporate rate and shareholder rate and a 20 percent AMT rate. 

Corporate Level Tax Calculation 

Corporate taxable income 

Corporate preference income 

Regular tax 

AMT 

Total corporate taxes paid 

Shareholder Level Tax Calculation 

Shareholder income 

Shareholder tax 

Credit for corporate taxes paid 

Net shareholder tax payable 

Corporation A Corporation B 

$645 0 

350 $l,oOO 

200 0 

0 200 

200 200 

$645 $645 

200 200 

200 200 

0 0 

Under this approach, corporations with significant preference income would pay tax at corporate AMT rates, but no 

additional shareholder level tax would be imposed currently. Additional shareholder tax would be collected only when 

preference income is distributed or shares are sold. Tax would be collected at that time because share basis is increased only 

by the amount of the deemed income. Thus, if a corporation has income that is taxed at less than a 31 percent rate, the 

shareholders’ aggregate basis in their shares will be less than the corporation’s aggregate earnings available for distribution. 

When distributionsexceed shareholder basis (or when shares are sold for amounts in excess of basis), additional shareholder 

tax will be paid. 

Example. A corporation has $100 of assets and a single shareholder with a stock basis of $100. During the year, 

the corporationearns $200 of preference income and pays AMT of $40. The corporation allocates $129 ($40 f .3 1) 

of income and $40 of tax credit to the shareholder. The shareholder’sbasis increases to $189 ($100 original basis 

plus ($129-$40)). The corporation has $260 of assets available for distribution. If the corporation distributes $260 

to its shareholder, the shareholder will recognize gain of $7 1, the amount of preference income not previously taxed 

at 31 percent. 

Under this approach, distributedpreference income is generally taxed at capital gain rather than at ordinary income rates, 

because distributionsin excess of basis are treated as gains from the sale of stock. In contrast, under current law and under 

distribution-relatedintegration,only retained preference income (which increases share value) is taxed as capital gains, while 

distributed preference income is taxed as ordinary income. 

In contrast to the treatment of dividend distributionsunder current law, this method treats distributions first as a return 

of capital, so preference income is not taxed until share basis is exhausted. This stacking order is not consistent with the 

dividend exclusion or CBIT prototypes or the imputation credit prototype, described in Chapter 11, which require that 

distributionsin excess of fully-taxed income be treated as taxable distributions of preference income before they are treated 

as returns of the shareholder’sinvestment. It is possible, however, to conform the stacking order in the shareholder allocation 

prototype to the stacking in those prototypes. To do so, a corporationwould be required to maintain an accumulated earnings 

and profits account (essentially under the rules of current law). Within the earnings and profits account, the corporation 
201 Notes 

would maintain a subaccount for fully-taxed earnings and profits (computed by tracking taxes paid, as in the EDA). See 

Section 2.B. Distributions in excess of the fully-taxed earnings, up to the amount of earnings and profits, would be treated 

as taxable dividends, rather than a return of the shareholder’s investment. 

15. Example. Assume that a shareholder has a basis of $10 in stock of a corporation. If the corporation earns 

$100 of taxable income and receives $50 of tax-exempt bond interest in year one, the corporation would 

pay $31 in tax. The shareholder would include $100 in income and would be entitled to offset the $31 

shareholder tax by the $31 credit for corporate level tax. The shareholder’s basis would increase by $1 19 

(the tax-exempt interest income plus the taxable income, reduced by the amount of taxes paid). Thus, the 

corporation could distribute its net cash of $119 without giving rise to shareholder level tax. This basis 

adjustment differs from the $150 adjustment that would be made in a partnership because of the $31 of tax 

collected at the corporate level. 

16. Example. Assume that a shareholder invests $100 in stock of a corporation. The corporation invests the 

$100 of contributed capital in an asset that costs $100. Assume that the corporation earns $100 and is 

entitled to expense the asset in year one, rather than depreciating it over its economic life of three years. 

The deferral preference will reduce the corporation’s income subject to corporate level tax in year one to 

$0. In years two and three, however, the preference turns around, because the corporation will have more 

income than it would have if the asset had been depreciated over 3 years. Thus, the corporation’s and the 

shareholder’s income in years two and three will be higher. 

17. Examde. A corporation’s only income is $100 of tax-exempt interest on bonds described in 5 57(a)(5). 

Thus, its taxable income is $0 and its AMTIis $100. The corporation pays $20 of AMT.Assume that an 

individual taxpayer with a 31 percent marginal tax rate holds all the stock of the corporation and has no 

other income. Disregarding AMT exemption amounts, the shareholder would include the $100 of corporate

AMTIin his own AMTI,and thus would owe individual AMT of $24. The shareholder could then credit 

the $20 of corporate AMT against his own AMT liability, resulting in a net AMT liability of $4. 

If the shareholder had other income, e.g., $100 of wage income, the shareholder would pay $31 of regular tax and $17 

of AMT ($200 AMTIX -24-$3 1). The $20 of corporate level AMT paid at the corporate level would be creditable to reduce 

the total tax due from the shareholder to $28. The shareholder would have an AMT credit of $17 to use against future regular 

tax liability but no corporate level AMT credit would be allowed. 

18. Permitting shareholders to credit corporate AMT paid against their regular tax liability without including any amounts 

in shareholder AMTI,in effect, would refund the corporate AMT to taxable shareholders. 

Example. The facts are the same as in the example in the preceding footnote. The 31 percent bracket shareholder 

also has $100 of wage income. If the Ah4T paid at the corporate level were creditable against regular tax, but no 

AMTI were imputed to the shareholder, the shareholder would pay only $11 of regular tax. 

19. One approach would continue to impose the corporate AMT without any current credit to shareholders for corporate

AMT paid. Shareholders would benefit from corporate AMT payments only when the corporation made the AMT credit 

allowed by IRC 5 53 to reduce a subsequent year’s regular tax liability. The AMT credit would be passed through to 

shareholders like other credits. This rule would, however, deny integration benefits to shareholders of corporations that are 

chronic AMT taxpayers, because those corporations may never use their AMT credits. This system also would require 

modifications to the shareholder basis rules to decrease share basis to reflect the payment’of a noncreditable, nondeductible 

tax. 

An alternative rule would impute to shareholders, in addition to the corporation’s taxable income, an amount of income 

based on the corporate AMT paid, and allow shareholders to credit the corporate AMT against their regular tax. The 

additional income imputed would equal the amount of corporate AMT paid, grossed up at 31 percent. 

Examde. The facts are the same as in the examples in the preceding two footnotes. Instead of including corporate

AMTI in shareholder AMTI, the corporation would allocate $64.52 of additional income ($20/.31) to its 

shareholder. The shareholder would then credit the $20 of corporate AMT against his regular tax liability. Thus, 

the shareholder’stotal taxable income would be $164.52;total tax liability would be $51; and the shareholder would 

be allowed to credit the corporate AMT to reduce the tax due to $3 1. 

This approach is similar to the method described in note 13. Unlike that method, however, this rule imputes a grossed-up 

amount of income to shareholders only to the extent of corporate AMT paid. As a consequence, it produces erroneous basis 
Notes 202 

adjustments in the case of deferral preferences, because deferral preference gives rise to partial basis when AMT is paid and 

subsequently gives rise to the full amount of basis when the preference turns around and generates regular taxable income. 

The basis adjustments could be corrected by continuing to calculate basis adjustments based on grossed-up taxes paid (rather 

than taxable income allocated to shareholders). Such alternative basis adjustmentswould require complex rules, complicated 

information reporting, and would create basis adjustments the timing of which differ from the timing of income passed 

through to shareholders. 

20. S corporations allocate income items pro rata. An S corporation allocates to each share of stock exactly the same amount 

of each item arising in a taxable year. This system is simple and administrable; it works well for S corporations because they 

may not have more than one class of stock. IRC 0 1361(c)(4) permits classes of stock in an S corporation to have different 

voting rights, but other differences generally are prohibited. Thus, the system achieves simplicityby requiring all the stock 

of an S corporation to possess similar economic rights. An integrationproposal that limits all corporations to a single class 

of stock, however, is neither feasible nor economically desirable. The variety of existing corporate capital structures 

precludes serious consideration of such a system. 

21. IRC 0 704(b). 

22. Treas. Reg. 0 1.704-1. 

23. The complex capital account maintenance rules contained in the regulations under IRC 0 704(b) illustrate the variety of 

issues that would have to be addressed. An alternative approach would look to IRC 0 305 to impute income to a shareholder 

whose proportionate interest in the corporation increases as does the holder of class B stock in the example in the text. We 

do not explore the implications of such an approach. 

24. Example. Two shareholders form a corporation and contribute $100 each. One shareholder receives 

preferred stock with a liquidation preference of $100 and a return of 10 percent. The other shareholder 

receives common stock, which is entitled to the remaining income and assets. Assuming the corporation 

makes no cash distributions, corporate income would be allocated as follows: 

Allocations Year-End Capital Accounts 

Year Corporate

Income Preferred Common Preferred Common 

1 50 10 40 110 140 

2 50 11 39 121 179 

3 50 12 38 133 217 

Under the terms of the preferred stock, the liquidationpreference of the preferred stock increases each year as its capital 

account increases. In year one, the preferred shareholder is treated as if it received $10and purchased an additional $10 

of preferred stock. As a consequence, the preferred shareholder is allocated $11 in year two (10 percent of $110 of 

preferred stock). If the corporation is liquidated at the end of year three, the corporation has total assets of $350 and 

the preferred stock has a capital account (liquidation preference) of $133. The common stock would thus receive the 

remainder of the assets, or $217. 

As the text notes, capital accounts would be adjusted to reflect corporate losses. Assume that the corporation is not 

liquidated until year four and there is a $100 loss in year four, so the corporation's assets are reduced to $250. In that 

case, no income would be allocated to either shareholder in year four, but the $100 loss would reduce the common 

shareholder's capital account to $1 17. Upon liquidationat the end of year four, the preferred shareholder would receive 

$133 and the common shareholders would receive $1 17. 

25. The full integration proposal in Blueprints used an annual record date method and designated the shareholders on the 

first day of the taxable year as the shareholders of record to avoid ''trafficking" in shares of loss corporations at year end. 

Blueprints, pp. 70-71, rejected a "last day" rule because, at year end, the market would have information indicating that the 

corporation would incur a tax loss for the year, and shares could then be sold to high-bracket taxpayers to whom the loss 

would be most useful. Because the shareholder allocationprototype does not permit the passthrough of losses to shareholders, 

loss trafficking is not an issue. The quarterly record date approach also minimizes tax-motivated year-end trading to capture 

credits for corporate taxes paid by limiting the benefit of year end ownership to one quarter of income and its proportional 

share of tax. 
203 Notes 

26. It may be desirable to allow (or require) corporations to close their books under certain circumstances. For example, 

a seller of a majority stock interest in a corporationmay wish to ensure that income generated by activities after the sale will 

not be allocated to her. Similarly, the government could have an interest in requiring closing of the books after extraordinary 

corporate events to assure that net income and loss are allocated to the appropriate shareholders. 

27. The effect of A’s loss is to defer taxation of $10.35 of corporate income until the purchaser sells his stock. If A can fully 

use the capital loss, A’s loss offsets the tax on $10.35 of corporate income. The purchaser, however, has a basis of $144.85 

($117.25 plus $27.60) in the stock of a corporationhaving assets with a value of $155.2.0.The purchaser thus has built-in 

gain of $10.35 in his stock. 

28. The Code provides that a partnership’s taxable year closes with respect to a partner whose entire interest is sold. See 

IRC 0 706(c). If a partner’s interest varies during a year, the Code simply provides the general rule that tax items are to 

be allocated to take into account this variation. Specific rules are provided for a few items of cash basis taxpayers, such as 

interest and taxes, which must be allocated on a per day basis throughout the taxable year. See IRC 0 706(d)(2). 

29. In that case, each prior quarter’s income would be unaffected by subsequent events, and each future quarter’s income 

would be allocated to the purchaser. 

30. We also rejected the alternative of allocating a corporation’s income on a per share per day basis throughout the taxable 

year. Although current law employs this system for S corporations, which must allocate income among stockholders on a 

strict pro rata basis, including daily allocation of income where there has been an ownership change, we believe that this 

system could not successfully be applied to large corporations with publicly held stock in which there is frequent trading. 

Publicly traded partnerships are widely held, publicly traded entities that are required under current law to allocate certain 

items among partners on a per day approach. However, these partnerships typically adopt conventions to minimize the 

difficulties of tracking frequent changes in ownership, for example, by allocating each month’s share of partnership income 

to the partner holding the partnership unit on the first day of the month. Compared to publicly traded partnerships, publicly 

held corporations have more shares of stock outstanding, and the stock is traded more frequently; for example, trading of 

the most actively traded stock can exceed one million share per day. A per share per day approach would require tracking 

of many millions of transfers during a year, and therefore a daily allocation method would be impractical for publicly traded 

corporations. 

31. The Blueprints system is one example. That system did not include a corporate level pax, taxed capital gains at ordinary 

income rates, and permitted unlimited use of capital losses against ordinary income. See Blueprints, p. 77. Accordingly, the 

Blueprints system permitted a shareholder of record who sold stock during the year to calculate gain or loss calculated by 

reference to his basis at the beginning of the year, based on the observation that the allocation of current year income would 

not affect the difference between the sale proceeds and his basis as of the date of sale. The corporate income or loss that 

he would have to report as the shareholder of record would be exactly offset by a corresponding basis adjustment. See 

Blueprints, pp. 71-72. 

The results are somewhat different under the shareholder allocation system, which retains a corporate level tax. The 

introduction of a corporate level tax means that allocations of taxable income increase share basis but do not create any 

additional shareholder level tax liability (because the corporate tax rate is at least equal to the maximum shareholder rate). 

For example, under the Blueprints system, an unexpected increase in allocable earnings of $100 would increase a selling 

shareholder’s taxable income by $100 but would increase basis (and reduce gain, or increase loss, on sale) by the same 

amount. Ignoring differences in character (which may have significant consequences), the shareholder’s total income would 

be the same. Under the shareholder allocation prototype, however, an unexpected $100 increase in earnings would result 

in an allocation of $100 of earnings and $31 of tax credits. If this increase occurred for a period prior to the period in which 

the sale took place, e.g., an unexpected increase in earnings for the first quarter with respect to stock transferred in the 

second quarter, the withholding credit will be available to the selling shareholder. The parties to the trmsfer would need to 

estimate the potential for material changes in earnings on pricing the stock. Blueurints acknowledged that the addition of a 

corporate level tax complicates calculation of gain on sale. Blueprints, p. 74. 

The current treatment of capital gains and losses would complicate calculations under a record date system. A 

shareholder who sold stock with a basis of $100 for $150 might not be indifferent between $50 of capital gain (if gain were 

calculated at the time of sale) and $75 of ordinary income and a $25 capital loss (if calculation of gain were deferred and 

the corporation earned $75 for the year). 

32. Where corporate tax is imposed at a rate greater than or equal to the maximum individual rate, the government does not 

suffer from delay in attributing income to the proper corporate entity. An upper tier corporation that held stock in a lower 

tier corporation might be required to report its income from the lower tier corporation with a one year delay. Thus, if an 
Notes 204 

upper tier corporation purchased stock in another corporation during year one, the upper tier corporation would report no 

income from the investment in year one. The upper tier corporation's share of the lower tier corporation's year-one income 

would be reported in year two. The government's interest would not suffer, as the lower tier corporation's income would 

have been subject to tax at the corporate rate in year one. The upper tier corporation and its shareholders would, however, 

suffer a detriment to the extent that the corporate rate exceeds shareholder rates and shareholders would have been entitled 

to use excess credits for corporate taxes paid. In that case, the upper tier corporation's shareholders have, in effect, made 

an interest-free loan of the excess credits to the government. 

Such a system could be restricted to situationswhere the upper and lower tier corporations have identical taxable years. 

If taxable years differ, the upper tier corporation would report the lower tier income in its taxable year in which the lower 

tier corporation's taxable year ends. If two corporations own stock in each other, this system could result in a continuous 

delay in proper attribution of the income. Under such a system, taxpayers would have an incentive to structure their 

investments to minimize relationships that cause detrimental reporting delays. To the extent such arrangements are 

impractical, however, a shareholder allocation system would treat intercorporate investments more harshly than direct 

investment. 

33. The pending tax simplificationbills would adopt a similar approach for large partnerships. See The Tax Simplification 

Act of 1991, H.R. 2777 and S. 1394, 102d Cong., 1st Sess. (June 26, 1991). See also U.S. Department of the Treasury, 

Widelv Held Partnershim (1990). 

34. This problem is closely analogous to the problem of extending preferences to shareholders, discussed in Section 3.E. 

35. Examule. A U.S. corporation's only income is a dividend from a foreign subsidiary. Under IRC 0 902, 

the corporation includes $100 in income and receives a credit for foreign taxes paid of $40. Under the 

foreign tax credit limitation rules of IRC 0 904, the corporation's foreign tax credit is limited to $31. The 

corporation's sole shareholder is ShareholderA who has a marginal tax rate of 15gercent and wage income 

of $100. Without foreign tax credit limitation rules at the shareholder level, Shareholder A will treat $31 

as a credit for taxes paid and use the excess credit of $16 to offset all tax due on his wage income. 

Section ll.D discusses the feasibility of using a shareholder level exclusion of foreign source income to avoid the 

application of IRC 8 904 at the shareholder level if foreign taxes were treated like U.S. taxes under the imputation credit 

prototype. 

Chapter 4 

1. Although there are no existing models of this prototype, others have suggested a similar approach using a bondholder 

credit. See, e.g., Steuerle (1989) (describing a "simplified integrated tax" that would be withheld by corporations at the 

maximum individual or corporate rate); Seidman (1990) (describing an FDIC proposal to require corporations to withhold 

34 percent of all their dividend and interest payments and require recipients to report the grossed-up amount of the 

distributionsand claim a credit for the tax withheldby the corporation); H.R. 4457, lOlst Cong., 2d Sess. (1990) (introduced 

by Congressman Vander Jagt, and proposing an approach similar to the FDIC proposal outlined by Mr. Seidman). For 

proposals that resemble CBIT even more closely, see Jacobs (1987) (describing a 28 percent "single business tax" on capital 

income that would be imposed by disallowing business interest deductions and excluding interest and dividends from 

investors' taxable income); Bravenec (1989) (describing a "nontraditional approach to integration" that would deny 

corporations interest deductions and exclude from income of investors dividends and interest received from corporations). 

The financial accounting ramifications of CBIT are, in many respects, the most direct of all the integration prototypes. 

The nondeductibility of interest expense would increase corporations' income tax burden, thereby increasing the provision 

for income taxes and reducing earnings per share. Generally, we would expect an increase in the provision for income taxes 

and a reduction in earnings per share for net borrowers. In the rare case of certain net lenders, the provision for income taxes 

could be reduced and earnings per share could be increased. Because nondeductibility of interest expense would increase 

taxes currently payable, CBIT also would serve to increase the reported current liability for income taxes and the cash flow 

requirements associated with this current liability. The recommended gradual phase-in of CBIT should allow for gradual 

changes in capital structures and enhance the comparability of interperiod financial results. 

A less obvious financial accounting effect of CBIT arises if a compensatory tax is imposed. The standards for accounting 

for income taxes generally require corporations to recognize as income tax expense both the taxes currently payable and the 

taxes that are payable during a future period but are, nonetheless, associated with earnings during the current period. See 

Accounting Principles Board, %inion No. 11 (1967), paragraph 34, and Financial Accounting Standards Board, Statement 
205 Notes 

No. 96 (1987), paragraph 7. Under these standards, income tax expense recognized by a CBIT entity would include the 

potential compensatory tax liability that is associated with preference income which is earned and retained by the entity. 

Thus, the compensatory tax could serve to further increase the provision for income taxes. The financial accounting for a 

compensatory tax has never been formally considered, however, and it is conceivable that the financial accounting authorities 

might permit corporations to disregard potential tax expense associated with future compensatory taxes provided the 

corporation’s earnings distribution policy suggests that the likelihood of a distribution of preference income is remote. The 

Accounting Principles Board has adopted such a position with respect to the provision for taxes that may arise with respect 

to distributed earnings of subsidiaries, e.g., foreign subsidiaries or subsidiaries that are not consolidated for tax purposes. 

See Accounting Principles Board, @inion No. 23 (1972), paragraphs 9-14. 

2. See Chapter 10. 

3. CBIT is related to, but not identical with, a bondholder credit system that taxes interest income at the debtholder level 

through an imputation credit system. CBIT differs from a bondholder credit system where the borrower and lender have 

different marginal tax rates. See Section 11.H, which describes a bondholder credit system and discusses the differences 

between that system and CBIT. 

4. See Section 13.H. If gains on sale of CBIT equity and debt are not subject to tax, losses on such securities also would 

not be allowed. Given the difficulty of the analysis of capital gains in the context of integration (see Chapter 8), we simply 

note here that the CBIT prototype would be revenue neutral at a 31percent rate with full exclusion of capital gains and losses 

on sales of CBIT equity and debt at the investor level. 

5. See Sections 4.F and 6.D. 

6. Compare Sweden’s flat rate tax on capital income, adopted in 1991 as part of a comprehensive tax reform package. See 

Swedish Ministry of Finance (1991) and Lodin (1990). Under the new system, a flat tax rate of 30 percent applies to all 

capital income received by individuals, including dividends, interest, and capital gains. Earned income is taxed separately, 

at graduated marginal rates ranging from approximately 31 to 50 percent. Unlike CBIT, Sweden’s flat rate tax on capital 

is not an integration proposal. Sweden generally retains the classical system of corporate taxation, taxing corporate income 

at a rate of 30 percent. The Swedish system provides a limited dividends paid deduction for new equity and a ”tax 

equalization reserve” that reduces the effective tax burden on retained earnings to approximately 23 percent. Swedish 

Ministry of Finance (1991), p. 39. 

7. A gradual phase-in also would provide an opportunityto evaluate the extent to which imposing one level of tax on interest 

paid to tax-exempt and foreign investors might induce those investors to change the composition of their portfolios or the 

level of their investment in U.S. business. Adjustments in the applicationof CBIT to these investors can be adopted to reduce 

such effects if undesirable portfolio shifts or changes in capital flows occur. See Section 4.F. Partial steps toward a CBIT 

regime that would narrow distinctionsbetween debt and equity also are possible on a revenue neutral basis. See Section 6.D. 

8. As recommended, the CBIT prototype can use a 31 percent rate-equal to the top individual marginal rate-rather than 

a 34 percent rate without losing revenue relative to current law. See Section 13.H. 

9. Carrybacks would not, however, be permitted if they would create a negative balance in the EDA. 

10. Fully-taxed income is determined in the same manner as under the dividend exclusion prototype. See Sections 2.B and 

4.D. 

11. Several nations have expressed concern about their increasing inability to tax capital income, and some interest has been 

shown in the adoption of a withholding tax of 10 to 15 percent on capital income, although concern over the potentially 

adverse implications of the unilateral adoption of such a tax has precluded general acceptance of such a tar. In 1989, the 

European Commission (EC) proposed a 15 percent withholding tax on savings bank and bond interest income earned by 

residents of the EC. This proposal, which would not have affected Eurobonds or residents of countries outside the EC, was 

not accepted, although an informal meeting of the Finance Ministers of the member countries supported a withholding tax 

on capital income if such tax also were supported by the United States, Japan, and other countries. See Turro (1989). EC 

Tax Commissioner Madame Scrivener subsequently proposed a 10percent tax on interest income, but this proposal also was 

not generally accepted; see Goldsworth (1990). Since then, Madame Scrivener has continued to express the view that a 

general withholdingtax on interest income is the best solution to the problem of tax avoidance in a world of increased capital 

mobility. See Nagle (1990) and Daily Tax Report (November 8, 1991). 
Notes 206 

12. This Report explores CBIT as an integration prototype directed to the taxation of equity and debt income generated by 

businesses. The CBIT approach, however, might be extended to other types of interest income. Such an expansion of CBIT 

might provide a means of taxing all interest income at a uniform rate. Economic efficiency suggests that taxing capital income 

at a uniform rate might improve welfare. While an expanded CBIT approach is beyond the scope of this Report, we note 

that it raises difficult issues. 

Home mortgage interest would be one important issue in considering an expanded CBIT regime. Under current law, 

home mortgage interest generally is deductible by the payor and includable in the income of the recipient. While the basic 

CBIT prototype retains the current law treatment, an expanded CBIT regime might subject home mortgage interest to CBIT. 

Subjecting home mortgage interest to the CBIT rules would ensure that one level of tax is collected on home mortgage 

interest. Under current law, home mortgage interest paid to tax-exempt or foreign investors (who may hold mortgage 

passthrough certificates) escapes the U.S. tax base entirely. Depending upon the level of interest rates following adoption 

of an expanded CBIT regime, the average homeowner with a mortgage might be better off with CBIT treatment than with 

the deductibility of current law. 

In addition, if all capital income were taxed at a single rate at the payor level, the distinctionbetween interest and other 

types of capital income that may have a significantinterest componentwould become more important. "IdentifyingDisguised 

Interest" in Section 4.G discusses the implicationsof CBIT for the current law distinctionbetween true leases that are treated 

as leases and financing leases that are treated as loans. That section reflects our judgment that, under the CBIT prototype, 

no important changes in current rules for distinguishingbstween interest and other types of capital income are necessary. 

In an expanded CBIT regime, however, the pressure on the line between interest and other capital income would be greater. 

13. hterest and dividends received from a nonCBIT business would be included in the taxable incomes of individual and 

business investors, and capital gains realized on the dispositionof interests in nonCBIT businesses would be taxable without 

regard to any change due to CBIT. 

14. We anticipate that entities might move freely from CBIT to nonCBIT status based on annual gross receipts, Le., a 

business which had gross receipts of $75,000in year 1, $125,000 in year 2, and $75,000 in year 3 would report its income 

under current law provisions in years 1 and 3 and file a CBIT return in year 2. CBIT tax paid in year 2 would allow payment 

of tax-free distributions attributable to the taxed amounts in year 3 and later nonCBIT years. The impact of year to year 

changes would cause some complexity and would cause a rate notch effect as an entity moves in and out of CBIT status. 

An alternative would allow organizations that generally meet the gross receipts test to remain nonCBIT entities until they 

have exceeded the floor for several years. 

15. If the lower bound were higher, an aggregationrule probably would be required. The least complicated approach would 

require individuals with more than a threshold amount, e.g., $lOO,OOO, on Schedules C and K of their Forms 1040 to pay 

tax at a schedular rate of 31 percent on the excess. While this approach would inhibit multiplicationof entities to avoid the 

CBIT loss limitation, it would not be effective to prevent use of multiple entities to evade the CBIT interest deduction 

disallowance rule. A refinement could require all nonCBIT small entities to report to their shareholders and partners their 

deductions for business hterest paid. (Individualproprietors would, of course, know this amount for Schedule C activities.) 

Individuals could then be required to add these amounts to the income reported on Schedules C and K in computing the 

schedular tax described above. 

16. An altemative would adopt graduated CBIT rates to reduce the impact of CBIT on small businesses. Because the 31 

percent CBIT rate equals the top individual rate, this would have the effect of imposing CBIT at rates identical to those at 

the individual level. The principal disadvantage of this approach is that it would require complex rules to combat multiple 

use of the graduated rates by common owners. Compare IRC 9 1551 (denying the benefit of graduated rates to corporations 

under common control). 

Another alternative that we rejected as unduly complex would subject all corporations and unincorporated businesses 

to CBIT, but tax all income of owner-managers at their personal rates rather than at the CBIT rate. Once owner-managers 

have been identified, the business would proceed to calculate its CBIT tax, excluding the share of profits and other income 

attributableto the owner-managers (whether that income is called salary, bonuses, partnership income, dividends, or interest) 

from the CBIT income of the business. The owner-managers then would include these amounts in their personal income when 

they calculate their taxes. This altemative, however, would introduce a set of complexities that a receipts-based exception 

avoids. One example would be the need to separate all interest income and expense items between their business and persmal 

components. Some taxpayers will see this task as unnecessarily difficult, while others will see it as an opportunity for tax 

planning. For example, a proprietorship operated out of the proprietor's home should bear a (nondeductible) portion of the 

home mortgage interest expense. Additional rules would be needed to address these problems. Taxpayers would likely find 

the rules to be complex, arbitrary, and unfair. 
207 Notes 

The criteria for being considered an owner-manager might be similar to the requirements for "material participation" 

under the passive loss limitationsof IRC $469. Another possible set of criteria would treat as owner-managers all individuals 

who report net earnings from self-employmentunder IRC $ 1402. (Net earnings from self-employment, as defined in IRC 

$ 1402(a), would have to be modified for CBIT purposes by adding back all the capital income that is excluded from the 

current self-employment tax. See, e.g., IRC $ 1402(a)(l) and (2), which exclude most rents, dividends, and interest from 

self-employment income.) A third possibility would follow the concept in IRC $ 91l(d)(2)(B), which identifies individuals 

who are engaged in trades or businesses in which both personal services and capital are material income-producing factors. 

That identificationalso was used to apply the maximum tax on earned income of former IRC $ 1348, repealed in 1981, and 

the IRS and the courts developed a considerablebody of law on whether services and capital are material income-producing 

factors in a given trade or business. 

17. On the other hand, impositionof tax on distributedpreference income (at either the corporate or shareholder level) may 

be viewed as retaining, in small part, the current system's bias against dividend distributions. See Chapter 5. 

18. See Section 2.B. To illustrate the functioning of such a mechanism under CBIT, assume that a corporation earned $100 

of taxable income and $100 of preference income. The corporation would pay tax of $31 and would add $69 of fully-taxed 

income to its EDA. The balance in the account would translate into $69 of excludable distributable income. Thus, if the 

corporation distributed $75 during the year, $6 would be deemed made from preference income and would be includable 

in the investor's taxable income. 

19. Other solutionsmay be possible. For example, a compensatory tax could be imposed, but a tax credit like that described 

in Section 4.F could be provided to tax-exempt and foreign investors. A compensatory tax would raise sufficient revenue 

to allow a refund of up to 50 percent of entity level taxes paid to tax-exempt and foreign investors. We expect that such a 

credit would significantly reduce the distortion in payout decisions the compensatory tax would create. As Section ll.B 

discusses, the compensatory tax creates a real increase in the tax burden on distributed preference income because we do 

not recommend refunding it to tax-exempt and foreigninvestors. If the compensatory tax were completely refundable to such 

investors, the amount of tax collected from investments by those investors would remain the same, and one would expect 

businesses and investors to adjust, in the long run, to what is merely a change in the collection mechanism without an 

additionalburden. A partial refund of entity level tax would mitigate the distortions created by a compensatory tax. See also 

Section 6.D. 

20. If a compensatory tax is adopted in CBIT, consideration could be given to allowing payments of compensatory tax to 

be credited against subsequent regular tax liability. Such a rule would allow the most taxpayer-favorablestacking of taxable 

income and preference income earned in different years. However, the existence of excess compensatorytax carryforwardslike excess ACT accounts in the U.K. system-may create "trafficking" concerns. See American Law Institute, Reuorter's 

Memorandum No. 3 (1991). 

Examule. A corporation earns $100 of preference income in year 1 and distributes $69, incurring $31 of 

compensatory tax. In year 2, the corporation earns $100 of taxable income and owes $31 of tax, which is offset by 

the previous year's payment of compensatory tax. The corporation now has a zero EDA and will owe $31 of 

compensatory tax when it distributes the second year's income. 

If compensatory tax is not creditable against regular tax liability, the corporation would owe $3 1 of regular taxin year 2 but 

would have a $31 EDA. This is the approach we generally follow in discussing a compensatory tax under CBIT. 

21. The CBIT prototype uses the imputed interest and OID rules to distinguish payments of interest from payments of 

principal; similar rules may be required for preferred stock. See "Current Law Interest Deduction LimitationsUnder CBIT, 'I 

in Section 4.G. These rules are necessary to ensure that payments representing a return of debt or preferred stock capital 

do not reduce the EDA and are not subject to compensatory tax or investor level tax. 

The role, if any, of the current earnings and profits rules requires reconsideration under CBIT. Although earnings and 

profits could be computed under CBIT principles, Le., without an interest deduction, it is unclear whether those rules would 

be necessary or app opriate as an additional (or alternative) mechanism for identifying payments that represent a return of 

equity or debt capid. The dividend exclusion prototype, which applies only to stock, retains the earnings and profits rules. 

See Section 2.F. 

22. The tax paid would result in an addition to the EDA and would ensure that the income would not be taxed again when 

redistributed. 
Notes 208 

23. It may be desirable to provide a 100 percent deduction without regard to the degree of affiliationbetween the payor and 

the recipient. Although the dividend exclusion prototype retains current law, that prototype applies only to equity. Under 

CBIT, which applies to both debt and equity, there seems to be no reason to accord a larger deduction to a related creditor 

than to a portfolio creditor, and maintaining parity between debt and equity requires the same treatment for shareholders. 

24. Imposing a 31 percent tax on all individual income in excess of $l00,OOO reported on Schedules C and K of Form 1040 

might be required to achieve these simplifications. See note 15 supra. 

25. Historically, the corporate and individualminimum taxes were enacted in response to public perceptions that corporations 

and individuals with substantial economic income were not paying any income tax. Although CBIT may result in some 

taxpayers not writing checks to the IRS (because most of their income is excludable CBIT interest and dividends), individuals 

do not in fact escape tax on interest and dividends paid by a CBIT entity, because the investors’ income tax is prepaid at 

the entity level and at the CBIT rate (which is equal to the top individual rate and exceeds the individual AMT rate). 

26. Other countries with integrated systems of corporate taxation typically treat foreign source income in a similar fashion; 

the domestic tax on foreign source income that is not initially collected because of foreign tax credits (or an exemption rule) 

is collected, at the shareholder’s tax rate, when the foreign source income is distributed to resident shareholders. Collection 

of this tax is not considered inconsistent with income tax treaty obligationsto grant relief for foreign taxes. If a compensatory 

tax were imposed under CBIT, the domestic tax would be collected at the 31 percent CBIT rate, rather than the rate paid 

by the shareholder on its other income. 

21. See U.S. v. Goodyear Tire & Rubber Co., 493 U.S. 132 (1989). 

28. Under this approach, the CBIT prototype collects U.S. tax currently on foreign source income of a branch used to pay 

interest. We view this as the correct approach. Unlike other differences typically found between the U.S. and foreign 

computations of the foreign source income base (e.g., depreciation or inventory), the treatment of interest under CBIT would 

be a major systemic difference. The decision not to permit a foreign tax credit against the portion of a branch’s foreign 

source income base used to pay interest can be analogized to placing such income in a separate limitation or “basket”under 

IRC 0 904(d). Since the foreignjurisdiction can be expected never to impose taxon this income, it is appropriate to prevent 

the averaging of high foreign taxes imposed on other foreign source income against the “zeronrate of tax imposed on the 

income used to pay interest. 

We recommend that the foreign tax credit limitation be computed as the lesser of (1) .3 1 times foreign source income 

computed with a deduction for interest expense allowable under foreign law and (2) actual U.S. tax liability. This approach 

has a disadvantage in that dividend income received by a U.S. corporation from a foreign subsidiary will be included in the 

foreign source income base without a reduction for interest expense allocable to the corporation’s investment in that 

subsidiary, i.e., because that interest expense will not be deductible for foreign tax purposes. The resulting inflation of the 

limitation will permit the U.S. corporation to absorb excess foreign tax credits generated by non-dividend income. 

An alternative approach would compute the foreign tax credit limitationby taking into account the interest expense that 

would be deductible and allocable to foreign source income under current law rules. See IRC $0 861 and 864. Under this 

approach, the foreign tax credit limitation formula would be: .31 X (worldwide income) X (foreign source income/worldwide 

income), where worldwide income is reduced by interest expense that would be deductible under current law and foreign 

source income is reduced by interest expense that would be allocable to such income under current law. An obvious 

disadvantage of this approach is that it would require the retention of current law provisions that determine the deductibility 

and allocation of interest expense. On balance, the choice between these alternatives depends upon whether the complexities 

associated with retention of current law interest rules are more or less acceptable than the potential averaging that would arise 

from reliance on foreign law. See also Section 4.G. 

29. Computation of the earnings of a foreign subsidiary without a deduction for interest might be considered appropriate on 

the ground that such earnings are calculated under IRC 0 902 in order to determine the U.S. tax liability of the U.S. 

corporate shareholder (a CBIT entity), and not of the foreign subsidiary. In other words IRC 0 902 deems the U.S. corporate 

shareholder to have earned the earnings used to pay the dividends it receives from the foreign subsidiary and to have paid 

the associated foreign tax. If this approach were adopted, an indirect credit could be granted for interest payments received 

by a 10 percent U.S. corporate shareholder from a foreign subsidiary. Compare WC 0 904(4(3)(C). A U.S. corporate 

shareholder receiving both interest and dividends from a foreign subsidiary with no other creditor would then receive a full 

indirect credit for foreign taxes paid by the subsidiary. This would permit the use of foreign tax credits to shelter the interest 

income from U.S. tax,however, which, as discussed in the context of foreign branch income, we consider objectionable. 

Moreover, in cases where a foreign subsidiary paid interest to a creditor other than a 10 percent U.S. corporate shareholder, 

this approach would result in the stranding of foreign tax credits at the subsidiary level, Specifically, the computation of 
209 Notes 

foreign subsidiary earnings without an interest deduction would reduce the indirect credit available to a U.S. corporate 

shareholder with respect to dividends received from the subsidiary, i.e., because those dividends would represent a reduced 

proportion of a larger, hypothetical amount of subsidiary earnings. It would be impossible for the U.S. shareholder to obtain 

a credit for the full amount of taxes paid with respect to income distributed as dividends because a portion of such taxes 

would be deemed to have been paid on income paid out as interest to a third party creditor. This would be the case, even 

though the foreign subsidiary was not actually taxed on income paid out as interest, by virtue of the availability of an interest 

deduction for foreign tax purposes. To avoid this result, we have proposed that the earnings of a foreign subsidiary be 

calculated for IRC 9 902 purposes with an interest deduction based on the interest expense claimed under foreign law. 

30. In the case of foreign operations conducted through a foreign partnership, this may raise an issue of comparability with 

a foreign branch. This issue is discussed below at note 37. 

31. Introduction of CBIT might induce some U.S. corporations to reorganize foreign branch operations as foreign 

subsidiaries. The nondeductibility of interest under U.S., but not foreign, tax law would effectively reduce the foreign taxes 

available to offset U.S. tax, thus providing greater incentives for operating in corporate form abroad in order to defer U.S. 

taxation. 

32. The branch profits tax also would be repealed because, in the absence of a dividend withholding tax, it would no longer 

be needed to maintain parity between U.S. branches and U.S. subsidiaries of foreign corporations. 

33. Significant exceptions to the portfolio interest exemption, Le., interest paid to a foreign bank on a loan made in the 

ordinary course of business and interest paid to related foreign persons, give the United States some leverage to obtain 

withholding rate reductions in treaties negotiated under current law. 

34. See IRC 0 882(c) and Treas. Reg. 0 1.882-5. 

35. Note that the 30 percent withholding rate would perform a function here analogous to the 31 percent schedular tax 

discussed in note 15. Reduction or elimination of the 30 percent tax by treaty might encourage the use of multiple small 

business entities to avoid CBIT. 

36. The term "nonCBIT debt" refers to debt issued by entities that are not subject to CBIT. NonCBIT debt includes Treasury 

securities, home mortgages (and mortgage passthrough certificates), debt issued by tax-exempt entities, and debt issued by 

foreign governments and businesses, all taxable to U.S. persons. State and local government debt is nonCBIT debt also; 

however, it would remain tax exempt to the extent provided in current law. 

37. U.S. CBIT entities needing funds for foreign operations could borrow through foreign subsidiaries. Borrowing through 

a foreign branch would not be desirable, however. Because a foreign branch would be a component of a CBIT entity, it 

would not be permitted to deduct interest expense. Thus, the branch would probably find it advantageous to borrow in the 

United States (where its ability to pay excludable interest could be expected to produce a lower interest rate) rather than 

paying higher, nonCBIT interest rates that would be required to attract foreign lenders. An alternative would treat foreign 

branches as if they were foreign subsidiaries for CBIT purposes. Interest paid by a foreign branch would then be deductible 

by the branch and taxable to the lender. Rules similar to those of IRC 0 861(a)(l)(B)(i) (providing foreign sourcing for 

interest paid by foreign branches of U.S. banks on bank deposits) could be applied to avoid the imposition of any applicable 

CBIT on such interest paid to a foreign lender. This approach would raise numerous technical and compliance issues. For 

similar reasons, borrowing through a foreign subsidiary would not be advantageous if borrowed funds were to be used in 

the United States. 

38. Alternatively, the credit could be fully refundable, without regard to the taxpayer's other tax liability. Making the credit 

nonrefundable is, however, consistent with the decision in Chapters 3 and 11 not to permit refunds of excess imputation 

credits to low-bracket shareholders and with the treatment of tax-exempt and foreign investors described in the text below. 

Although interest and dividend income would not be taxable under CBIT, most low-bracket individuals who would invest 

in CBIT entities should have sufficient tax liability on wages and nonCBIT income to use the CBIT investor credit. 

39. See also American Law Institute, Reporter's Memorandum No. 3 (1991). 

40.See Chapter 6. Under a distribution-relatedintegration system that denies refunds of imputation credits on corporate 

dividends, tax-exempt investors would have an incentive to invest in debt rather than equity. By imposing a tax on investment 

income, the taxation of debt and equity would be conformed, and tax-exempt entities would have an incentive to invest in 

dividend-paying stock to use the excess imputation credits against the tax due on other income. This structure would 
Notes 2 10 

encourage tax-exempt entities to hold a mixture of debt and equity, since the excess credits associated with corporate 

dividends could be used to offset the tax due on other kinds of investment income. 

41. In theory, the policies which led Congress to enact IRC $ 263A(f) would justify its retention for small business entities; 

however, given the capitalizationthreshold for application of IRC Q 263A(f)(1j(B) (assets costing more than $1 million or 

having long life or production period), retention of its complexity may not be justified for the few situations in which it 

would apply. In contrast, absent special rules to equate self-constructed and purchased assets, capitalizationof interest for 

CBIT entities could undercut the CBIT revenue base by converting some nondeductible interest into basis eligible for cost 

recovery. 

42. The rules of IRC Q 265 would, however, be expanded to limit the deduction of expenses attributable to CBIT interest 

and dividend income. See Section 4.1. 

43. A similar expansion of IRC Q 265(a)(4) to cover regulated investment companies and other conduits which hold stock 

and debt of CBIT entities also will be required. See Section 4.H. 

44. If A’s lender were taxable, the disallowance of interest deductions to A would result in the collection of a double tax. 

However, the potential for tax arbitrage described in the text led us to adopt the disallowance solution. 

45. As discussed in Section 4.E, the prototype computes the foreign tax credit limitation by calculating a branch’s foreign 

source income taking into account the interest deduction allowed to the branch under foreign law. The alternative is to require 

allocation and apportionment of interest expense to the foreign source income as under current law. In that case, the 

provisions listed in the text would continue to be relevant for purposes of determining the foreign tax credit limitation. 

46. For example, if the seller enjoys a reduced rate on capital gains, compared to a zero rate on CBIT interest, this tension 

will be reduced, but not eliminated. See also Chapter 8. 

47. The Service’s guidelines for ruling that a lessor is the owner of assets for tax purposes (and hence that the lessee’s 

payments are rents) include rules governing (1) the length of the lease compared to the useful life of the property, (2) the 

residual value of the property at the end of the lease, (3) options to purchase or sell property at the end of the lease term, 

and (4) the lessor’s equity investment in the property. See Rev. Proc. 75-21, 1975-1 C.B. 715. See also Rev. Proc. 75-28, 

1975-1 C.B. 752, Rev. Proc. 76-30, 1976-2 C.B. 647, and Rev. Proc. 79-48, 1979-2 C.B. 529. 

In theory, every leasing transaction has an interest component, because the lessee obtains current performance (the 

possession of the property) but makes deferred payments. In that sense, a lease is economically similar to an installment sale 

of the property. Compare Halperin (1986) (several different types of accelerated or deferred payments contain implicit loans); 

Mundstock (1991) (economic equivalence of loans and leases). The degree of similaritybetween the two, however, depends 

on several factors, including the term of the lease agreement and the rights retained by the lessor with respect to the property. 

The tax law historically has respected a broad range of leases, and we do not think it necessary to change that treatment in 

the move to CBIT, although it would be possible to consider CBIT treatment for certain rents and royalties. 

48. That the courts’ efforts in this area have led to inconsistent results is hardly surprising given the factual nature of each 

inquiry into who is the true owner of property that is the subject of complex contractual arrangements between parties. No 

case shows this inconsistency better than the Supreme Court’s only examination of this area in the last 50 years, Frank Lyon 

v. United States, 435 U.S. 561 (1978), rev’g 536 F.2d 746 (8th Cir. 1976), rev’g 75-2 USTC 7 9545 (E.D. Ark. 1975). 

Based on all of the facts and circumstances, the trial court upheld the taxpayer’s contentionthat it was the true owner of the 

building. The Court of Appeals, however, analogizing the rights of a property owner to a bundle of sticks, agreed with the 

government’s argument that taxpayer “totesan empty bundle and that the term ’owner’ for tax purposes cannot reasonably 

be attached to the empty wrapping taxpayer has retained.” 536 F.2d at 751. The Supreme Court then undertook its own 

evaluation of the facts, and cited some two dozen facts to support its conclusion that the taxpayer was the tax owner of the 

building. Statutory standards might help the courts to reach more consistent results. 

49. See IRC $9 483, 1274. IRC $7872 also should be retained in order to characterize properly the interest component of 

certain below-market loans. 

50. It may be possible to simplify the current OID rules for CBIT debt, because neither the issuer nor the lender must 

currently accrue deductions or income. Thus, it may be sufficient to adopt rules that correctly identify the character of 

payments. Compare IRC Q 483. Similar rules may be needed to distinguish dividend payments from redemption payments 

on preferred stock. See Q 305(c). The treatment of capital gains under CBIT may, however, result in some retention of the 

current timing rules. If capital gains on CBIT debt are taxed, it may be appropriate to provide debtholders with an increase 
211 Notes 

in basis (with a correspondingdebit to the issuer’s EDA) to ensure that accrued discount on CBIT debt is not taxed as capital 

gains when the debt is sold. See Section 9.B. 

51. Consideration might be given to providing Treasury with the option of issuing both taxable debt and tax-exempt debt. 

52. See IRC 8 103. 

53. The exemption also may permit distributionsto be taxed at a lower rate, if the beneficiary is in a lower tax bracket after 

retirement. 

54. “CBIT income“ refers to dividendsand interest on CBIT debt and equity (and, if capital gains on CBIT debt and equity 

are exempt from tax under CBIT, capital gains on such assets). The two accounts would increase when the pension fund 

receives contributions, nonCBIT income, or CBIT income, and would decrease when the pension fund makes distributions 

to beneficiaries. If CBIT income were reinvested in nonCBIT assets, only the return on those assets would be added to the 

nonCBIT income account. If no compensatory tax is adopted, CBIT income would include only excludable CBIT interest 

and dividends. 

Pension funds would, as under current law, also track nondeductible employee contributions, which are exempt from 

tax when distributed. 

The transition to the new regime should be straightfonvard. Pension funds would calculate the sum of all previous 

contributionsand investment earnings on the date of enactment of CBIT. Those earnings would go into the nonCBIT account, 

and any future CBIT earnings would go into the CBIT account. 

55. Special rules may be needed to limit the allocation of EDA balances to preferred stock upon liquidation. For example, 

it may be inappropriateto allocate any EDA to preferred stock on which current, fully excludable dividendshave been paid. 

In that case, the liquidation proceeds simply represent a return of capital. 

56. IRC 8 732 prevents a step-up in basis, however, thereby preserving a potential tax whenever the distributee partner 

disposes of the distributed asset. 

57. Such exceptions might be patterned on existing IRC $9 731-732 or prior IRC 0 333, which was repealed in 1986. 

58. See Treas. Reg. $ 301.7701-2. In general, an organization that has associates and an objective to carry on business for 

joint profit is classified as a corporation rather than a partnership if it has more corporate characteristics than noncorporate 

characteristics. The corporate characteristics relevant to this determination are (1) continuity of life, (2) centralization of 

management, (3) limited liability for debts, and (4) free transferability of interests. 

59. IRC 5 7704. 

60. IRC 8 851 et seq. A RIC also may retain and pay tax on long-term capital gains, in which case shareholders must include 

such gains in their income and are credited with their share of corporate tax paid. 

61. IRC 9 856 et seq. REITs are allowed a dividends-paid deduction for distributions of both ordinary income and capital 

gains income, but are not allowed to impute retained capital gain income to shareholders. 

62. IRC 8 860A et seq. 

63. See IRC 8 1381 et seq. which generally apply to cooperatives. See also IRC 0 501(c)(12) (certain cooperative telephone 

or electric companies); and IRC 8 521 (farmers’ cooperatives). 

64. These changes also would apply to sole proprietorships not eligible for the small business exception. 

65. IRC 5 265(a)(4) should be expanded to cover CBIT investments of all three conduit entities. As discussed in the context 

of rules for savings and loan associationsunder CBIT, policymakers could consider imposing a withholdingtax of 31 percent 

on distributionsfrom RICs, REITs, and particularly REMICs to tax-exempt investors attributable to home mortgage interest 

to prevent unfair competition between these entities and savings and loan associations. 

66. The patronage dividend mechanism is sufficiently flexiblethat it should permit the cooperative to shift income attributable 
Notes 212 

to the disallowance of interest deductions to patrons. In effect, the cooperative could substitute a patronage deduction for 

the interest deduction if patrons are generally in a tax bracket under 31 percent. 

67. For example, consideration might be given to allowingbanks to pay deductible (and includable)interest on a limited class 

of deposits. The possibility of such an option for savings and loan associations is discussed in the text below. 

68. Unlike the alternative approach, this rule would require a provision defining the institutions eligible for its special rule; 

e.g., the special rule could apply to CBIT entities that earn at least 80 percent of their total income from interest and 

dividends. 

69. The potential problems could be exacerbated if losses arising from nonapplication of IRC 5 265(a) to financial institution 

operating expenses were allowed to generate net operating losses that could be used by other members of a consolidated 

group. 

70. S&Ls may well argue that such a provision is necessary to preserve parity with REMICs and other entities which we 

recommend retain their conduit status. Since REMICs, for example, could market mortgage pass through instruments to taxexempt institutions without imposition of an entity level tax of 31 percent, REMICs would clearly have an advantage in 

raising funds from the tax-exempt sector over S&Ls. As suggested earlier, an alternative solution to this result might be to 

impose a 31 percent withholding tax on REMIC distributions to tax-exempt organizations or impose such a tax directly on 

tax-exempt organizations receiving tax-exempt interest through a REMIC by treating such income as unrelated business 

taxable income. Under current law, interest paid on REMIC regular interests is tax fr& to tax-exempt investors and, in 

general, to foreign investors. A portion of the income on REMIC residual interests is subject to UBIT in the hands of taxexempt organizations and is subject to 30 percent withholding tax when distributions are made to foreigners. 

71. Under current law, insurance companies generally include in gross income premiums and investment income and deduct 

from gross income general business expenses and distributionsto policyholdersand beneficiaries. In addition, the companies 

are allowed to deduct the net increase in the amount of insurance reserves during the taxable year. If reserves decrease, the 

amount of the decrease is included in income. Over the life of any insurance policy, the net deduction for reserves is always 

zero (since the reduction in reserves as claims or benefits are paid generates items of income that offset the earlier 

deductions). Thus, the reserve deduction affects the timing of insurance company deductions for claims and benefits, but does 

not increase the ultimate deductions to more than the amount of claims and benefits actually paid. 

Tax reserves are calculated on a discounted basis to reflect the time value of money. The deduction for the net increase 

in insurance reserves serves two purposes. First, it prevents that portion of premiums needed to fund future casualty or 

benefit payments from being taxed. Second, it provides for a deduction equal to the expected investment return on reserve 

funds. As a result of the combined deduction for reserves, claims and benefits, insurance companies are able to deduct 

currently the present value of anticipated future payments, instead of deducting those payments when made. The difference 

between the present value of future payments and nominal amount of those payments decreases over time, and each year a 

deduction is allowed to the extent of the decrease during the taxable year. 

Insurance companies also make dividend payments to policyholders. Policyholder dividends consist of various 

components, one of which is an interest component. Dividends paid to policyholders are generally deductible from income 

and, among other things, provide a mechanism for life insurance companies to adjust effectively the amount of the reserve 

deduction for changes in the rate of investment return. Thus, the interest-like deduction available to insurance companies 

under current law is spread among deductions for the change in reserves, for claims and benefits paid, and for policyholder 

dividends paid. For a more complete discussion of the issues related to insurance company policyholder dividends, see U.S. 

Department of the Treasury, Report to the Congress on Life Insurance Company Taxation (1989) and U.S. Department of 

the Treasury, Report to Congress on ProDertv and Casualtv Insurance Taxation (1991). 

72. CBIT would not alter current law rules which result in exclusion of much of the amount paid to policyholders in the form 

of claims, benefits, or policy dividends. Under current law, virtually all death benefit distributions payable under life 

insurance policies are fully excluded from gross income. Casualty claim payments are typically offset by loss (lRC 0 165) 

or rollover (lRC 0 1033) deductions allowed to the recipient. However, some other insurance company distributions are 

included in income. Business policyholders of casualty policies must generally include policyholder dividends in income, 

because they generally may deduct the related premiums. Individuals receiving policyholder dividends from either P&C or 

life policies or receiving policy surrender distributions from life policies generally are required to take those distributions 

into income only to the extent that they exceed the total of previous premium payments less previous distributions. As a result 

of these rules, very little of the investment income earned on cash value is included in taxable income at the individual level 

under current law. 
213 Notes 

PART III 

Introduction 

1. Under these conditions, any system of integration would result in the imposition of a single level of tax at a single tax 

rate, regardless of whether corporate earnings were distributed or retained. For example, assume that a corporation earns 

$100, and all corporate and individual income is taxed at a flat rate of 34 percent. .Under the shareholder allocation 

prototype, $100 of income would be imputed to the shareholder, who would pay $34 in tax. The tax due also would be $34 

under any of the three distribution-relatedintegration systems. In each system, the corporation would pay $34 of tax. Under 

the dividend exclusionprototype the corporation could distribute its $66 of after-tax earnings tax-free to shareholders. Under 

the imputation credit system discussed in Chapter 11, when earnings were distributed, the shareholder would have a $34 

credit, which would exactly offset his tax liability. In a dividend deduction system, the corporation would have a $100 

deduction that would offset its tax liability in the year of distribution, and the shareholder would pay tax of $34. Under 

CBIT, the earnings would be subject to $34 of tax at the corporate level but would not be taxable upon distribution as interest 

or dividends to investors. 

2. The equivalency analysis set forth in the preceding note does not take into account the possible additionalburden created 

by taxing capital gains on corporate stock. See Chapter 8. Appendix C discusses the equivalence of distribution-related 

integration systems. 

Chapter 5 

1. Although no agreement exists on the precise specificationof the standard accounting rules, there is sufficient conformity 

that most analysts are able to ascribe to an accepted list of preferential items. See, e.g., Budget of the United States 

Government. Fiscal Year 1992, Ch. XI, "Tax Expenditures.'I 

2. See IRC 0 312. Because corporate shareholders generally claim a dividendsreceived deduction for both regular tax (IRC

0 243) and minimum tax (IRC 0 56(g)(4)(c)(ii))purposes, preference income flows through to most corporate shareholders 

under current law. 

3. SeeMcLure (1979), pp. 131-32, and Polito (1989), pp. 1036-37 (both arguing that corporate preferences should be passed 

through to shareholders under a fully integrated tax system); and Kitchen (1987), p. 360 (defending the ability to pass 

preferences through under Canada's integrated tax system). 

4. Congress has at times indicated a willingness to discriminate between corporate and noncorporate preferences. For 

example, IRC 9 291 restricts the availability to corporations of certain preferences that are otherwise available to both 

corporate and noncorporate entities alike. See also IRC 8 56(b), which specifies several AMT adjustments that apply only 

to taxpayers other than corporations, and IRC 0 56(c) and (g), which specify adjustments that apply only to corporations. 

5. See, e.g., the tax expenditure estimates prevented in the Budget of the U.S. Government, cited in note 1. Although the 

approximately $50 billion annual corporate tax expendituresnoted in the 1992 Budget overstates the magnitude of revenue 

cost (primarily because behavioral adjustments are not considered in the tax expenditure estimates) this figure serves to 

illustrate the significant revenue impact that would result from extending preferences to shareholders. 

6. As discussed in Chapter 13, a complete analysis of the economic effects of the integration prototypes should include an 

examination of the efficiency cost of the revenue offsets. 

7. See Avi-Yonah (1990), pp. 199-202. 

8. See Section 2.B. The same is true of an imputationcredit system of distribution-relatedintegration. Under such a system, 

extending preferences to shareholders can result in shareholders receiving tax credits that exceed the corporate level taxes 

paid. This occurs if the integrationrules implicitly(and incorrectly) assume that the corporation has paid taxes on preferencerelated income, and if the corporation tax rate exceeds the individual tax rate. For example, such errors would occur if a 

shareholder imputation credit method required that a shareholder compute his credit as a fixed percentage of dividends 

received (if the percentage is based on the statutory rate of tax), gross up the dividend by the amount of the credit, apply 

his tax rate to the grossed-up dividend, and apply the credit to the resulting tax liability. This procedure would extend 

preferences to shareholders whenever the corporate and personal tax rates are equal, but it would provide greater subsidy 

for preferences if the corporate tax rate exceeds the shareholder tax rate. 
Notes 214 

9. If it were desired to extend some (but not all) preferences to shareholders, a distribution-relatedintegration system could 

be structured to accomplish this result. Preferences in the form of tax credits could be passed through simply by treating such 

credits the same as taxes actually paid. The relative ease of passing such credits through in an integrated system should 

encourage policymakers so to structure any tax preferences that it desired to pass through to shareholders. Exemption 

preferences also could be passed through, but, in an imputation credit system, that would require additional accounts at the 

corporate level and separate treatment at the shareholder level. Deferral preferences create the most substantial mechanical 

problems if passed through to shareholders. See also Section 3.E. 

10. A compensatory tax ensures that full corporate level tax has been paid on distributed income by assessing a “toll charge“ 

on the corporation with respect to each distribution of preference income. Section ll.B and Appendix C examine different 

types of compensatory tax systems. To determine the amount of the toll charge, corporations would maintain an account of 

corporate tax paid or of fully-taxed income to determine the amounts of fully-taxedand of preference income. A “stacking” 

rule could then be applied to determine the extent to which distributed earnings were made from the corporation’s fully-taxed 

or preference income. The stacking rule most favorable to taxpayers is to treat corporate distributionsas paid first from fullytaxed income and then from preference income. Thus, if the corporation has sufficient fully-taxed income to apply to 

distributions, the corporation and its shareholders will suffer no adverse consequences from a decision not to extend 

preferences to shareholders. Chapter 11 contains a discussion of stacking alternatives and their economic effects. The 

principal alternative is a pro rata stacking rule, which would treat distributions as containing a proportionate share of the 

corporation’s retained preference income. 

If the compensatory tax rate is set equal to the corporate tax rate, the effect is to recapture corporate tax preferences.

In that case, if a corporation distributes only fully-taxedincome (determined under stacking rules), no additional tax liability 

results. For distributions in excess of fully-taxedincome, each dollar of tax-exempt preference income is subject to the full 

corporate tax rate, and the full amount of tax paid is available as a shareholder credit. If the shareholder credit is fully 

refundable, the tax system collects no additionalnet taxes from a compensatory tax. If the credit is not fully refundable, then 

the tax system collects an additionaltax onpreferences distributed to shareholderswho have insufficienttax liability to absorb 

the credit or who are tax-exempt. 

If the compensatory tax is set at a rate below the corporate tax rate, distributions in excess of fully-taxed income result 

in additional corporate level tax liability on preference income, but at less than a dollar-for-dollarrate. This achieves a result 

somewhat analogous to the current alternative minimum tax, because distributed preference income bears tax at a rate lower 

than the corporate tax rate. Setting the compensatory tax at a rate lower than the corporate tax rate differs from an alternative 

minimum tax: the compensatory tax is triggered only on distributions, while the current alternative minimum tax applies 

regardless of whether funds are retained or distributed. 

A third alternative sets the compensatory tax rate equal to the shareholder rate rather than the corporate rate. This 

approach, adopted in the U.K. imputation system, effectively taxes the corporation at the shareholder rate on distributed 

preference income and allows shareholders a credit at the same rate. For shareholders who pay tax at that shareholder rate, 

the compensatory tax acts as a withholding tax on funds distributedto shareholders.If the shareholder credit is not refundable 

and cannot be carried forward, the compensatory tax creates an additional tax burden on distributed preference income for 

shareholders whose tax rate is less than the statutory rate. Only refundabilityof tax credits will eliminate such consequences 

for tax-exempt shareholders. 

Section 11.B examines the treatment of preference income distributed to tax-exempt shareholders under both a 

compensatory tax and a credit limitation approach. 

11. See Section ll.B for a discussion of the different methods for limiting the shareholder credit to corporate level tax 

actually paid. This method requires the corporation to maintain an account of corporate taxes paid. In a dividend exclusion 

system, the amount of taxes paid is converted into a corresponding amount of fully-taxed income. The account would be 

increased by corporate tax paid and the amount of credits from dividends received from. other corporations and decreased 

by the amount of credits attached to distributions made to shareholders (or the fully-taxed income equivalents). As with the 

compensatory tax, a stacking rule is necessary to determine the extent to which distributions are made out of fully-taxed 

income. Shareholder credits with respect to distributionswould thus be allowed only to the extent the corporation’s account 

was sufficient to fund the credits. Distributions considered made out of preference income would not carry imputation credits 

and, thus, would be subject to tax at the shareholder tax rate, as under present law. 

12. See Section ll.B. 

13. See Section 2.B. If integrationwere extended to retained earnings through a dividend reinvestment mechanism, a decision 

not to extend corporate level tax preferences to shareholders could readily be implemented by restricting the dividend 
215 Notes 

reinvestment option to fully-taxed retained earnings. This could be accomplishedby limiting the dividend reinvestment option 

to the balance in the corporation’sEDA, in the dividend exclusion and CBIT prototypes, or the SCA, in the imputation credit 

prototype. See Chapter 9. 

14. See Section 4.D. 

15. See Section 3.E. 

Chapter 6 

1. In some cases, the Code also permits deductibilityof donors’ contributionsas charitable contributions (IRC 6 170), while 

contributions to pension funds are generally deductible as business expenses (IRC 8 404). 

2. This is true only when individuals’ tax rates are constant over their working life and in retirement. If tax rates during 

retirement are lower, current law treatment of pension savings is even more valuable. 

3. Income from an exempt organization’s investments in a publicly traded partnership is subject to UBIT, regardless of 

whether the partnership’s business is unrelated to the entity’s exempt purpose. 

4. As Chapter 5 notes, most preference items confer tax deferral rather than complete exemption. Corporate income sheltered 

from tax by a deferral preference can be distributed to a tax-exempt shareholder without shareholder level tax, preserving 

the value of tax deferral until the preference “turns around” and additional tax is imposed at the corporate level. Corporate 

preference income distributed as interest to tax-exempt debtholders receives even more favorable treatment: not only is the 

income exempt from tax at both the corporate and shareholder level, but the interest deduction may be available to offset 

otherwise taxable income. This benefit is not available for all preference income. IRC 6 265, for example, disallows 

deductions for interest and other expenses attributable to tax-exempt bond interest. 

5. In 1989, tax-exempt entities were allocated $1.6 billion in income from partnerships, or approximately 2 percent of the 

total amount allocable to all partners. Of the tax-exempts’ share, an estimated $260 million was trade or business income 

that could have been subject to UBIT. The remainder consisted of rents, royalties, interest, dividends, and other forms of 

income not subject to UBIT. 

6. Depending on the integrationsystemadopted, there could still be an advantage in distributingcorporate preference income 

to tax-exempt shareholders. For example, under a shareholder credit limitation system, preference income would be exempt 

from tax at the corporate level and would be exempt from tax at the investor level if distributed to a tax-exempt shareholder. 

Retained preference income, realized in the form of capital gains on stock, also would be exempt from tax in the hands of 

a tax-exempt shareholder. A compensatory tax, discussed in Section 11.B, would impose a corporate level tax on distributed 

preference income, but would not change the treatment of retained preference income. 

7. A dividend exclusion system would not provide equivalent treatment of debt and equity held by tax-exempt investorsunless 

interest also were nondeductible at the corporate level and excludable by the recipient. This regime is CBIT; see Chapter 4. 

8. See Sections 11.Eand 12.A, respectively. A dividend deduction systemwithout withholdingwould equalize the treatment 

of debt and equity investments by tax-exempt investors. Corporations would be able to deduct dividends paid, as they now 

deduct interest, and neither type of income would be taxable to the tax-exempt investor. This result could be changed by 

denying the deduction (or the benefit of the zero rate) for dividends paid to such tax-exempt shareholders, but such an 

approach would require corporations to track the identities and tax status of shareholders. Coupling a nonrefundable 

“withholding”tax with a dividend deductioncould achieve results similar to a nonrefundablecredit under an imputationcredit 

method of integration. 

9. The United Kingdom refunds the imputation credit to tax-exempt investors. However, while the U.K.’s imputationcredit 

is fully refundable to all domestic shareholders, including tax-exempt shareholders, the U.K. has a partial distribution-related 

integration system, so earnings distributed to a tax-exempt shareholder still bear a tax equal to the excess of the corporate 

rate over the credit rate. See Appendix B. Tax-exempt organizationsown approximately 40 percent of the outstanding stock 

of U.K. companies. 

10. An effort to provide tax-free treatment for corporate income allocated to tax-exempt or tax-favored investorsunder CBIT 

would raise major problems. For income distributed in the form of interest and dividends, the relative advantage of such 

investorscould be maintained by providing refunds of corporate tax paid with respect to funds distributed. For undistributed 
Notes 216 

income, however, eliminating the corporate level tax would require allocating undistributed income to the shareholdersexactly the type of administrative complexity that occurs under a shareholder allocation system and that the CBIT approach 

to integration seeks to avoid. 

11. A dividend deduction proposal passed by the House of Representatives in 1985would have made a portion of dividends 

received by certain tax-exempt organizations subject to UBIT. See H.R. 3838, 99th Cong., 1st Session, 0 311 (1985) and 

H. Rept. No. 426, 99th Cong., 1st Sess. (1985), p.240. 

12. For example, under an imputationcredit system of distribution-relatedintegration, providing full shareholder imputation 

credits on dividend income to tax-exempt investors would allow them to invest in a mix of equity and debt so the credits 

could be used to offset the tax on other investment income. This approach is similar to Australia’s system for tax-exempt 

investors, adopted shortly after enactment of a shareholder credit limitationintegration system. Allowing the credit to offset 

other investmentincome also discourages streaming of franked dividendsto taxable investors and unfrded dividends to taxexempt investors. 

For example, assume a tax-exempt entity earns $100, of which $25 is dividend income and $75 is interest income. 

Assume, in addition, that the dividend carries an imputation credit for corporate tax paid at a 31 percent rate and that the 

tax-exempt entity is subject to tax on all investment income at a 12 percent rate. The net dividend of $25 would be treated 

as a gross dividend of $36.23, with a tax credit of $11-23. The tax-exempt entity would have a tax liability (before credits) 

of $13.35 (.12X111.23), which would be offset in part by the $11.23 credit. The net tax due would be $2.12. 

13. If credits are nonrefundable, the revenue neutral rates are as follows: 8.4 percent for shareholder allocation, 7.6 percent 

for the imputation credit prototype, 7.2 percent for CBIT with no taxation of capital gains, and 6.1 percent for CBIT with 

current law capital gains taxation. 

Chapter 7 

1. Unlike many other countries, the United States also taxes the worldwideincome of all U.S. citizens and U.S. corporations, 

whether or not they are residents of the United States. 

2. Some or all of the U.S. shareholders of a foreign corporation may, however, be subjkt to current U.S. tax on all or a 

portion of the corporation’sincome if it m s income which is either passive, e.g., interest, dividends, royalties, and similar 

income or particularly mobile or holds assets that produce such income. See,e.g., IRC $9 951, 1293. 

3. Thus, for example, if a foreign subsidiary of a U.S. company earns $100 abroad, pays $40 in foreign corporate level 

taxes, and remits $27 in dividendsto its U.S. parent ($30, net of a $3 withholding tax imposed by the foreign country), the 

parent must report $50 in foreign source dividend income ($27 plus $3 plus 50 percent of $40),and can claim a credit 

(subject to the appropriate limitations) for direct foreign taxes of $3 and indirect foreign taxes of $20. 

4. Merely acquiring U.S. stock and debt securities does not constitute a U.S. trade or business. 

5. See, e.g., Bergsten, Horst, and Moran (1978) and Caves (1983). In the public economics literature, studies by Musgrave 

(1969), Horst (1980), and Giovannini (1989) have attempted to compare the relative efficiency of capital export and capital 

import neutrality under various stylized assumptions. See also the overview in JCS-6-91 (1991). 

6. See “Savingsand Investment” in Section 1.B. 

7. Setting tax rates independently implies that countries take policies of their trading partners as given, and misestimate 

effects of their own policies. See, e.g., Gordon (1983). In particular, analyses of capital export neutrality often assume that 

foreign countries’ tax rates are independent of the resident country’s tax rates. The source country may, of course, take into 

account that most investment from abroad originates from countries that grant a worldwide credit for foreign taxes paid. The 

source country may, therefore, be able to increase taxes on foreign investment without reducing capital inflows because 

foreign govemments, not investors, would absorb the tax. In effect, a policy of capital export neutrality may lead to a 

transfer from the resident country’s treasury to that of the source country. 

8. The foreign tax credit tends to promote capital export neutrality, because it eliminates an investor’s U.S. tax liability to 

the extent of foreign taxes paid, but requires the investor to pay a residual U.S.tax if the U.S. tax rate is higher than the 

foreign tax rate. In this situation, the investor is neutral between domestic and foreign investment, because the investor bears 
217 Notes 

the same tax burden in either case. For additional discussion, see Hines and Hubbard.(1990) and JCS-6-91 (1991). As 

explained in the text, however, the foreign tax credit does not always have this effect. 

9. The indirect credit thus provides equal treatment for foreign direct investment by U.S. corporations, whether through a 

foreign subsidiary or a foreign branch operation. 

10. This conclusion turns on accepting, as we do in Chapter 13, the traditional view of dividends. See Section 13.B. For 

additional discussion of these issues, see Hines and Hubbard (1990) and the studies cited therein. 

11. The statutory exemption for portfolio interest reflects the difficulty of taxing highly mobile debt capital. The exemption 

for capital gains represents an incentive to foreign persons to invest in U.S. capital markets and a concession to the 

administrativedifficultiesof determining gain and collecting tax where the income is not physically paid from U.S. sources. 

12. Treaties also suggest another explanation for the nondiscriminationruleto protect the bargain agreed to by the parties. 

Treaties limit withholding rates but generally do not impose direct limitations on a source country’s right to tax business 

profits, This creates some risk that the source country may alter the bargain, without directly affecting withholding rates, 

by changing the way that business profits are taxed to foreign investors. The nondiscriminationrule indirectly prevents this 

by requiring that changes in the taxation of business profits burden domestic and foreign capital equally. 

13. The shareholder allocation prototype treats foreign taxes by statute like U.S. taxes, but we do not recommend adoption 

of that prototype. 

14. The following examples illustrate the tension between a policy of avoiding additional taxation of foreign source profits 

and a policy of collecting one level of U.S. tax on profits from all sources. Assume that a U.S. individual owns 100 percent 

of a domestic corporation that in turns owns 100 percent of a foreign corporation. The V.S. corporate rate is 34 percent, 

the individual rate is 31 percent, and the United States has adopted a dividend exclusion system. The foreign corporation 

earns $100 of foreign profits in the relevant taxable year and pays foreign taxes of $25. The foreign subsidiary later 

distributes the after-tax income to its domestic parent, which distributes the dividend (net of any U.S. tax) to its sole 

individual shareholder. If the domestic parent is required to include $100 of profits in income for the taxable year of the 

distributionbut is given a tax credit of $25 against its U.S. tax liability, and the individual is allowed to exclude the dividend 

altogether, then the aggregate level of tax of the foreign profits will be no greater than if the profits were from domestic 

sources. No additional taxation will exist. Compared to current law, exempting the dividend in the hands of the individual 

shareholder will significantly reduce the United States’ portion of the aggregate tax burden borne by the foreign profits. The 

United States’ portion of the total tax paid will only be $9 out of $34, or 26 percent of the total, compared to the United 

States’ portion under current law: $29 out of $54, or 54 percent of the total. 

If, in contrast, the tax regime provides a credit for the $25 of foreign taxes paid by the subsidiary to the domestic parent 

but requires the individual shareholder to pay tax upon the appropriate portion of the subsequent distribution by the parent 

under the dividend exclusion prototype, then the foreign profits will bear an additional amount of tax relative to a similar 

amount of domestic profits. The domestic corporation will owe $9 of additional tax upon receipt of the distribution from the 

foreign shareholder, and the individual shareholder will owe a tax of $15 upon the subsequent distribution of a grossed-up 

dividend of $49. The foreign profits will have been subject to aggregate foreign and U.S. taxation of $49, in comparison 

with aggregate taxation of $34 for similar profits from domestic sources. Under this approach, the United States’ portion 

of the total taxes paid for such income will be $24 out of $49, or 49 percent of the total. However, the total tax burden on 

the earnings decreases to $49 from current law’s $54, because there is only one level of U.S. residual tax. 

15. This problem would be even more severe if shareholder credits in a shareholder allocation or imputation credit system 

were actually refundable, rather than simply available to offset tax liability on other income. 

16. See Sections 2.C and ll.D. 

17. See Section 4.D. 

18. See Section 3.5. 

19. For domestic corporationsowned by foreign shareholders, the first level of tax is the normal domestic corporate tax and 

the second level is the 30 percent withholding tax on dividends. For a U.S. branch of a foreign corporation, the first level 

is the corporate tax on the branch’s U.S. business income and the second level is the branch profits tax under IRC 0 884(a). 
Notes 218 

20. Other countries with integrated tax systems, as a rule, have not extended benefits of integration to U.S. shareholders 

except as a result of tax treaties. However, the U.S. treaties with the U.K., Germany, and France extend some benefits of 

integration to U.S. shareholders in certain cases. On the other hand, Australia generally extends the benefits of integration 

to foreign shareholders by statute. See Appendix B. 

21. The following example illustrates the problem in the context of an imputation credit system that refunds imputation 

credits to foreign shareholders. The issues would be the same in a dividend exclusion system that refunded corporate tax to 

foreign shareholders. Assume, for example, that two domestic corporations each earn an a~ualpre-tax profit of $100. 

Corporation A has one shareholder, a U.S. resident individual. Corporation B also has one shareholder, a nonresident alien 

individual who resides in a country that has a tax treaty with the United States. The tax treaty limits the U.S. dividend 

withholding rate to 15 percent for portfolio investors (including the shareholder of corporation.B) and contains a standard 

prohibition against discrimination based on capital ownership. Assume also a 34 percent corporate tax rate, a 31 percent 

individual tax rate and that corporate taxes are credited to shareholders at the 31 percent individual rate. 

If neither corporation distributes earnings, each pays a tax of $34 on its $100 profit. No discrimination exists between 

the two corporations, and the withholdingrules are not implicated.If, instead, each corporation distributesone-half of profits, 

the domestic shareholder receives a cash distribution of $33, an imputation credit of $14.83, and a grossed-up dividend, Le., 

including credit of $47.83. See Section 11.B. The domestic shareholder will have a tax liability with respect to the gross 

distribution of $14.83, which will be exactly offset by the imputation credit. Thus, for corporation A both distributed and 

retained earnings are taxed at a 34 percent rate. 

There is a significantly different result for corporation B. The foreign shareholder receives a cash dividend of $33. If 

he also receives an imputation credit of $14.83, his gross dividend will be $47.83. The withholding tax on this distribution 

will be $7.17, entitling him to a refund of $7.66. In this case, undistributedprofits are taxed at 34 percent, but distributed 

profits are taxed at 18.7 percent ($50 of pre-tax income that bears $17-$7.66 of tax). 

22. In the past, countries with nonintegrated tax systems, including the United States, have responded that this argument is 

highly stylized, that it ignores the economic reality that profits distributed to foreign shareholders bear a higher level of tax 

than profits distributed to domestic shareholders, and that such an integration regime is discriminatory. As noted in the text, 

this response has generally been rejected by countries with integrated systems, although the United States has had some 

success in negotiating partial integration benefits for its shareholders. 

23. See Section 2.A. 

24. This would not be true in an integration system that imposed both a nonrefundable compensatory tax and a withholding 

tax on dividends. A nonrefundable compensatory tax combined with a withholdingtax would subject distributed preference 

income to two levels of tax, rather than the one level of tax imposed under current law. (Note that, if a compensatory tax 

were adopted in CBIT, the current withholding tax on dividends would be repealed.) See Section 4.E. 

25. See Section 3.1. 

26. See Section 6.D, which describes such an approach for tax-exempt entities. Such an approach would minimize portfolio 

shifts by foreign shareholders and would provide an opportunity for achieving greater parity between debt and equity 

investments in U.S. corporations by foreign investors. 

Chapter 8 

1. Presumably, if shareholders were not taxed on gains, they would not be allowed losses on stock sales. 

2. As described in Section 13.B, we accept the traditional view of dividends, under which the value of $1 of retained 

earnings is $1 as long as the managements of corporations maximize firm value. Under the new view, also described in that 

section, distributions to shareholders in the form of dividends are unavoidable. For a dividend paying corporation in this 

view, an incremental dollar of retained earnings raises share value by less than $1. 

3. The value of stock in a corporation that has retained earnings may include the value to a prospective purchaser of the 

resulting capital loss that will be realized when the stock is resold after the earnings are distributed, although the value of 

this loss to a purchaser depends on the purchaser’s marginal tax rate and ability to use capital losses, and the amount of time 

the purchaser expects to elapse before the earnings are distributed and it dispose of the stock. 
219 Notes 

Assume, for example, that a dividend exclusion system is adopted and that the corporate and shareholder tax rates both 

are 34percent. A corporation earns $100of fully-taxed income in year one and pays $34in tax, so it has retained earnings 

of $66 and an EDA balance of $66.How much should a prospective purchaser pay for all the stock? The answer is that the 

purchase price of the stock will vary between $66and $100,depending on the tax attributes of the purchaser and the expected 

timing of the distribution of the $66 of retained earnings and the purchaser’s resale of the stock. 

The after-tax value of the retained earnings to any purchaser is $66.In addition, if the corporation distributes all of its 

earnings, the shareholder will realize a capital loss upon disposition equal to the amount paid for the stock. (The amount 

realized on the disposition would be zero, assuming the corporationhas no assets after the distribution.) In theory, the value 

of the capital loss may be as great as $34(and thus, a purchaser would be willing to pay $100)if: (1) the distribution of the 

earnings and the disposition of the stock are expected to occur very shortly after the purchase of the stock, (2)the purchaser 

expects to have sufficient capital gains against which to use the capital loss, (3)the purchaser expects to face a 34 percent 

marginal tax rate, and (4)the distribution does not reduce the basis of the shares. 

The value of the capital loss may be much less. The value of the capital loss will be less if the shareholder does not 

dispose of the stock immediately, cannot use the capital loss immediately, or is subject to tax at a marginal rate of less than 

34 percent. If, for example, the capital loss is worth zero, the purchaser would pay only $66 for the stock. 

4.Depending on marginal tax rates, the tax system may collect as little as no tax or as much as two full levels of tax on 

corporate earnings. If the corporate tax rate does not exceed the individual rate, the tax system may collect virtually no tax 

on corporate earnings if, for example, a seller of stock is tax-exempt and a purchaser is taxable. In that case, the seller will 

not pay tax on capital gains attributable to fully-taxed retained earnings, but, after the earnings are distributed, the taxable 

purchaser can sell his stock and realize a capital loss. That loss may be valuable enough to offset tax collected on the 

earnings at the corporate level. On the other hand, the tax system may collect two full levels of tax if, for example, a seller 

of stock is taxable and a purchaser is tax-exempt. In that case, the initial shareholder’s capital gain is taxed in full, but the 

offsetting capital loss creates no tax benefit to the purchaser. Current law in some cases limits the availability of a capital 

loss following a distribution. See, e.g., IRC 0 1059 (basis reduction for extraordinary dividends). 

5. The analysis in the text oversimplifies this issue to illustrate the general point. The analysis can be complicated if 

preferences are subsequently distributed or if the preference is a deferral or tax credit rather than an exclusion of income. 

6.This could be accomplished by increasing inside basis in a manner similar to the treatment of electing partnerships under 

IRC 8 754and electing purchasers of corporate stock under IRC 0 338.Applying such a rule to small acquisitions of stock 

(particularly where there is frequent public trading) would be administratively impossible; however, using a dividend 

reinvestment plan could provide some relief. See Chapter 9. 

7.Halperin and Steuerle (1988)indicate that total capital gains in the economy over time are approximately equal to gains 

attributable to inflation plus retained earnings. Their research indicates that the real gains in value in one sector, e.g., land 

in the 1970s)tend to be offset by real losses in another sector, e.g., corporate stock in the 1970s.According to Halperin 

and Steuerle, from 1948 to 1985 the total change in economywide net worth equals the sum of (1) average net investment 

of 12.3percent of net national product (NNP), (2)average inflationary gains in value of 16.1 percent of NNP, and (3) 

average real gains in value of -2.6percent of NNP. See also Steuerle (1991).If total capital gains are attributable only to 

inflationary increase in asset values and retained earnings, the case for reduced taxation of nominal capital gains on corporate 

stock is much stronger. 

8.See IRC 00 705and 1367.Treas. Reg. 0 1.1502-32provides a comprehensiveset of basis adjustmentsfor C corporations 

that are members of a consolidated group. 

9.In cases where expected increases in future earnings that are reflected in the price of equity never materialize, an equity 

holder may realize a gain that never creates a correspondingamount of income to be taxed under CBIT at the entity level. 

In that case, however, the purchaser of the equity interest will realize a corresponding loss, and disallowing both the gain 

and the loss achieves a roughly accurate solution. 

ExamDle. A purchases Corp. X stock for $100,when Corp. X is expected to earn $l,OOOper year. One year later, 

Corp. X announces a new product line that is expected to increase its earnings to $1,500per year. A sells his stock 

to B for $150.Six months later, one of Corp. X’s competitors introduces a superior product. Corp. X’s expected 

future earnings decline to $l,OOOper year. B then sells his stock for $100. 

Without taking into account the time value of money, the marginal tax rates of the two investors, or capital loss limitations, 

A’s $50 gain is offset ‘by B’s$50loss. 
Notes 220 

10. A completeexemptionalso may create an incentive to restructure transactions. For example, because investor level gains 

on a sale of stock would be exempt but entity level gains on a sale of assets would not, there would be a considerable 

incentive to structure acquisitionsof corporationswith appreciated assets as stock sales rather than asset sales. This is similar 

to the bias that exists under current law, under which sales of stock result in only one level of tax, while sales of assets, 

which typically either are preceded by a liquidating distribution of assets or followed by a liquidating distribution of sales 

proceeds, generally result in two levels of tax. 

11. Proposals made in other contexts, e.g., a mandatory IRC 0 338 election, might be considered. Current law permits 

certain purchasers of 80 percent or more of a corporation’s stock to elect to treat a stock purchase as an asset purchase. A 

mandatory IRC 8 338 election, adapted for CBIT, would require recognition of gain at the entity level if a certain percentage 

of the equity of a CBIT entity changes hands. A mandatory IRC 5 338 election may be more palatable in an integrated 

system than under current law, because any gain realized would be subject to only one level of tax.Gain would be taxed 

solely at the entity level, and no additional investor level tax would be due. 

Another possible approach would tax capital gains realized on the sale by a CBIT entity of its equity interest in another 

CBIT entity, e.g., a corporation’s sale of the stock of a subsidiary. For the reasons discussed above, taxing capital gains on 

CBIT equity realized by a CBIT entity would tend to impose a second level of tax on earnings. Taxing entity level capital 

gains on CBIT equity also would create disparities between equity investments held directly by individuals and those held 

through other entities, e.g., affiliated groups of corporations. On the other hand, extending the exemption for capital gains 

on CBIT equity would multiply the potential for deferral of entity level tax. Without special rules limiting tax-free 

contributions of assets to subsidiaries or partnerships, CBIT entities would be able to structure some sales of assets as sales 

of CBIT equity. 

12. Auerbach (19%) discusses alternative means of retrospective capital gains taxation that approximate accrual-equivalent 

capital gains taxation. 

13. The text focuses on the different sources of capital gains for traditional forms of equity and debt. The sources of capital 

gains for hybrid instruments may reflect both equity-type and debt-type gains. For example, fixed rate, nonconvertible, 

cumulative preferred stock of a creditworthy company may react to interest rate changes in much the same way as debt. 

14. The credit quality of debt may change because of changes in the underlyingvalue of the firm. For example, debt issued 

by a manufacturing firm might rise in value because the demand for the firm’s product rises unexpectedly,thereby increasing 

the likelihood that the firm will pay off the debt in a timely manner. In essence, the debt is more valuable because the firm 

has become more valuable. The rise in value represents a capital gain to the debtholder. Such a gain is analogousto the gain 

an equity holder would realize from the same event, and the deferral concerns are the same. 

15. An unexpected fall in the market interest rate, for example, could generate a capital gain to the holder of long-term, fixed 

rate, noncallable debt. The value of the debt would rise until the debt’s interest payments would provide a new investor with 

a return equal to the market interest rate. 

Example. A noncallable perpetuity is a debt instrument that never matures. If the interest rate at issuance is 10 

percent, a $100 perpetuity would pay $10 of interest per year. If the market rate of interest drops unexpectedly to 

5 percent, the value of the perpetuity would double to $200, so its $10 annual interest payment would represent a 

5 percent rate of return on the value of the debt. If the debt holder sold the perpetuity, he would realize a capital 

gain equal to the $100 increase in value. 

The effect of changes in interest rates is less pronounced for short-term bonds because there is a shorter period over 

which off-market interest payments will be received and because the present value of the prepayment of principal is a more 

significant component of price. For example, if the bond in the example above were scheduled to mature in one year, an 

unexpected drop in interest rates would cause the bond to increase in value only to $104.76 ($110/1.05), rather than to $200 

as with the perpetuity. However, a change in market interest rates creates an qual and offsetting gain or loss to the 

borrower. A decline in the market interest rate increases the amount the borrower must pay to eliminate his debt. If the 

borrower repurchased the debt in the example for $200, he would recognize the loss in the form of a $100 deduction. See 

Treas. Reg. 9 1.163-4(c). If market interest rates increased, the borrower could repurchase his debt for less than its issue 

price and would realize income from the cancellation of indebtedness. See Treas. Reg. 6 1.61-12(c). 

Interest rate changes also can affect the value of equity. For example, an increase in interest rates may decrease the value 

of common stock to the extent that stock price reflects the discountedpresent value of future cash flows on the stock because 

the higher interest rate also will decrease the discounted present value of future cash flows from corporate assets. An increase 
221 Notes 

in interest rates also may create an offsetting increase in the value of common stock if a corporationhas outstandinglow-rate 

noncallable debt. 

16. Thus, if CBIT included a compensatory tax and gains on CBIT equity were exempt, considerations of simplicity may 

support exempting gains and denying losses on CBIT debt (to both borrowers and lenders) as well. Althoughgains and losses 

on debt that are attributable to changes in interest rates represent real accretions to wealth (or real reductions in wealth) to 

borrowers and lenders, distinguishing between gains and losses on debt arising from changes in the value of the firm and 

those arising from changes in interest rates would be virtually impossible. Further, a change in interest rates creates no net 

gain in the tax system, because the lender’s gain or loss is offset by the borrower’s loss or gain. To the extent that debt 

holders and equity holders face the same tax rate and would pursue the same realization strategy, the Treasury would collect 

the same tax revenue if such gains and losses were included in taxable income as it would if such gains and losses were 

ignored. This conclusion is weakened if differences in tax rates and differences in the timing of realization are taken into 

account. Excluding all gains and losses on debt could create a net loss of tax revenue to the system in some cases, e.g., if 

interest rates increase and the lender is tax-exempt and the borrower is taxable. Strengthening the case for exempting such 

gains and losses is the observation that they are most important for long-term, fixed rate debt with call restrictions. Longterm, fixed rate debt has become less important in recent years. For nonfmancial corporations, the ratio of long-term debt 

(corporate bonds, mortgages, and tax-exempt bond) to total credit market debt has fallen from 71.6 percent in 1962 to 56.4 

percent in 1990. See Flow of Funds Accounts (1991). To the extent that even long-term debt has more flexible interest rate 

adjustment than in the past, long-term fixed rate debt is even less important than the above calculation would suggest. 

17. See IRC 0 302. A redemption also may qualify for sale treatment if it terminates a shareholder’s interest in the 

corporation or is made to a noncorporate shareholder in a partial liquidation. 

18. The analysis in the text generally applies to individual shareholders. Corporate shareholders, which are entitled to a 

dividends received deduction (DRD), may favor dividends over share repurchases even under current law. A corporation 

entitled to a 100 percent DRD would always prefer a dividend, which would be entirely tax-free and would preserve share 

basis to offset later gains. A corporation entitled to a 70 or 80 percent DRD might prefer dividends in some cases. 

The problems raised by share repurchases under the classical system are discussed at length in the American Law 

Institute (1989), which recommends adopting “a minimum tax on distributions” of 28 percent (the maximum rate applicable 

to individual taxpayers at the time) on the gross amount of any nondividenddistribution to ensure that the second level of 

tax is collected. See Section 12.C. 

19. Thus, a shareholder with a basis of $150 in his stock would pay the same amount of tax on a $200 distribution and a 

$200 payment in full redemption of his stock. In each case, the $200 payment would result in $50 of capital gain. 

The rules determining stock basis should be reexamined under shareholder allocation. Although each share of stock has 

traditionally been viewed as having a separate basis, an aggregate basis approach may be more suitable under shareholder 

allocation, as under the partnership rules. For example, if aggregationis not permitted and a shareholderholds both low basis 

shares and high basis shares, a pro rata distribution might result in recognition of gain on the low basis shares, while an 

equivalent amount paid in full redemption of only a portion of the stock might be tax-free because the shareholder could 

choose to surrender only high basis shares. 

20. A DRIP would reduce the bias against share repurchases out of taxable income. DRIPSare discussed in Chapter 9. 

21. Some have contended that the best approach would recharacterize a share repurchase as a pro rata dividend, followed 

by sales of shares among shareholders to reflect the fact that, after a share repurchase, some shareholders have cash and 

others have an increased proportionate interest in the corporation. All shareholders would pay tax on ordinary dividend 

income and would add that amount to share basis. Selling shareholders would recognize gain or loss measured by the 

difference between the amount realized on the sale and their basis in the shares. See Chirelstein (1969). Abandoning the 

realization requirement to tax nontendering shareholders would create additional complexity and administrative difficulties. 

Indeed, since integration reduces the tax incentives for share repurchases over dividends in comparison to current law, a 

change in that policy does not seem appropriate or necessary. Moreover, allocating the EDA balance among all shareholders 

would require income allocations as complex as those required in the shareholder allocation prototype. See Chapter 3. 

22. Attempting to treat third-party sales of shares as dividends that would be excludable to the extent of the issuing 

corporation’s EDA balance would entail information reporting (by brokers to the issuing corporations and by issuing 

corporations to selling shareholders and the IRS) to an unprecedented degree. Such a system would be highly impractical 

and undesirable. 
Notes 222 

23. Rules similar to those in IRC $ 302 would be retained. Because corporations, for example, may have an incentive to 

use redemptionsof tax-exempt shareholders’ stock in a dividendexclusion system, it might become necessary to reduce EDA 

balances in proportion to shares redeemed. 

24. Example. A corporationowns an asset worth $100 and its sole shareholder has a basis of $100 in her stock. 

The value of the asset declines to $60, and the shareholder sells her stock for $60, realizing a $40 capital 

loss. If the corporation then sells the asset for $60, it too will realize a capital loss. 

A shareholder level loss that mirrors an unused net operating loss at the corporate level is similar to a shareholder level 

loss attributable to unrealized depreciation. 

Example. The facts are the same as in the preceding example, except that the corporation sells the asset before the 

shareholder sells her stock. The corporation has no taxable income (and no EDA balance), so that the $40 loss 

represents an NOL carryforward available to offset future income. The shareholder sells her stock for $60 and 

realizes a $40 capital loss. 

25. Under current law, capital losses of individuals are allowed only to the extent of capital gains plus $3,000 of ordinary 

income. See IRC $ 121101). It would be possible to allow capital losses on corporate stock only to offset capital gains on 

corporate stock (plus $3,000 of ordinary income) and generally match loss and gain duplication to reduce loss duplication. 

See also IRC $9 269 and 382-84; Treas. Reg. $8 1.1502-21 and -22. 

Chapter 9 

1. A system of basis adjustments for retained earnings is inherent in the shareholder allocation prototype. See Chapter 3. 

A DRIP also may be appropriate in the imputationcredit prototype described in Chapter 11. Section 11.I discusses special 

considerations in adopting a DRIP in the imputation credit prototype. A DRIP would be unnecessary under CBIT if gains 

and losses are not taxed to investors, because basis in such investments would be irrelevant. 

2. This would not be true in the case of a dividend deduction system, discussed in Chapter 12. Under such a system, deemed 

dividendswould be taxable to shareholders but would give rise to a corporate level deduction. Thus, at minimum, a DRIP 

in a dividend deduction system would require shareholder consent, as under current law. While we do not address the issue 

further, we question whether a DRIP should be allowed in a dividend deduction system. Rate arbitrage might occur if a 

corporation and its shareholders can elect a current corporate level deduction in return for a shareholder level tax. 

3. For example,under the dividend exclusion prototype, a shareholdermust meet a 45 day holdingperiod in order to exclude 

dividends received. See Section 2.B. 

4. For example, dividend stripping generally results in basis reduction under current law, and the same rules may be 

appropriate in the context of a DRIP. Basis allocation rules also might be used. 

Example. The facts are the same as in Example 1, except that the fair market value of X shares at the time of the 

DRIP distribution is $10 per share. Under these circumstances, the basis of both Lot A and Lot B shares will exceed 

fair market value under either allocation method. In these circumstances, basis sufficient to bring the basis of all 

shares up to fair market value should be so allocated. The balance should be allocated to all shares, pro rata. 

5. The EDA would continueto be available to pay excludabledividends(or interest, in CBIT) on any class of stock (or debt, 

in CBIT). In theory, it would be possible to maintaina separate EDA, as well as a deemed dividend account, for each class 

of stock. However, such an approach would require unacceptably complex allocations of the EDA among classes of stock, 

similar to the allocations of corporate income required under the shareholder allocation prototype. See Chapter 3. 

6. We rejected three alternative rules. First, the stacking rule could treat cash distributions first as a return of capital to the 

extent of previous deemed dividends. The rule recommended in the text is more favorable than this rule for any corporation 

with a remaining EDA balance, because shareholderswould generally prefer excludable dividendsto basis reduction. Second, 

the stacking rule could follow current law and treat cash distributions as a return of capital only after a corporation’s earning 

and profits are exhausted. Deemed dividendsthat had been declared would reduce earnings and profits by the amount of the 

deemed dividend and cash distributions would be tax free to the shareholder to the extent treated as payments out of the 

remaining EDA. This rule would be consistent with the current treatment of corporate dividends and with the notion that 

shareholders recover capital only after recovering earnings. Under this rule, however, a corporation that had used the DRIP 

to eliminate its EDA balance but had additional earnings and profits attributable to retained preference income would be 
223 Notes 

required to pay taxable dividends before it could treat distributions as a retum of capital. While corporate shareholders 

entitled to a DRD might prefer taxable dividends to basis reduction, we believe that the rule in the text is more favorable 

to taxpayers in most cases. Finally, cash distributions might be treated entirely as dividends and no earnings and profits 

account or account of deemed dividendswould be kept. The advantage of the third alternative is that corporations would not 

need to keep an account of deemed dividends. This approach, however, may discourageuse of DRIPS. 

7. We would not permit DRIPS for debt in CBIT because interest is generally paid in cash as it accrues. As Section 4.G 

discusses, CBIT would generally retain OID or imputed interest rules to distinguish payments of interest from payments of 

principal. CBIT would not, however, retain the current rules governing the timing of imputed interest income. 

This approach raises the question of how accrual, e.g., Zero-coupon, and payment-in-kind bonds would be treated. 

Considerationshould be given to adopting rules that would prevent accrued discount (which, like interest, is not taxable to 

a debtholder when received) from being taxed as capital gain if the debt instrument is sold before the discount is paid. One 

approach would be to maintain the current OID timing rules. Accrued discount would increase a debtholder’s basis (but 

would not be includable in income) and would decrease the issuer’s EDA (but would not be deductible). Similar issues are 

presented by discount preferred stock. See IRC 0 305(c). 

8. Mechanically,a mandatory DRIP would operate like the elective DRIP, except that a corporation would be required to 

reduce its EDA to Zero at the end of each year through deemed or actual distributions. A mandatory DRIP might cause 

restrictions on the forms of equity eligible for DRIP distributions to be more desirable. 

Chapter 10 

1. Auerbach (1990) presents an overview of issues relating to gains and losses during the transition to integration. 

2. As indicated in Chapter 13, we believe the best empirical evidence supports the traditional view of dividends, which holds 

that the existing two-tier corporate tax has not been fully capitalized into share values. Accordingly, we believe that 

integration may create some transition gains to owners of corporate stock but that such gains will not be as great as those 

anticipated by advocates of the new view. 

3. The second and third transition concems described in the text are sometimes referred to as carryover problems. 

4. See Graetz (1977). 

5. See Section 2.B and Section 4.D, respectively. 

6. The stacking order rules for distributions from the EDA (see Sections 2.B and 4.D) may prolong the deferral of the tax 

on the retained earnings, however. 

7. The American Law Institute ReDorter’s Study Draft (1989) on corporate tax reform contains a deduction for dividends 

paid that would apply only to new equity. The proposals avoid the complexity of tracking new and old equity instruments 

by limiting the deduction to the product of a specified rate and capital contributed after the date of enactment of the 

proposals, less extraordinary distributions. American Law Institute (1989). See Section 12.C. 

8. The current rules governing the conversion of a C corporation, Le., a corporation taxed under the classical system, to 

one of the various passthroughentities suggest the difficultiesand complexities that would be involvedin attemptingto isolate 

old equity from new equity. These rules, which include the rules that apply to C corporations that convert to a partnership, 

an S corporation, or a RIC or REIT are concerned in varying degrees with preventing corporate income attributable to 

preconversion years from escaping the two-tier tax. None provides a particularly satisfying approach to dealing with the 

transition to an integrated corporate system. 

For example, an approach modeled on the existing rules for taxing C corporations that convert to partnerships would 

treat the corporation as though it had distributed all its assets to its shareholders in a liquidating distribution in with built-in 

gain or loss with respect to the assets is realized at the corporate level and built-in gain or loss with respect to the stock is 

realized at the shareholder level. The shareholders would then be treated as recontributing the assets to the corporation. This 

mark-to-market approach would tax all the built-in gain or loss with respect to assets at the corporate level and all the built-in 

gain or loss with respect to stock at the investor level. (Altematively, an approach modeled on the existing rules for taxing 

C corporations that convert to passthrough status as a RIC or REIT would confine the mark-to-market approach to the 

corporate level, with shareholders taking a carryover basis in their stock. See Notice 88-19, 1988-1 C.B. 486.) Although 
Notes 224 

the mark-to-market approach would eliminate any long-range transition effects from the change to an integrated corporate 

system, the substantial and immediate tax cost, together with the administrative burden that would ensue from the need to 

value all corporate assets, makes this approach unacceptable. 

A transitional approach also could be modeled on the existing rules for taxing C corporations that convert to S 

corporation status. Current law does not treat the conversion as a taxable event. However, S corporation shareholders are 

taxable on distributions from earnings and profits accumulated in C corporation years to the extent the S corporation’s 

distributions exceed its cumulative taxable income. IRC 0 1368. In addition, IRC $ 1374 provides that if the S corporation 

recognizes gain on an asset held at the time of the conversion within a 10 year period followingthe conversion, the gain is 

subject to a corporate level tax. The total amount of gain subject to corporate level tax cannot exceed the net built-in gain 

inherent in the corporation’s assets at the time of the conversion. IRC $ 1374(c)(2). Certain items of income and deduction 

that are attributable to periods before the conversion but have not yet been recognized are taken into account in computing 

the corporation’s built-ingain. IRC 0 1374(d)(5).This approach avoidsthe immediate tax cost associated with the partnership 

conversion model but does not avoid the valuation problem. It is administratively more burdensome than the partnership 

conversion model because the corporation has to make valuations on an asset-by-asset basis and monitor assets held at the 

time of the conversion (as well as income and deduction items attributable to pre-conversion periods) for a 10 year period. 

In addition, this approach distributes the tax burden of the transition to integration in an unequal manner because it allows 

those corporations with wasting assets or assets onwhich gain can be deferred beyond the end of the 10 year period to escape 

corporate level tax on the gain. 

9. The choice between limiting integration to newly contributed equity and extending it to all equity reflects assumptions 

about the extent that investor level taxes affect corporate dividend decisions and share prices. If dividend payments are 

unavoidable and shareholders do not place an intrinsic value on dividends relative to retained earnings, the classical system 

does not create any bias against dividend distributions, and investor level taxes on dividendsare already capitalized into share 

values. This is the new view of dividend distributions. See Section 13.B. If that view is correct, then applying integration 

to dividends from accumulated as well as newly contributed equity would not encourage dividends and would confer a 

transition gain to holders of existing equity, the price of which would increase. As discussed in Chapter 13, however, we 

reject the new view. Accordingly, we believe that extending integration to existing equity, particularly under a phase-in, 

would not confer unacceptable transition gains, and that retaining the classical system for existing equity would maintainthe 

tax bias against dividends for such equity. 

10. The Department of the Treasury recommended a phase-in approach in its 1984 proposal to provide relief from the double 

taxation of corporate income. That proposal generally would have allowed corporations a deduction equal to 50 percent of 

dividendspaid to their shareholders and also would have reduced the corporate dividendsreceived deductionfrom 75 percent 

to 50 percent. The proposed 6 year phase-in rule would have allowed a 25 percent dividendspaid deductionin the first year 

that would have increased by 5 percentage points in each of the next 5 calendar years. Similarly, the dividends received 

deductionwould have been 75 percent in the first year, with a 5 percentage points decrease in the deduction for each of the 

next five calendar years. See Treasury I, Vol. 2, pp. 136-137, 140. 

11. The imputationcredit prototypedescribed in Chapter 11 could be phased in. The imputationcredit prototype contemplates 

additions to the SCA and associated shareholder level credits by reference to the maximum tax rate applicable to 

shareholders, currently a 3 1 percent rate. Where the corporate tax rate is less than the maximum shareholder rate, it would 

be appropriate to base shareholder credit account and imputation credit amounts on the lower corporate tax rate. This level 

of integration might be phased in two alternative ways. First, a phase-in rate might be set as a percentage of the maximum 

shareholder rate to accomplish a smooth phase-in of integration. For example, a 5 year phase-in could base the shareholder 

credit account additions and allowable shareholder credits on a rate equal to 20 percent of 31 percent (6.20 percent) in the 

first year, 40 percent of 31 percent (12.40 percent) in the second year and so on. Alternatively, the imputation credit 

prototype might be phased in by linking imputationcredits to a shareholder tax rate less than the maximum individual rate. 

For example, SCAs and imputationcredits might be based on the 15 percent individualrate for a several years before moving 

to the 31 percent rate. If only partial distribution-related integration were contemplated, this system could be used 

indefinitely. Such a system would be similar to the United Kingdom’s imputation system. See Appendix B. 

12. See generally Graetz (1977). 

13. Most corporate debt may be called without premium after a period of time, typically 5 to 7 years. Debt instruments 

typically permit the debt to be called earlier upon payment of a redemption premium. A CBIT phase-in is likely to 

significantly mitigate the increase in the cost of borrowing because corporations would be able to call their debt in substantial 

part before the disallowance of the interest deduction is fully phased in. 

14. See Section 4.G. 
225 Notes 

15. If an accrual method taxpayer accrues but does not pay interest before the CBIT phase-in begins, then pays the previously 

accrued interest in a CBIT transition year, this approach assures that either holder level tax (in the form of the portion of 

dividends and interest includable in the income of shareholders or debtholders) or compensatory tax is paid on such interest. 

16. The formula for transition years' additions to the EDA would be: 

+ p(dividends and interest received from CBIT entities) + p(allowab1e interest deduction) 

where p is the transition percentage. 

17. As Section 4.D discusses, payments of interest and dividendsreduce the EDA in the order in which they are made. These 

examples assume, for purposes of illustration, that interest payments are made first and thus reduce the EDA first. 

PART IV 

Introduction 

1. Australia, Denmark, Finland, France, Germany, Ireland, Italy, New Zealand, and the.United Kingdom have all adopted 

imputation credit systems. See Appendix B for a discussion of certain of these countries' systems. 

2. Differences among dividend exclusion, dividend deduction and imputation credit systems of integration are due to 

differences in tax rates applicable to different shareholders or types of income. See Appendix C. 

Chapter 11 

1. Individual shareholders subject to rates less than 31 percent would be allowed to use the credits against tax on other 

income. See Section ll.E. 

2. The grossed-up dividend is the cash dividend received by the shareholder divided by one minus the maximum individual 

tax rate (cash dividend1 -.31). 

3. Additional restrictions on the amount of the credit would be imposed to prevent streaming of credits to taxable 

shareholders, and consideration could be given to requiring corporations to frank dividendswith credits at the full 31 percent 

rate as long as there is a balance in the SCA. See Section ll.F. 

4. See also note 48, below. 

5. A compensatory tax may take either of two forms. First, it might apply only to distributions of earnings that have not been 

taxed at the full corporate rate. This requires a corporation to determine the amount of corporate tax deemed to have been 

paid with respect to each distribution and to pay additional tax to the extent that earnings used to make the distribution have 

not been subject to tax at the full corporate rate. The French and German systems follow this model. See Appendix B. 

Alternatively, the compensatory tax might be imposed on all distributions, regardless of the amount of corporate tax 

previously paid, with the compensatory tax allowed as a credit against regular corporate tax. Under such an "advance tax" 

system, a corporation is not required to determine explicitly the amount of tax deemed paid on a particular distribution. In 

an advance tax system in which the shareholder credit is computed using a corporate tax rate of 34 percent, a corporation 

is required to pay a compensatory tax on all dividends equal to 51.5 percent of the dividend (.34/.66). The corporationwould 

be entitled to credit this tax against its regular corporate tax liability. Shareholderswould be entitled to a credit equal to 51.5 

percent of the amount of any cash distribution, and the credit would be includedin income together with the cash distribution. 

The 51.5 percent rate applied to net cash dividendsis used in lieu of applying the 34 percent corporate rate to a grossed up 

amount; 51.5 percent of a $66 cash dividend ($34) equals 34 percent of $100, the $66 cash dividend grossed up at the 34 

percent rate ($66/.66). A corporation's ability to credit the compensatory tax against its regular corporate tax liability means 

that the compensatory tax results in additional tax liability only to the extent that distributions exceed the amount of fullytaxed earnings between the two regimes. The United Kingdom's Advance Corporation Tax (ACT) system represents an 

example of the second type of compensatory tax. 
Notes 226 

The principal substantivedifference is that the advance tax systemimplicitlytreats distributions as made first out of fullytaxed income, while a compensatory tax can, in theory, be combined with any stacking rule. In practice, most existing 

compensatory tax systems, such as those in France and Germany stack distributions first against fully-taxed income. While 

they differ mechanically, the two alternativeshave similar economic impact on corporations subject to the compensatory tax. 

6. If a compensatory tax is set at the corporate tax rate and is refundable to shareholders so it acts solely as a withholding 

tax, all distributed income is taxed only once, at shareholder rates. Although the tax is collected at the corporate level, rather 

than at the shareholder level, no net separate corporate level tax is imposed. The compensatory tax, however, serves to 

ensure payment of the shareholder level tax as preference or shielded foreign source income is distributed. The refund of 

imputation credits associated with distributionsmeans that the net amount of tax borne by the distribution will be determined 

solely by the shareholder's tax rate and taxable or tax-exempt status. 

7. Timing preferences, as well as exclusion preferences, would increase the corporate level cost of dividends in a 

compensatory tax system. A compensatory tax requires current payment of tax on distributed preference income, thus 

removing the tax deferral created by timing preferences. Consider a firm with $100 in economic income in year one and 

$100 worth of timing preferences. Suppose further that in year two its economic income is zero (but tax is due on the $100 

deferred from the year before) and that the firm distributes all of its income in year one. With a compensatory tax, the firm 

has to pay $34 in year one; there is no mainstream tax to which the credit can be applied. Thcrefore, it carries over the $34 

credit to year two, so that in year two its tax liability is zero. In contrast, under a credit limitation system, no tax is paid 

in year one, but $34 is paid in year two.Thus, if the firm's economic income is distributed as it is earned, the present value 

of timing preferences to the firm under the credit limitation scheme is greater than under the compensatory tax scheme. On 

the other hand, taxable shareholders would receive credits in year one in a compensatory tax regime that they would not 

receive in a credit limitation system. The overall effect, therefore, would depend on the relationship of the compensatory 

tax rate to that of the shareholders. 

8. The imputationcredit prototype, like the dividendexclusion prototype, is not expected to change significantlycorporations' 

provision for income tax expense or the determination of taxes currently payable or payable at a future date for financial 

accountingpurposes. Note 1in Chapter 4 discusses the possible effect of a compensatory tax on corporate financial reporting. 

9. Mechanically, one can determine which distributions are made out of fully-taxed income either by tracing taxable and 

preference income or by tracking taxes paid. A tracing-of-income approach requires the corporation to maintain different 

accounts for earnings and profits that have been taxed at different rates, including different accounts for income earned in 

different years, if tax rates have changed from year to year. We consistently recommend tracking taxes paid rather than 

tracing taxable income. See Section 2.B, Section 4.D, and Section 12.A. Tracking taxable income is significantly more 

complicated than tracking taxes paid and does not seem to offer any offsetting advantages. Australia's imputation credit 

system tracks taxes paid. The French and German imputation credit systems illustrate the complexity of tracking income. 

See Appendix B. 

10. The following example compares three alternative stacking rules. The example assumes that the corporation pays tax at 

either 34 percent (nonpreference income) or 0 percent (preference income) and that corporate taxes paid are credited at the 

31 percent shareholder rate. 

Alternative Stacking Rules 

Stack Stack 

Preferences Preferences Pro Rata 

Last First Stacking 

Economic Income 100 1OQ 100 

Preference Income 10 10 10 

Taxable Income 90 90 90 

Tax (@34%) 30.6 30.6 30.6 

Preference Income Available for Distribution 10 10 10 

Nonpreference Income Available for Distribution 59.4 59.4 59.4 

Cash Distribution 50 50 50 

Tax Deemed Paid on Distribution 22.46 17.97 20.22 

The "stackpreferences last" approach treats each dollar distributed as coming first from nonpreference income. The $50 

distributed is less than the amount of nonpreference income available for distribution, thus, the distribution is deemed to be 

entirely nonpreference income. The "stack preferences first" approach treats each dollar distributed as coming first from 

preference income (taxed at zero percent) and then from nonpreference income. Thus, the first $10 distributed is deemed 
227 Notes 

to have borne no tax. The pro rata stacking approach treats each dollar as from preference and nonpreference income in the 

same proportion as the corporation’s after-tax preference and nonpreference income. The pro rata approach thus treats each 

dollar distributed in the example as having borne tax at an effective rate of 30.6 percent (90/100X34%)+(10/100XO%). 

The indirect foreign tax credit allowed under IRC 9 902 to certain U.S.corporate shareholders uses a pro rata stacking rule 

to determine the amount of foreign taxes associated with distributions from foreign corporations to related U.S.corporations. 

11. The ACT in effect stacks distributions first against fully-taxed income. For example, assume that the corporate rate is 

33 percent and the credit rate is 25 percent, and that a corporation earns $100 of fully-taxed income and $100 of preference 

income in a year. If the corporation distributes $100, it will pay ACT of $33.33 (.25 X$100/.75). It will owe mainstream 

tax for the year of $33 and will be permitted to credit $25 of ACT against the mainstream tax. Thus, its tax liability for the 

year will be $8. The effect is the same as if the corporation had first paid $33 of mainstream tax and then paid a $133.33 

grossed-up distribution, deemed to be composed of $100 of fully-taxed income and $33.33 of preference income. 

Compensatory tax of $8.33 (.25 X$33.33) would be due on the distribution. In both cases, the total tax paid is $41.33. 

In contrast, the French and German systems explicitly adopt stacking rules that stack preferences last. The German 

system uses an “available net equity” account to track taxable and preference income. Available net equity is divided into 

separate “EK” baskets, consisting of income taxed at various rates. The balances in EK 50, EK 36 and EK 0 represent 

income taxed at the statutory retained earnings rate, the statutory distribution rate and at a zero rate, respectively. However, 

the corporation’s income may actually be subject to rates other than those for which corresponding EK categories exist. The 

German system converts each category of income subject to tax at some other rate into equivalent amounts of EK 36 and 

either EK 50 or EK 0, as appropriate. 

The following equation converts pre-tax income subject to tax at some non-EKrate into equivalent amounts of pre-tax 

income subject to tax at the distribution rate (36 percent) and either the statutory rate (50 percent) or the zero rate: .36X+(.5 

-or 0) X(Y-X) = T, where Y equals the total amount of pre-tax income (known), X equals pre-tax income subject to the 

distribution rate, (Y -X) equals pre-tax income subject to either the statutory rate or the zero rate, and T equals the amount 

of tax paid with respect to Y (known). Because X and (Y-X) must be positive, the effective tax rate, T/Y, determines 

whether the equation must contain the statutory rate or the zero rate (and whether the residual amount of income is converted 

into EK 50 or EK 0). The following equations convert the pre-tax amounts, X and (Y-X), into their after-tax EK amounts: 

EK36 = (1-.36)XX 

EK50 (IfT/Y > .36) = (1-.5O)X(Y-X) 

EK 0 (If T/Y < .36) = Y-X 

French corporations are required to segregate fully-taxed income from income potentially subject to the compensatory 

tax or precompte mobilier for tax accountingpurposes. In general, dividends eligible for the imputation credit or avoir fiscal 

are deemed to be distributed first out of current fully-taxed income, and then out of fully-taxed retained income of each of 

the immediately preceding 5 years. Once fully-taxed income for this 5 year period has been exhausted, a corporation may 

choose to allocate a dividend distribution to (1) dividends received from foreign subsidiaries, (2) the long-term capital gains 

reserve, or (3) other miscellaneous preference income, in any order. France thus allows stacking of dividends last against 

preference income. 

Appendix B discusses these systems in more detail. 

12. The formula set forth in the text is based on the formula used to determine the EDA in the dividend exclusion and CBIT 

prototypes. Multiplying the EDA formula by (U.69-1) converts after-tax income at the 34 percent corporate rate into 

imputation credits at the 31 percent maximum shareholder rate. 

13. If the 34 percent corporate rate were the credit rate, the credit in the example in the text would equal $17 and the 31 

percent shareholder would have an excess credit of $2.17 to offset other tax liability. 

14. This is the method used, for example, by New Zealand. See Appendix B, Section B.5. 

15. In general, the treatment of the adjustment as a current year item should extend only to determining the SCA balance. 

Interest on deficiencies or overpayments should be calculated as under present law. Under a compensatory tax, if liability 

is adjusted upward, the corporation would either be allowed to use accumulated excess compensatory tax to satisfy the 

liability or, if there is no excess, would be required to pay additional tax. If a corporation’s prior year tax liability is adjusted 

downward, it would either increase the balance in its excess compensatory tax account, or to the extent it did not use the 

prior year tax liability to avoid compensatory tax on distributions, it would receive a refund. The corporation would not 

receive a refund of the corporate taxpayment where it has been used to avoid compensatory tax because this corporate tax 
Notes 228 

payment has been claimed as a credit by shareholders. If a refund were allowed, shareholders would have been able to claim 

a credit for taxes that the corporation, after allowance of the refund, did not actually pay. 

16. The contrary approach, which would treat audit adjustmentsas an adjustment to the SCA in the taxable year to which 

the adjustment relates, is complicated and burdensome. Under that approach, a corporation that receives a refund of corporate 

tax paid may have reported to shareholders credits in excess of its adjusted balance in the SCA. An unanticipated reduction 

would occur in the SCA for the year in question, which the corporation would have to satisfy by reducing its remaining SCA 

in that year, or, if there were no remaining SCA, by paying tax equal to the deficit SCA balance (together, possibly, with 

imposition of penalty or interest). 

17. Allowing a loss to be carried back to obtain a refund of some or all of the taxes used to frank a dividend may be 

appropriate in theory, particularly if the corporation’s shareholders are the same at the time of the dividend and the loss, but 

would be difficult to implement in practice. For purposes of determining shareholder level consequences, the franked 

dividend could be recharacterized retroactively as a retum of capital or a distribution of preference income, depending upon 

whether the corporation had sufficient retained preferences income at the time of the dividend. If the distribution constituted 

a retum of capital, no shareholder level tax would be due, but basis in the stock would be reduced by the amount of the 

distribution (which would not be grossed up for the credit). If the distribution were paid out of preference income, the 

amount of shareholder level tax would be computed only on the amount of the distribution (which also would not be grossed 

up for the credit). Requiringretroactive adjustments in shareholders’basis or tax liability would be impractical to administer, 

however, especially if shares of a corporation are widely held. 

The argument that tax refunds should be limited to the SCA balance is weakened somewhat because, under the credit 

limitation systemwithout full refundability, amounts withdrawn from the SCA to frank past dividendsmay not actually have 

been used by shareholders. Shareholders cannot obtain refunds of imputation credits, and thus tax-exempt, foreign and some 

low-bracket shareholders may not enjoy the benefit of some imputationcredits. In contrast, in a systemwith full refundability 

of imputation credits, all SCA amounts used to frank dividends would be fully used by shareholders. While there is thus 

some theoreticaljustification for allowingrefunds in excess of the SCA to the extent that the imputationcredits were not fully 

used, it would be impractical to trace the use of the imputation credits by shareholders. 

18. Current law contains limitations on the ability of taxpayers to accelerate the recognition of losses or to increase the 

amount of loss recognized for tax purposes to an amount exceeding the loss incurred economically. Such limitations include 

limitations on the deductibility of investment interest, passive activity losses, and amounts in excess of the amount the 

taxpayer has at risk with respect to an activity. Under present law, these limitations either do not apply to C corporations 

or apply only to C corporations that are personal service corporations or closely held corporations (essentially defined as 

corporations more than 50 percent of the stock of which is held by or for five or fewer individuals). 

By eliminating or reducing substantially the tax disadvantages of incorporation, distribution-related integration may 

encourage the use of corporations to avoid these rules. Because distribution-related integration removes the double tax on 

distributed corporate earnings, taxpayers may view corporations as attractive vehicles for engaging in activities designed to 

accelerate or increase tax losses. For example, individuals might use passive activity losses by contributing a loss-producing 

passive activity and an income-producing active business to the same corporation. The deferral benefit achieved by this 

structure would continue until the earnings sheltered by the preference were distributed. Distributed income would be fully 

taxable to taxable shareholders, although it would be tax-exempt in the hands of exempt shareholders. In addition, the income 

generated when the preference reverses would be subject to only one level of tax. Thus, it may be appropriate to extend some 

of or all the loss limitation rules described above to C corporations if, after distribution-related integration is adopted, 

experience shows that taxpayers are using C corporations to avoid those rules. 

19. A dividends received exclusion (DRE) would be as effective as a DRD in preventing multiple taxation of corporate 

dividends. The two could, however, produce different technical effects increases where Code limits or classifies taxpayers 

based on receipts or income. For example, dividends are taken into account under IRC 0 448@)(3), which limits the 

availability of cash method accounting for certain taxpayers with annual gross receipts in excess of $5 million. See Treas. 

Reg. 0 1.448-1T(f)(2)(iv). By contrast, dividends are excluded under IRC 9 263A(b)(2)(B), which limits capitalization of 

cost requirements for certain taxpayers whose annual gross receipts do not exceed $10 million. See Treas. Reg. 0 1.263AlT(d)(2)(iv)(B). Regardless of the general approach, however, special adjustments may be provided wherever appropriate. 

See, e.g., IRC 0 170(b)(2)(B)(corporate charitable deductionsare limited to 10percent of taxable income determined without 

regard to the DRD). During any period of transition to integration, the current law DRD could be increased in stages from 

70 percent to 100 percent as the percentage of integration increases. During periods when there is less than 100 percent 

integration, a 100 percent DRE would be inappropriate and also would require appropriate phase-in. 
229 Notes 

20. If all dividends were either fully unfranked or completely franked, it would be relatively easy to retain the current 70 

or 80 percent DRD. The mechanics would be similar to those discussed in Section 2.B in the context of the dividend 

exclusion system. Partially franked dividends would create significant complexity, however. To determine its DRD a 

corporation eligible for only a 70 or 80 percent DRD would have to separate a partially franked dividend into a fully franked 

portion and a completely unfranked portion. 

Examule. A corporation that has a zero SCA balance owns 5 percent (by vote and value) of the stock of a second 

corporation and has no other assets. The second corporation pays a cash dividend of $166, which carries an 

imputation credit of $29.65. 

The recipient corporation must convert the partially franked dividend into fully franked and unfranked components. 

A $29.65 imputationcredit would fully frank a cash dividend of $66. Thus, the unfranked dividend is $100 ($166-

$66). After taking into account the 70 percent DRD, the corporation must pay tax of $10.20 on $30 of income. 

Using the formula in Section ll.B, the corporation would add $38.55 ($29.65 for the credits received on the franked 

portion plus $8.90 with respect to the $10.20 of tax paid on the unfranked portion) to its SCA. If the corporation 

then distributedall its remaining cash to shareholders, it would distribute $155.80 of cash ($166-$10.20) and attach 

an imputationcredit of $38.55. Assuming a 31 percent shareholderrate, shareholders would pay tax, after claiming 

imputation credits, of $21.70 (($194.35 gross dividendx.31)-$38.55). This represents shareholder tax at the 31 

percent rate on the remaining $70 of preference income not taxed in the hands of either corporation. 

21. The alternative would tax the recipient corporation on the dividend and permit the tax to be offset by any imputation 

credit attached to the dividend. The imputation credit and any additional corporate taxes paid on the dividendwould increase 

the recipient’s SCA. This alternative rule would eliminate tax preferences upon the initial distribution of preference income, 

whether the distribution was made to a corporate or an individual shareholder. 

22. A compensatory tax system might suggest a different result. Once the decision is made to tax distributed preference 

income to the distributing corporation, the rationale for extending preferences while the distributed income is in corporate 

solution may not be compelling. See Section 4.D. As noted in the text, however, some countries with compensatory tax 

systems (notably the United Kingdom) forgo the compensatory tax for certain intercorporate dividends. 

23. See H. Rept. No. 426, 99th Cong., 1st Sess. (1985), p. 302; S. Rept. No. 313, 99th Cong., 2nd Sess. (1986), p. 515. 

24. If, unlike the prototype recommended here, the SCA were based on tracing taxable income, difficulties with respect to 

the AMT would arise in determining the amount of tax that has been paid with respect to a particular distribution by a 

corporation that has paid AMT. However, under the tracking-tax-paid approach, adding minimum taxes to the SCA can be 

done directly. As indicated in note 26, the amount added to the SCA would be adjusted to reflect the maximum 31 percent 

rate at the shareholder level. Indeed, the need to allow imputation credits with respect to corporate AMT is an important 

reason for preferring the tracking-of-taxes-paid approach to a tracing-of-taxable-income approach under the credit limitation 

system. 

25. The corporate AMT also seems appropriate under a compensatory tax. While a compensatory tax would prevent the 

passthrough of preferences to shareholders, it would not ensure that corporations pay some level of tax on retained income. 

Imputation credits attached to a dividend represent tax prepaid at the corporate level and thus should be allowed for 

purposes of the individual AMT. 

Example. A shareholder with a 31 percent marginal rate has $100 of AMT preference income, a $100 gross 

dividend, and a $31 imputationcredit. Her AMTI is thus $200. She should owe only $17 in AMT ($48 of tax less 

the $31 imputationcredit). Mechanically, this can be accomplished by computing her regular tax for AMT purposes 

as zero ($31 of tax less $31 imputation credit), but allowing the full imputation credit in computing tentative 

minimum tax. Thus, her tentative minimum tax is $17 ($48-$31) and her AMT is $17 ($17-0). 

Similarly, we recommend that excludable dividendsnot be viewed as preference income for individual AMT purposes 

under the dividend exclusion and CBIT prototypes. See Section 2.E and Section 4.D. 

26. Although the AMT rate is 20 percent, compared with the maximum shareholder rate of 31 percent, corporate AMT 

payments are not added dollar-for-dollar to the SCA but instead, like regular tax, are reduced to reflect the difference 

between the corporate and shareholder rates. This rule is necessary because corporate AMT payments give rise to an equal 

AMT credit that offsets regular corporate tax at the 34 percent rate. 
Notes 230 

Example. A corporation invests $100 in an asset that will produce $100 per year for 2 years. As a deferral 

preference, the corporation is entitled to expense the asset in the first year. 

Year Cash Taxable AMT Regulartax AMT TaX Cummulative 

flow income before credit credit due SCA 

1 100 0 20 da da 20 17.44 

2 100 100 da 34 20 14 29.65 

At the end of year two, the corporation has an SCA of $29.65 and $66 of retained earnings. The corporation 

distributes $66 to shareholders, and no additional tax is due. If the AMT were instead added to the SCA dollar-fordollar, the corporation would have an SCA of $32.21 and excess credits of $2.56. 

27. Mechanically, the limitation on additions to the SCA allows distributions by the U.S. corporation out of earnings 

attributable to dividends from the foreign corporation to be treated in the same manner as distributions out of earnings 

attributable to preference income from U.S. sources. 

28. IRC 9 901. 

29. Section 2.C discusses a shareholder level exclusion of foreign source income. 

30. Continuing to tax income distributed to shareholdersbut preserving the benefit of preferences for tax-exempt shareholders 

under a compensatory tax system would require making imputation credits attributable to the compensatory tax fully 

refundable to tax-exempt shareholders. If policymakers were to choose to tax preference and foreign income as well as 

nonpreferenceincome received by tax-exempt shareholders, a compensatory tax should be adopted with nonrefundability of 

credits to tax-exempt shareholders. This result cannot be accomplished under a credit limitation system without a 

compensatory tax. Such a compensatory tax system might be limited to preference income, but this would require separate 

tracking of foreign source income, which could continue to be paid free of U.S. tax to tax-exempt entities. Alternatively, 

if, contrary to the recommendations here, one chooses to tax neither preference nor nonpreferenceincome distributed to taxexempt shareholders, credits should be made refundable to tax-exempt shareholders; a system of refundable credits could 

be provided with either a compensatory tax or a credit limitation system. Refundability, however, would cause significant 

revenue loss. 

31. See also Section 6.D for a discussion of an alternative approach under an integrated system that could be designed to 

maintain the overall level of tax revenues collected on corporate capital supplied by tax-exempt entities and achieve greater 

neutrality between the tax burden on their debt and equity capital. 

32. Assume, for example, that a U.S. corporation with 1,000 shares outstanding of a single class of stock and an SCA 

balance of $2,000 makes a distribution of $10 per share and designates $2 per share as the applicable imputationcredit with 

respect to each share. One hundred of the corporation’s shares are owned by a foreign person subject to U.S. withholding 

tax at a rate of 15 percent under an applicable tax treaty. The foreign shareholder will be subject to U.S. withholdingtax 

of $150 on the distributionof $1,OOO (100 sharesX $10 distribution X 15 percent withholdingtax). The corporationwill reduce 

its SCA by $2,000, although the foreign shareholder cannot offset the imputation credit against the U.S. withholdingtax. 

33. Considerationmight be given to allowing a shareholder to carryforward unused imputation credits for some period of 

time, such as 5 years. Such a carryforward would add complexity, but should serve to enable virtually all shareholders 

subject to original tax rates below 31 percent and those currently in a tax-loss position to use any excess credits. 

34. If imputation credits were fully refundable to all taxpayers, corporations and their shareholders would have no tax 

incentive to develop strategies for directing the credit to particular taxpayers. Because fully refundable credits would be 

equally valuable to all taxpayers, taxpayers would be indifferent to the form of a distribution, e.g., a $69 dividend carrying 

a $31 credit versus a $100 dividend carrying $0 credit or $100 of interest or other income such as rent or wages. However, 

in accord with the recommendations of Chapters 6 and 7, this prototype does not permit refunds of credits to tax-exempt 

or foreign shareholders. Credits thus would be available only to offset tax liability the taxpayer would otherwise owe on the 

dividends or other income. As a result, certain taxpayers, e.g., tax-exempt and foreign shareholders, would not be indifferent 

between receiving a dividend carrying a credit and a higher cash dividend distribution because to them the credit would not 

be the equivalent of cash. 
231 Notes 

If the alternative tax on investment income, described in Section 6.D, were adopted, imputation credits would be used 

by tax-exempt entities to reduce or eliminate that tax and the incentives for streaming would be reduced. 

35. One difference is that the imputationcredit prototype allows low-bracket shareholders to use excess credits to offset tax 

on other income. 

36. New Zealand requires a corporation generally to frank all dividends paid during a year to the same extent even if the 

dividends relate to different classes of stock. A corporation may change its franking ratio during a year only if an officer 

of the corporation declares that the change is not "part of an arrangement to obtain a tax advantage" and the corporation 

notifies the tax authorities of the change. 

Australia has adopted several rules to prevent a corporation from underfranking a dividend. These rules require the 

corporation (1) to take into account all dividends that are paid on the same day, that have been declared but not yet paid, 

or that the corporation is committed to pay later in the same year (a "committed future dividend"), e.g., dividends on 

preferred stock, in allocating franking credits to a given dividend, (2) to frank a dividend that was a committed future 

dividend at the time of payment of an earlier dividend at least to the same extent as the earlier dividend, and (3) to frank 

a dividend at least to the same extent as any other dividend paid on the same day. These rules, however, do not prevent a 

corporation from franking an earlier dividend at one rate and franking a later dividend at a lower rate if the corporation is 

not committed to pay the later dividend or the later dividend is paid in the next year. 

Additional anti-abuse rules might be adopted as necessary. See Appendix B for a discussion of anti-streaming rules 

adopted by certain of our trading partners. 

37. The implementation of distribution-related integration may require certain adjustments to the treatment of qualifying 

reorganizations to reflect the shareholder credit system. One issue is whether the current law treatment of "boot" (money 

or property other than stock or securities in a corporate party to the reorganization) is appropriate under distribution-related 

integration. Under current law, a shareholder receiving boot in a reorganization recognizes gain equal to the lesser of the 

gain realized and the amount of boot received. If the receipt of boot has the effect of a dividend, gain recognized is taxed 

as a dividend to the extent of the shareholder's ratable share of the corporation's earnings and profits. Dividend equivalency 

is tested by treating a target shareholder as receiving only stock of the acquiring corporation and the acquiring corporation 

as then redeeming an amount of the shareholder's stcck equal to the amount of boot received. 

The current treatment of boot raises problems under distribution-related integration because of the rule that limits the 

amount of boot that is taxable to the amount of the recipient's realized gain. Under distribution-relatedintegration, this would 

allow the distribution of preference income to high-basis shareholders without shareholder level tax. It also would allow the 

distribution of fully-taxed income to high-basis shareholders without a reduction in the SCA, so amounts in the SCA 

subsequently could be used to frank distributions of preference income. This is similar to the issue created by share 

repurchases. If policymakers adopt special rules for share repurchases, similar rules may be appropriate for boot. See 

Chapter 8. 

38. Assume, for example, that a corporation has two active businesses, each generating a mix of taxable and preference 

income. If the corporation could isolate each of the businesses in a separate corporation but leave the entire SCA balance 

in one corporation, shares of the corporation without any SCA balance could be distributed to tax-exempt shareholders, and 

shares of the corporation with the SCA balance could be retained by taxable shareholders. 

39. In April 1990, RepresentativeVander Jagt introducedlegislation that essentially adopts this approach. H.R. 4457, 10lst 

Cong., 2d. Sess. (1990). The Vander Jagt bill would allow a tax credit to a shareholder or bondholder equal to the "gross-up 

amount" included in the holder's income. A recipient of a cash dividend or interest payment from a C corporation would 

include the gross-up amount, as well the cash received, in income. However, the amount of the credit would be limited to 

a portion of the taxpayer's tax that equals the ratio of his interest and dividend income to his total income. A corporation 

would be required to attach credits to a payment of interest or dividendsrepresenting the same proportion of the corporation's 

post-1989 taxes as the ratio of the amount of the net dividend or interest payments bears to post-1990undistributed earnings 

and profits. No deduction would be allowed for interest or original discount paid or accrued by a C corporation. See also 

note 1 in Chapter 4. 

The ALI Reporter's recent integration memoranda also adopt such an approach. See American Law Institute, ReDorter's 

Memorandum No. 3 (1991). 
Notes 232 

40.A bondholder credit system could be adopted either while retaining the current deduction for interest paid by corporations 

or in a system denying deductions for either interest or dividendsat the corporate level. Retaining the deductibility of interest 

would require imposing a withholding tax on interest payments and allowing recipients a credit for such withholding. The 

following example shows the calculation of the imputation credit with and without an interest deduction. 

Example. For simplicity, this example assumes that the corporate rate is 31 percent. A corporation earns $100 of 

taxable income and agrees to pay $50 of after-tax interest. If no interest deduction is allowed, the corporation would 

pay tax of $31 and would add $31 to its taxes paid account. The taxes paid account would represent available 

imputation credits for both interest and dividends. The corporation could attach an imputation credit of up to $22.46 

to the interest payment. The $8.54 remaining in its taxes paid account would fully frank its remaining after-tax 

earnings of $19. 

If an interest deduction is allowed but a withholding tax on interest is imposed, the corporation would have to pay 

gross interest of $72.46. Net of the 31 percent withholding tax ($22.46), the interest payment would be $50. Taking 

into account the $72.46 interest deduction, the corporation would have taxable income of $27.54 and would owe 

tax of $8.54. Thus, the total tax paid would be $31 ($22.46+$8.54). The corporation’s SCA balance, which would 

be available only to frank dividend payments, would be sufficient to frank a dividend of its remaining after-tax 

earnings of $19. 

41. Therefore, CBIT might be viewed, to some extent, as substituting taxation of the payor for taxation of the recipients. 

To illustrate the concept of substitute taxation, assume a manufacturer borrows $100 for one year and agrees to pay $10 of 

interest to the lender. Assume both the manufacturer and the lender have a 31 percent marginal tax rate. The manufacturer 

plans to use the $100 to produce a product that will provide a return sufficient to pay $110 to the lender at the end of the 

year, At the end of the year, the manufacturer sells the product for $115. Under current law, the manufacturer’s taxable 

income is derived by deducting from its $115 of gross sales $100 for wages, materials, and other costs of producing the 

product, and $10 for interest expense. The manufacturer would be liable for tax of $1.55 ($5X.31), and would use the 

remaining $113.45 ($115-$1.55) to repay the $100 principal on the loan and the $10 interest, leaving an after-tax return 

of $3.45. The lender would pay $3.10 of tax on its interest income ($lOX.31) and would receive an after-tax return of 

$6.90. 

Under CBIT, the lender need only be paid $6.90 in interest. The manufacturer’s taxable income would be determined 

by deducting from gross sales the $100 for wages, materials, and other production costs. Thus, the manufacturer would have 

taxable income of $15 ($115-$100) and would pay $4.65 of tax ($15X.31). The manufacturer would then use the $110.35 

in after-tax gross receipts ($115 -$4.65) to pay $100 in principal on the loan and $6.90 in interest to the lender. The lender 

would not include the $6.90 of interest it received in its taxable income, because the tax on that income was by the 

manufacturer. The manufacturer’s after-tax return would be $3.45 ($110.35-$106.90), and the lender’s after-tax return 

would be $6.90. Compared to current law, the manufacturer’s $4.65 CBIT liability can be viewed as including the same 

$1.55 of income tax on the manufacturer, and an additional tax of $3.10 on the lender’s interest income; CBIT substitutes 

an additional $3.10 of tax on the borrower for the income tax that current law would impose on the lender. 

42. The fact that the imputation credit system taxes income at the shareholder’s or lender’s rate creates other differences 

between the two models. For example, no small business exception would be needed. The bondholder credit system, like 

an imputation credit system, also provides greater flexibility to change policy recommendations in the future. For example, 

relief could be provided to tax-exempt and foreign investors simply by permitting full or partial refunds of imputation credits. 

Compare Section 4.F. As with the imputation credit system, however, this flexibility is earned at the cost of substantial 

complexity. 

43. It may be appropriate to retain the withholding tax for unfranked dividends and interest payments. The issue is the same 

as the treatment of taxable dividends and interest payments if no compensatory tax is imposed under CBIT. See Section 4.E. 

44. Example. A corporation earns $100 of taxable income, pays tax of $34, and adds $29.65 to its SCA. See 

Section ll.B for a discussion of how the SCA balance is calculated. The corporation could elect to pay 

deemed dividends of up to $66 (($29.651.31-$29.65) = $66). If the corporation declared a deemed 

dividend of $66, shareholders would include $95.65 in income and would be entitled to imputation credits 

of $29.65. Share basis would increase by $66. 

45. Excess credits could be used to offset other tax liability, but would not be refundable, as with imputation credits attached 

to a cash dividend. 

46. See Section 9.A for a discussion of the allocation of basis among shares. 
233 Notes 

47. The prototype also adopts a holding period requirement and extends certain other rules of current law. See Section 1 l.F. 

Those rules would apply to deemed dividends as well as to cash dividends. 

48. The rule described in the text would not prevent a corporation from adopting a dividend policy under which it pays 

unfranked cash dividends. It would, however, prevent a corporation from &h paying partially franked or unfranked 

dividends and using the elective DRIP. Neither of the two common reasons that might lead a corporation to pay partially 

franked or unfranked dividends arise in circumstances in which a DRIP would be useful. First, a corporation might want 

to distribute cash but have an insufficient SCA balance to frank all dividends fully. In that case, however, the SCA balance 

will be completely exhausted by the cash distributions, and the corporation will neither need nor be able to use the DRIP. 

Second, the corporation might want to retain an SCA balance to frank future distributions. If the corporation intends to retain 

an SCA balance for future use, however, it would not use the DRIP to reduce its SCA balance. 

Chapter 12 

1. See Treasury I, Vol2, pp. 136-37, 140; and The President’s 1985 Proposals, pp. 122-26. A partial or full deduction for 

dividends paid is often expressed in terms of a split rate system, in which distributed earnings face a lower tax rate than 

retained earnings. With a full dividend deduction, a split rate system results in a zero corporate tax rate for distributed 

earnings. With partial dividend deductibility, the effective rate of deduction is (t,-tJ/t,, where t, and td are, respectively, 

the tax rate on retained earnings (the corporate rate) and distributed earnings. 

2. Although a dividend deduction could avoid extending integration benefits to tax-exempt and foreign shareholders by 

imposingnon-refundable, corporate level withholding, such a system replicates the imputation credit discussedin Chapter 11. 

For example, the imputation credit prototype could be duplicated by withholding at a 34 percent rate and allowing credits 

at a 31 percent rate. The two systems may have different nontax consequences. See American Law Institute, Reporter’s 

Memorandum No. 1 (1990)) pp. 45-47. 

3. See Section 13.H. 

4. Compare Institute for Fiscal Studies(1991) and the Reporter’s Study Draft proposals discussed in Sections 12.B and 12.C, 

which avoid this problem by imputing a deduction on equity capital rather than tracking actual dividend payments. 

5. See Section 2.B. This account would restrict the dividends paid deduction to the amount of income that otherwise would 

have been taxed fully at the corporate level. For example, if a corporation paid tax of $34 under current law it should 

beallowed a dividend deduction of up to $lethepre-tax earnings, not the after-tax amount of $66 added to the EDA. The 

difference occurs because the dividend deduction system operates on a pre-tax basis whereas the dividend exclusion system 

operates on an after-tax basis. Presumably, the corporate AMT be retained and the interaction between dividend deductions 

available for regular tax purposes and for AMT purposes would have to be addressed. 

6. The following examples illustrate how such results would occur, absent a limitation mechanism similar to the EDA. 

Example 1. A corporation earns $100 of tax-exempt bond interest income in one year. The corporation has no 

additional earnings in the next year and distributes the $100 of exempt income it earned in the first year. The 

corporation has a dividend deduction of $100, creating a net operating loss that can.be carried forward to shelter 

$100 of future retained taxable income from tax. 

Example 2. A corporation earns $100 of foreign source income and pays foreign taxes of $34 in one year. After 

the foreign tax credit, it pays no U.S. tax. In the second year, the corporation has no additional earnings but 

distributes $66. The corporation has a dividend deduction of $66, which creates a $66 net operating loss that can 

be carried forward to shelter $66 of future taxable earnings. 

7. An alternative approach, suggested in The President’s 1985 Proposals, would require the distributing corporation to report 

to shareholders the portion of the dividend deducted. The deducted portion would be fully taxable to the corporate 

shareholder. The nondeducted portion would be eligible for a 100 percent dividends received deduction. Thus a corporate 

shareholder would be entitled to a 100 percent dividend received deduction with respect to dividends received in excess of 

the distributing corporation’s previously taxed earnings. This approach would preserve preferences until distributed out of 

corporate solution. 

8. See Chapter 9, note 2. 
Notes 234 

9. See Institute for Fiscal Studies (1991) and the description in Gammie (1991). 

10. While the proposal would reduce tax-induced distortions in corporate financing decisions, if capital gains from retained 

earnings were to receive very favorable tax treatment at the investor level the IFS proposal would tend to encourage 

retention. 

11. Shareholders funds are defined as: 

(1) shareholders’ funds for the previous period, plus 

(2) any new equity contributed, plus 

(3) the AFCE allowance for the previous period, plus 

(4) the taxable profits for the previous period, less 

(5) the tax paid on those profits, less 

(6) dividends and distributions to shareholders and capital repaid. 

A new corporation would have shareholders’ funds for the initial period equal to the value of the equity capital contributed 

by shareholders. Additional rules would be needed to determine an existing corporation’s shareholders’ funds on the date 

of introduction of AFCE. 

12. The followingexample illustrates the difference between intercorporate equity and debt investments under the proposal. 

If Corporation A uses $100 raised from new equity to buy shares in CorporationB, shareholders’ funds are $0 for A and 

$100 for B. If, on the other hand, A raised $70 from equity and $30 from debt to buy shares in B, A would have 

shareholders’ funds of -$30. The negative AFCE allowance would reduce the interest deductible on the $30 of debt against 

A’s profits. 

13. See American Law Institute, Reporter’s Studv Draft (1989). 

14. According to the Reporter’s Studv Draft new equity capital includes “all amounts paid in for stock or as shareholder 

contributions to capital after the date of this proposal. ‘I The critical distinction is between “accumulated”and “contributed“ 

equity. Eamings on new “contributed“ capital become “accumulated“capital, do not increase the QCC, and, therefore, do 

not qualify for a dividend deduction. The intent is to treat contributed equity capital in a manner consistent with new 

borrowing. That is, if the allowablerate for deduction were 7 percent, an increase in contributed equity of $1 million would 

generate $70,000 in dividend deductions. Earnings on the $1 million invested would not qualify for a dividend deduction. 

15. An important difference between the IFS and Reporter’s Studv Draft proposals is that the former grants dividend relief 

to both accumulated and new equity, while the latter grants relief only to new equity. The Reporter’s Studv Draft 

distinguishes between accumulated and contributed equity. An allowable dividend deduction is computed as the product of 

new contributed equity and the allowablerate. 

16. As a consequence, low-bracket investors would be subject to a lower tax burden on dividends than on nondividend 

distributions. 

17. The four Reporter’s Studv Draft proposals include coordinating rules to ensure that any particular transaction is subject 

to no more than one of these rules. For example, the MTD is imposed only to the extent that a distribution does not trigger 

interest disallowance or a reduction in the capital base for the dividends paid deduction. The MTD also does not apply to 

the purchase of stock as a portfolio investment. A distribution does not trigger interest disallowance to the extent that it 

reduces the capital base for the dividends paid deduction. 

18. See Chapter 10 and Section 13.B. 

PART V 

Chapter 13 

1. See,e.g., Shoven and Whalley (1972), Shoven (1976), Ballard, Fullerton, Shoven, and Whalley (1985), and Fullerton, 

Henderson, and Mackie (1987). 

2. See Gravelle and Kotlikoff (1989). 
235 Notes 

3. Whether these distortions in fact create significant efficiency costs depends on the response of business enterprises to the 

tax bias against incorporation. Gordon and MacKie-Mason (1991), analyzing data on individual business enterprises, find 

that changes in organizational form (between C and S corporations, and between S corporations, partnerships, and 

proprietorships) are sensitive to changes in tax rates and other tax policy incentives. 

4. For example, some potential investments that benefit from corporate organization on. account of liquidity of corporate 

securities or access to capital markets will not be undertaken even if they earn more (before taxes) than comparable 

investments in the noncorporate sector. Publicly traded partnerships, including master limited partnerships with units traded 

on organized exchanges, can have the liquidity of publicly traded corporations without the corporate taxes if they limit their 

investments to certain types of activities, principally real estate and natural resources. REITs, REMICs, and RICs avoid a 

second level of tax provided they satisfy certain restrictions on assets and business activities. Alternatively, businesses may 

elect S corporation status. This allows them to retain some of the benefits of incorporation, but at the expense of conforming 

to certain restrictions. For example, S corporations have limitations on the number of investors they can have and the type 

of stock they can issue. See IRC 5 1361(b). 

5. In addition to corporate domestic income as a percentage of net national product, mentioned earlier, Figure 13.2 shows 

gross domestic product of all corporations and nonfinancial corporations, relative to gross domestic product; and gross 

domestic product of nonfinancial corporations relative to GNP, from 1950 to 1990. 

6. Compare the declines in 1989 and 1990 in corporate profits relative to net national product (Figure 13.1) and in total 

income in the corporate sector relative to net national product, gross domestic product and gross national product (Figure 

13.2) with the stability in income of proprietorships and partnerships relative to net national product (Figure 13.1). 

7. S corporation income here is measured consistent with pre-1987 figures. 

8. In the MidsessionReview of the Budget (1990), estimated corporate receipts were decreased by approximately $7.5 billion 

to reflect revisions of the 1986 Act's effect on corporate income taxes and the greater than anticipated use of Subchapter S 

filings by corporations. 

9. A bias would remain, however, if business tax preferences and losses that reduce the effective tax rate on noncorporate 

income did not pass through corporations to their shareholders. 

10. A common rule of thumb is that the accrual-equivalent tax rate on capital gains is about one-fourth the statutory rate. 

See Poterba, "Tax policy and corporate saving" (1987) and the references therein. This adjustment captures reductions 

attributable to deferral and to the fact that the basis of inherited property is stepped up to fair market value (eliminating the 

tax on capital gains accrued before the holder's death). 

11. For example, in the late 19709, marginal tax rates on individuals were as high as 70 percent for unearned income, while 

the top marginal rate on corporate income was 46 percent and there was a 60 percent exclusion for long-term capital gains. 

This created an incentive in some cases to shift income into corporations, because the combination of the corporate tax rate 

and the effective capital gains rate was lower than the individual tax rate on the same amount of income. See Feldstein and 

Slemrod (1978). This was particularly likely to be true for corporations with income low enough to take advantage of the 

graduated corporate rate structure. 

12. In comparing corporate and noncorporate investments, however, the degree of bias may be reduced by the existence of 

accelerated depreciation allowances. The relative importance of those allowances depends upon the marginal business level 

tax rate facing the corporate or noncorporate enterprise. In the case of the debt-equity choice, the focus is on a corporation 

contemplating the best method to finance that portion of net investment that is not being funded by the government through 

a policy of accelerated writeoffs. The existence of accelerated allowances is immaterial to that choice. 

13. In certain special cases, however, debt may not enjoy a tax advantage over equity. Consider, for example, a corporation 

whose tax liability is determined under the AMT. That corporation faces a 20 percent corporate income tax rate. Thus, if 

the accrual-equivalentcapital gains rate were sufficiently low relative to the shareholder tax rate on interest income, equity 

might be the tax preferred form of financing for the minimum tax corporation. 

Because statutory corporate tax rates are graduated, a corporation with taxable income under $75,000 also would face 

a relative low (15 to 25 percent) corporate tax rate. For such a corporation, equity is less tax-disadvantaged than for 

corporations with larger profits that face the 34 percent statutory tax rate. In addition, a corporation with a substantial net 

operating loss can be thought of as having a low corporate tax rate and, therefore, as deriving little benefit from debt as 

opposed to equity financing. 
Notes 236 

14. The idea that debt can improve managerial incentives is at the core of Jensen's (1986) "free cash flow" theory, a 

prominent explanation of the increase in debt financing. Jensen contends that managers, if given the leeway, will take 

advantageof the inability of suppliers of funds to ascertain whether the firm is investing efficiently. Managers may squander 

cash flow by investing for their own benefit in projects with negative present value. An arrangementin which outside lenders 

hold debt and managers hold the residual claims minimizes this misuse of cash flow. Higher productivity (and, hence, 

shareholderprofitability) could result from better managerial incentives. Some studies providingempirical evidencein support 

of this proposition are reviewed in Bemanke (1989). 

This theory is subject to challenge, however. While debt financing is one way to mitigate the problem Jensen describes, 

it may not be the best option. If the objective is to make managers bear more residual risk, other means could be used 

(including incentive-based management compensation or reform of the oversight role, which in principle is exercised by 

boards of directors). Tax considerations have likely played a role. If taxes have contributed to increased debt, then high debt 

levels may not be the most efficient way to operate the firm. 

15. This is true to the extent that debt is costly to renegotiate. See Gertler and Hubbard (1990). The idea is that managers 

should be made residual claimants only on the component of profits they can influence: the firm specific component. For 

example, managers should not be punished if the business does poorly during a recession but no worse on average than its 

competitors. 

16. See Warshawsky (1991). 

17. Looking at changes in debt to asset ratios in the "upper tail" (the ninetieth percentile corporations) reveals that some 

firms are close to having negative net worth on a market-value basis. 

18. See Bernanke and Campbell (1988), Bemanke, Campbell, and Whited (1990), and Warshawsky (1991). 

19. The empirical evidence on the effect of taxes on corporate borrowing decisions is mixed. Studies by Ang and Peterson 

(1986), Long and Malitz (1985), Bradley, Jarrell, and Kim (1984), and Marsh (1982), for example, fail to find plausible 

or significant tax effects. Other studies, in contrast, frnd significant relationships between tax policy variables and corporate 

borrowing. See, e.g., Auerbach (1985), Bartholdy, Fisher, and Mintz (1985), MacKie-Mason (1990), and Masulis (1983). 

At least two studies have directly estimated the responsiveness of corporate debt financing to changes in the tax advantage 

of debt. Nadeau (1988) estimates that a 1 percent increase in the tax advantage of debt relative to equity will cause a 0.2 

percent increase in the fraction of external funds obtained by issuing debt. Rangazas and Abdullah (1987) estimate that a 1 

percent increase in the tax advantage of debt relative to equity will cause a 0.12 percent increase in the debt to value ratio 

in the short run, and a 0.4 percent increase in the debt to value ratio in the long run. 

20. This argument is made formally in Gertler and Hubbard (1991). 

21. Some financial economists have maintained that tax parameters are irrelevant for dividend payout decisions, arguing 

that share prices of dividend paying firms are set by investors who face equivalent (typically zero) tax burdens on dividends 

and capital gains. See, e.g., Miller and Scholes (1978). 

22. See, e.g., Bhattacharya (1979) and Miller and Rock (1985). 

23. The new view (sometimes described as the "tax capitalization" or "trapped equity" approach) is developed in King 

(1977), Auerbach (1979), and Bradford (1981). See also the survey in Poterba and Summers (1985). 

24. A temporary change in the dividend tax rate would change both dividend payments and investment incentives because 

of intertemporal substitution. 

25. Again, investment incentives are only affected by transitory changes in investor level dividend tax rates. 

26. Under the new view, other tax factors such as the corporate tax rate and capital cost recovery allowances affect the 

corporation's dividend distributionsand the investment policy. To understand why, under the new view, permanent dividend 

taxes do not affect investment incentives, one must recognize that this view assumes that retained earnings provide the funds 

for marginal corporate equity financed investment. Consider, for example, a corporation that wants to invest $1 of capital 

by retaining an additional dollar of earnings. To retain the dollar, the corporation must reduce dividends by $1. At a 20 

percent marginal individual income tax rate, the $1 of dividendsforegone represents $0.80 net of the personal level tax on 

dividends, so $0.80 represents the cost of the investment in terms of dividends foregone. In the followingperiod, suppose 

the investment earns a 6.4 percent pre-tax return, leaving $0.043 to distribute to the shareholders after paying corporate tax 
237 Notes 

at a 34 percent marginal corporate income tax rate (0.043 = 0.064x(1-0.34)). Upon distribution, the shareholder receives 

a net dividend of $0.034, after paying the 20 percent tax on the dividend distribution (0.034 = 0.043 X(1-0.20)). 

In determining investment incentives, however, it is the return to the shareholder relative to the cost of the investment 

that is relevant. In our example, the investment costs the shareholder only $0.80 in terms of foregone dividends, since that 

is how much she would have had to invest if the $1 had been distributed to her rather than reinvested within the corporation. 

Consequently, the rate of return relevant for determining whether the investment should be undertaken is 3.4 percent divided 

by 80 percent (4.3 percent), the pre-dividend tax return. Because the cost of the investment is always reduced by the dividend 

tax in exactly the same proportion that the return from the investment is reduced by the dividend tax, the dividend tax does 

not affect investment decisions under the new view. 

The new view does assume, however, that share appreciation on investments financed by retained earnings is subject 

to capital gains tax. The effective accrual tax rate on capital gains does affect investment incentives, even under the new 

view, To see why, assume that the effective accrual tax rate on capital gains is 6 percent. When the corporation retains a 

dollar, the investor owes capital gains tax of $O.O6*q, where q gives the share appreciation caused by $1 of retained 

earnings. We assume that the firm pays dividends, so that q must equal 0.851 (0.851 = (1 -0.2)/(1-0.06)) to insure that 

shareholders are just indifferent between dividends and retained earnings. Thus, the shareholder pays capital gains tax of 

$0.051,thereby sacrificing a total of $0.851 in after-tax income to make the investment of one dollar. In the next year, the 

investmentpays a dividend of $0.043, of which the investor keeps $0.034 after paying taxes at a 20 percent rate. To measure 

the investor's after-tax rate of return, we must adjust for the fact that only $0.851 was sacrificed rather than $1. As a result, 

the investor earns a 4 percent rate of return (0.04 = 0.034/0.851) after taxes. Note, however, that since the investmentyields 

4.3 percent before investor level taxes, the investor level tax rate is simply the 6 percent effective tax rate on capital gains 

(0.04 = 0.043*(1-0.06)). Thus, the capital gains tax, but not the dividend tax, reduces the investor's incentives under the 

new view. 

27. Under the new view, managers are assumed to maximize shareholder value, and corporations can be described as 

"immature" (with desired investment spending exceeding internal funds) or "mature" (with internal funds exceeding desired 

investment spending). Immature firms use their available internal funds from retained earnings, then seek more costly 

external finance. They would never pay dividends and issue new shares at the same time. Investors in mature firms must 

be indifferent at the margin between receiving a dollar in dividends or receiving a capital gain on the reinvested dollar. If 

the value of an additional dollar of investment in the firms is denoted by q, the investor must be indifferent between receiving 

a dividend of $1-valued at 1 -m, where m is the investor level tax on dividends-and a capital gain of q dollars-valued 

at q(l -z), where z is the investor level accrual-equivalent tax rate on capital gains. Hence, 1 -m=q(l -z), so that q= (1 - m)/(l -z) < 1. Under certain assumptions, q is related to the ratio of the market value of the firm to the replacement cost 

of the firm's capital stock. Hence, the dividend tax is capitalized in share values (Le., decreasing m would increase q and 

the value of the firm). 

28. Under the traditional view, dividends offer nontax benefits to shareholders, so that tax-disfavored dividends are not a 

cheaper source of funds for the firm than external finance. Using the notation of the previous note, q= 1, and investor level 

dividend taxes are not capitalized in share values. 

29. See Poterba, "Tax policy and corporate saving" (1987). The Tax Reform Act of 1986 is assumed in the analyses 

discussed in this chapter to have increased the payout ratio from the 0.61 value reported by Poterba to 0.73 under current 

law. 

30. Statistical analysis is difficult because it is often difficult to isolate changes in tax rates on income from dividends that 

occur independently of changes in tax rates on nondividend income (which would affect the required return on corporate 

equity, share values, profits, and dividends in equilibrium). 

31. Brittain (1966) analyzes data onU.S. corporations from 1920 through 1960. For the corporate sector as a whole, he finds 

that in the short run (first year) a 1 percent increase in dividend tax rates would reduce the dividend payout ratio by 0.18 

to 0.42 percent. As corporations gradually adjust to the new tax system, they respond more fully, and in the long run the 

behavioral responses are larger, ranging from 0.61 to 1.02 percent. Brittain concludes that the dividend tax rate explains 

dividend payout better than any of a variety of measures of the tax penalty on dividendsrelative to capital gains. 

Feldstein (1970) examines the dividend payment behavior of British firms from 1953 through 1964, and finds that payout 

decisions were sensitive to the tax penalty on dividends relative to capital gains. Feldstein finds that in the short run (first 

year) a 1 percent increase in the tax penalty on dividends relative to capital gains (measured as the opportunity cost of 

retentions in terms of foregone dividends) will reduce the dividend payout ratio by between 0.27 percent and 0.68 percent. 

In the long run, Feldstein's estimates are close to 1.0. 
Notes 238 

King (1971, 1972) examines data on British corporations from 1949 through 1967. He finds behavioral responses that 

are lower than Feldstein's by about one-half. However, Feldstein (1972) countered that King's estimates are biased downward 

because of data problems, and maintains that the true response is closer to his own original estimates than to King's 

estimates. 

Poterba and Summers (1985) also examine data on British firms, using information through 1983. They find that 

dividends are very sensitive to the tax penalty variable. They estimate that a 1 percent increase in dividend tax rates would 

reduce dividend payout rates by 0.18 to 0.54 percent in the short run and by 1.03 to 2.6 percent in the long run. 

Poterba, "Tax policy and corporate saving" (1987) provides estimates based on data for the United States for the period 

1948 through 1986. Poterba estimates short-term responses in the dividend payout ratio with respect to the dividend tax 

penalty ranging from 0.61 to 0.78 percent. In the long run, Poterba's elasticities range from 1.56 to 4.00 percent. 

Another type of evidence comes from studies of changes in asset prices in response to taxes. Such studies attempt to 

test whether investor level dividend taxes are capitalized in share prices. Poterba and Summers (1985) studied the reaction 

of prices of British stocks to the announcement in 1970 that an integrated tax system would replace the double taxation of 

dividends. They found no significant increase in stock prices, suggesting that dividend taxes were not capitalized into share 

values. 

32. This estimated sensitivity, in principle, could reflect investors' perceptions that dividendtax changes are temporary. Even 

in the new view, a temporary decrease in dividend tax rates would increase dividend payout. Poterba and Summers (1985) 

argue, however, that empirical evidence is consistent with an effect on payout of "permanent" dividend tax changes. 

33. See Shoven (1987) and Poterba, "Tax policy and corporate saving" (1987). 

34. The calculations follow Poterba (1987), and are based on tabulations of the COMPUSTAT Industrial and Research files. 

35. In different contexts, see Lintner (1956), Easterbrook (1984), Jensen (1986), Gertler and Hubbard (1991). 

36. See the discussion in Fazzari, Hubbard, and Petersen (1988) and Hubbard (1990). 

37. Empirical evidence in support of the proposition that capital income taxes affect investment is more conclusive than for 

the case of saving. Modern theoretical models of business fixed investment build on early work by Jorgenson (1963), which 

demonstrated a link between capital spending and the cost of capital, which in turn depends in part on tax rates. Initial 

empirical evidence by Hall and Jorgenson (1967) bolstered this view. Criticism of the Hall-Jorgenson approach by Eisner 

and Nadiri (1968) and Eisner (1969) (see also later work by Chirinko and Eisner, 1983) centered on the Hall-Jorgenson 

approach of combining output and cost of capital effects in a single term. In this work by Eisner and others, the cost of 

capital effect in isolation was small. A significant effect of taxes on investment spending has been demonstrated in recent 

models using a range of underlying theoretical approaches. See, for example, Summers (1981), Feldstein (1982), Feldstein 

and Jun (1987), Fazzari, Hubbard, and Petersen (1988), and Auerbach and Hassett (1990, 1991). 

38. See Shoven and Whalley (1984) for a discussion of computable general equilibrium models. 

39. The assumptions underlying the models were made to conform to each other whenever possible. Common assumptions 

include inflation rates (3.5 percent), asset holding periods (seven years), share of capital gains excluded from tax through 

step up in basis at death (two-thirds), historical dividend-payout ratios (two-thirds of the real return), and historical debt 

shares (40 percent for corporations, 34 percent for noncorporate enterprises, and 38 percent for owner occupied housing). 

Each model generally characterizes the productiontechnologies in a particular industry in a similar way, and where possible 

the models assume consistent behavioral responses of dividend-payout ratios and debt to equity ratios to changes in taxes. 

Only Federal taxes on capital income are taken into account in measuring investment incentives. 

40.By taxing distributions out of tax-favored or foreign-taxed income, a compensatory tax can significantly offset the 

efficiency gains otherwise resulting from integration. In particular, had a compensatory tax been incorporated into the CBIT 

prototype (rather than the investor level tax actually recommended), the decision to retain, rather than distribute, current 

earnings would be as distorted by tax considerations as under current law. 

41. The analysis of corporate borrowing in the model is based on Nadeau (1988). He estimates an elasticity of the fraction 

of total external financing in the form of debt to the difference between the real rate of return required on equity and the 

real interest rate of 0.224. The representation of corporate borrowing in the model is consistent with an elasticity of the debt 
239 Notes 

to asset ratio with respect to the tax advantage of debt of 0.3. Nadeau measures the tax advantage of debt as 1-[(l -tJ(ltJ(1 -td)], where t,is the tax rate on debtholders, t, is the corporate tax rate, and t, is the effective tax rate on the real return 

to equity (including the benefit from the preferential treatment of capital gains). Rangazas and Abdullah (1987) have 

estimated that this elasticity is about 0.4 in the long run, somewhat larger than the behavioral response assumed in the model 

used in this Report. 

42. The gain to shareholders from a dollar distributed as a dividend relative to an additional dollar of retained earnings is 

given by (1 -m)/(l -z), where m is the tax rate on dividends and z is the accrual-equivalenttax rate on capital gains. The 

model assumes an elasticity of the dividend payout ratio with respect to this measure of relative after-tax values of 

approximately unity. This estimate is conservative. For example, Poterba (1987) estimated the long-run elasticity to be in 

the range from 1.6 to 4.0, while Feldstein (1970) estimated long-run elasticities ranging from 0.85 to 1.33. 

43. In all calculations, noncorporate business is assumed to be financed using 34 percent debt, and owner-occupied housing 

using 38 percent debt. These calculations are based on information from Balance Sheets for the U.S. Economy, Board of 

Governors of the Federal Reserve System, various issues. 

44. In fact, because nominal interest payments are deductible, the effective marginal tax rate on debt-financed investments 

is negative in these calculations. 

45. These calculations assume that retentions are never distributed. Thus, they may overstate the difference between the 

taxation of dividends and retentions. This assumption is probably appropriate for the calculations below, however, since 

incentive effects in these calculations are based on a marginal expansion of the capital.stock. R.etained earnings used to 

finance such an expansion would be retained indefdtely. 

46. In the scaled-tax-rate calculations, and compared to current law, all prototypes reduce slightly the overall average cost 

of capital for the economy, and encourage additional savings and investment. The small reduction in the overall average cost 

of capital is caused by the reduction in the premium that corporate investments must earn to compensate investors for taxinduced corporate financial distortions. The direct tax cost of investment has, by assumption, remained fixed at its current 

law level. Since CBIT reduces financial distortions most significantly, it generates the largest reduction in the overall average 

cost of capital. This effect is not the focus of the present analysis, however. 

47. The incidence of the corporate income tax is discussed in detail in Section 13.G. 

48. Mackie (1991) describes the technical details of the model outlined in this section. The model is based upon Fullerton 

and Henderson (1989). 

49. See, e.g., Gordon and Malkiel (1981), Fullerton and Gordon (1983), and Gertler and Hubbard (1990). 

50. Even though in the scaled-tax-rate calculations the integration prototypes may leave constant the effective tax rate on 

investment, they still might encourage capital formation by reducing tax-induced distortions in corporate financial policy. 

Although small in an absolute sense, this effect may be large relative to the other gains brought on by the integration 

prototypes. Nonetheless, the static, single period calculations reported in the tables do not incorporate such an effect. 

51. We use a modified version of the Mutual Production Model introduced by Gravelle and Kotlikoff (1989). 

52. Corporate financial behavior in the MPM is based on CES functional forms with an elasticity of dividend payout ratio 

with respect to the tax penalty on dividends relative to capital gains equal to -3.0, and an elasticity of the leverage ratio with 

respect to the tax advantage of debt relative to equity equal to 0.3. Thus, the financial behavior in the MPM is consistent 

with, but not identical to, that assumed in the augmented Harberger model described earlier. For technical details of the 

MPM, see Gravelle (1991). 

53. As statutory tax rates rise to make the distribution-relatedprototype revenue neutral, the tax advantage of debt relative 

to equity also rises because the higher tax rates increase (1) the value of deducting nominal interest, and (2) the tax rate on 

purely inflationary capital gains. At the set of tax rates needed for revenue neutrality, these two effects, combined with a 

relatively large distortion in dividend policy, are sufficient to counteract the effect of the dividend exclusion or credit. As 

a result, relative to current law the tax benefit to debt rises, and corporations actually increase slightly their use of debt. 

54. The portfolio allocation model is described in Galper, Lucke, and Toder (1988). 
Notes 240 

55.Households hold debt and corporate equity, directly and indirectly, through certain pension holdings. The household 

allocations of debt and corporate equity in Table 13.9reflect direct holdings. Pension holdings of debt and corporate equity 

are shown separately. 

56.Household wealth includes small net holdings of foreign equity. As a result, total wealth slightly exceeds the value of 

total physical capital, so shares can differ between the top and middle panels of Table 13.9. 

57.Though not shown, the PA model also simulates changes in portfolio shares across income groups. The shareholder 

allocation, imputation credit, and CBIT prototypes shift stock ownership from high-income to low-income groups; the 

dividend exclusionprototype shifts stock holdings to higher-income groups. In all cases, the shifts are quantitatively small, 

Larger cross-household shifts in taxable debt accompany the prototypes, especially CBIT. Broadly speaking, all of the 

prototypes reduce the share of total debt held by low-incomegroups, while raising the share held by middle- and high-income 

groups. 

58.Note that this can result simply because existing businesses in the noncorporatesector decide to incorporate. It does not 

necessarily imply a change in ownership of assets. 

59.Both the augmented Harberger model (AH) and MPM simulations suggest that each integration prototypewould improve 

economic welfare. The models also suggest possible gains at both real and financial margins. Nonetheless, there are 

substantial differences between these two models’ results. Perhaps most noticeably, the MPM produces much larger shifts 

in physical capital and in economic welfare than does the AH model. There are some key differences in the models’ 

predictions about corporate financial policy, real capital shifts, and welfare changes, as described below. 

Changes in corporate financial policy. For a given prototype and financing mechanism, the two models predict very 

similar changes in the corporate dividend payout ratio. In the lump-sum calculations, furthermore, the two models predict 

fairly similar changes in the corporate leverage ratio. In contrast, with the scaled-tax-rate replacement mechanism, the two 

models predict somewhat different changes in the corporate leverage ratio, especially under the two distribution-related 

prototypes. Such differences can be traced to the fact that the two models (1) start with somewhat different statutory rates, 

(2)use slightly different behavioral responses in estimating corporate financial behavior, and (iii) have different equal-taxyield requirements. 

Changes in capital allocation. The MPM generally produces larger shifts in physical capital than does the AH model. 

This difference reflects in part the MPMs greater scope for substitutabilitybetween corporate and noncorporate resources. 

The greater substitutabilitystems from two sources: (1) a much larger implied substitution elasticity between corporate and 

noncorporate business in each industry; and (2)a corporate-noncorporatechoice in the provision of rental housing that is 

not considered in the AH model. 

Changes in welfare from improved consumption. The MPM predicts larger gains from improved consumption choices. 

This difference is due principally to the MPM’s greater shifts incapital (and other resources) discussed above. The greater 

substitutionbetween the corporate and noncorporate form in the MPM means that, because investors are quite sensitive to 

tax differences, current law does more to distort the allocation of real resources in that model than in the AH model. 

Consequently, relieving the tax distortion produces a larger gain in the MPM than in the AH model. 

Changes in welfare from coruorate financial policy. The MPM generally produces larger changes in welfare from 

changes in corporate debt and dividend policy. Some differences between the models’ welfare results reflect differences in 

the predicted changes in the leverage and dividend payout ratios, as discussed above. In addition, for each prototype the 

MPM has a larger fraction of the economy’s stock of capital allocated to the corporate sector under current law than does 

the AH model. Thus, the same per unit financial distortion would produce a larger absolute (Le., dollar) loss in the MPM 

than in the AH model. 

60.Our gains also are on the same order of magnitude as those estimated for the 1986Act. See, e.g., Fullerton, Henderson, 

and Mackie (1987). 

61.See Harberger (1966),Shoven (1976),and Fullerton, et al. (1981). 

62.See Fullerton (1984). 

63.See Fullerton and Henderson (1989). 
24 1 Notes 

64. Others also have emphasized the role of debt finance and capital gains taxes in reducing the size of the corporate tax 

wedge, and so reducing the efficiency cost of the corporate tax system. See, e.g., Gordon and Malkiel (1981) and Stiglitz 

(1973). 

65. The important differences are three. First, in this Report, only Federal income taxes distort investment decisions, while 

in Fullerton and Henderson, state and local income and property taxes also act to distort investment decisions. (All other 

things constant, this would tend to make the welfare gains from integration in Fullerton and Henderson larger than those in 

this Report.) Second, Fullerton and Henderson’s calculations are based on the new view of dividend taxes while this Report 

uses the traditional view. (All else constant, this would tend to make the welfare gains from integration in Fullerton and 

Henderson smaller than those in this Report.) Finally, in this Report the model has been augmented to account for taxinduced financial distortions. (This would tend to make the welfare gains from integration, even those due to real resource 

allocation alone, smaller in Fullerton and Henderson than those in this Report.) 

66. Fullerton and Gordon (1983), for example, estimate that eliminating the tax incentive for corporate debt would generate 

gains equivalent to about 0.8percent of consumption, while Gordon and Malkiel(l981) estimate that it would generate gains 

of about 0.4 percent consumption. 

67. Neither Gravelle (1989) nor Fullerton, Henderson and Mackie (1987) considered the welfare costs of distortions of 

corporate financial decisions. 

68. Harberger (1977 and 1980) argues that evidence on rates of return on capital is consistent with capital mobility. On the 

other hand, Feldstein and Horioka (1980) found that domestic saving and investment rates moved too closely together in the 

1960sand 1970sto be consistent with capital mobility. Feldstein and Horioka reasoned that if capital were perfectly mobile 

internationally, national savings rates should be independent of national investment rates. Capital would flow to wherever 

it received the highest return, and so returns would be equalized globally. Therefore, if saving increased in a country, rather 

than reducing interest rates below the global interest rate and thereby increasing investment at home, the additional saving 

would flow abroad. However, examining data from OECD countries, they found that, over long periods, national saving 

and investment rates were highly correlated. In a regression of national investment rates on national saving rates, the 

estimated coefficient on saving was statistically significant and close to unity. They interpreted this to mean there was very 

little international capital mobility, so that a one dollar increment to national saving produced almost a one dollar increment 

to national investment. 

Since Feldstein and Horioka, there has been a series of papers examining the saving-investment relationshipintime series 

and cross-section studies, generally with the intent of overturning their result. The result has, however, until recently, held 

up remarkably well for data from many countries over a long period. Recently, however, studies by Feldstein and Bacchetta 

(1989) and Frankel (1990) indicate that the close correlation between saving and investment may have broken down during 

the 1980s. Using data from the OECD countries, Feldstein and Bacchetta found that the coefficient on saving in a savinginvestment regression is markedly lower for the 1980-1986 period than for prior years. Frankel used a long time series of 

U.S. data and found that the relationship between saving and investment held up well before 1980, but for the 1980-1987 

period the estimated coefficient on saving is relatively small and statistically insignificant. 

Several authors have pointed out that national savings and investment rates are both endogenous variables. Hence if there 

are exogenous variables that are correlated with both saving and investment, one could find a significant correlation between 

the two even in the presence of perfect capital mobility. See, e.g., Obstfeld (1986), Summers (1986), and Frankel (1986). 

Feldstein and Bacchetta (1989) rejected most of these explanations. 

More recently, researchers have studied impacts of domestic capital market imperfections on capital flows. For example, 

Gertler and Rogoff (1990) present a model in which capital is perfectly mobile internationally, but capital market 

imperfections can lead domestic saving to be correlated with domesticphysical investment. In their model, there is a domestic 

sector consisting of risky projects. There also is an international market for a riskless asset which yields a world rate of 

return. Foreigners can invest funds directly in the risky domestic projects, but because of asymmetric information they do 

not know how much of their funds are actually used in the project and how much reinvested in the international capital 

market. The probability of the project’s success depends on how much money is actually invested in it. There is 

underinvestment of foreign funds in the risky domestic sector, but foreign investment increases with increased domestic 

investment in the risky sector. If saving increases, thereby increasing investment of domestic funds in the risky sector, 

foreigners will be willing to contribute more funds too. This may cause saving and investment to be correlated. While this 

model is stylized, it does point out that international mobility of capital in one market (for low-risk assets) need not imply 

that returns are equated internationally in markets for risky assets. 
Notes 242 

69. Most of the empirical evidence pertains to debt securities. When looking at securities (as opposed to saving and 

investment rates), the appropriate test is whether returns are equalized across national boundaries. To implement this test, 

one needs to define (and measure) the relevant returns that should be equalized. This is not always easy. 

Mishkin, "Are Real Interest Rates Equal Across Countries" (1984), Mishkin, "The Real Interest Rate" (1984), and Mark 

(1985) found evidence against real interest parity. In a less direct test, Barro and Sala-i-Martin (1990) estimated a system 

of country real interest rate and investment equations derived from a macroeconomic model. They found some evidence that 

global factors, e.g., global stock returns, are more important in determining a country's real interest rate than country 

specific factors. Of course, real interest parity may not hold even in the presence of perfect capital mobility if there is an 

expected change in the real exchange rate or an exchange rate risk premium. A test for capital mobility that allows for the 

existence of expected changes in the exchange rate or exchange rate risk premia is whether covered interest parity holds. 

Frankel and MacArthur (1988) and Frankel (1990) present evidence that covered interest differentials have narrowed over 

time, and that they are currently small for major industrial countries. 

The covered interest differential measures only the extent of institutionalbarriers and market imperfections that impede 

capital flows. It does not measure the substitutabilityof domestic and foreign assets in investors' portfolios. The uncovered 

interest differential is a better indicator of capital mobility capturing asset substitutability. The difference between the 

uncovered interest differential and the covered interest differential is the exchange rate risk premium, the size of which 

provides a measure of the substitutability of assets across currencies. Froot and Frankel (1989)' Giovannini and Jorion 

(1987), and others have rejected uncovered interest parity, suggesting the presence of a risk premium. Frankel (1990) 

presents some evidence that much of these differences is accounted for by expected changes in real exchange rates rather 

than exchange rate risk premia. 

To summarize, there appears to be substantial integration in asset markets for short-term debt. Of course, even if there 

is a high degree of capital mobility in these markets, imperfect substitutionbetween these markets and other asset markets 

(for equity or long-term debt) could still be consistent with weak overall integration of capital markets. 

Tests of equity market integration in the capital asset pricing model have generally rejected international integration. See, 

e.g., Stehle (1977) and Jorion and Schwartz (1986). This may be due in part to the sample period (which does not include 

much of the 1980s). French and Poterba (1991) stress informational problems as an explanation for imperfect international 

diversification in equity markets. 

70. See Mutti and Grubert (1985) for details. 

71. The model assumes not only that debt capital is more internationallymobile than equity capital, but also that debt is more 

important in cross-holdingsof assets. In the model's calibration, 66 percent of foreign holdings of U.S. assets are in the form 

of debt, while 60 percent of U.S. holdings abroad are in the form of debt. 

72. This is true even for shareholders that are tax-exempt institutions. Taxes borne by pension and life insurance funds reduce 

the incomes of their beneficiaries, and taxes falling on charitable and educational institutions reduce the services they can 

provide. 

73. See, e.g., Harberger (1962), Shoven and Whalley (1972), Shoven (1976), Pechman (1987), and Gravelle and Kotlikoff 

(1989). 

74. See Harberger (1962). 

75. See Ebrill and Hartman (1982) and Gravelle and Kotlikoff (1989). 

76. See, e.g., Stiglitz (1973). The risk of bankruptcy may constrain the use of debt to finance the marginal investment, and 

that risk plays an independent role in the effect of the corporate tax. See, e.g., Gordon and Mallciel (1981). 

77. See, e.g., Harberger (1983), Mutti and Grubert (1985), and Pechman (1987). 

78. See Young (1988), Murthy (1989), and Gravelle (1991). 

79. This possibility seems likely for the United States since the corporate tax is not a residence-based tax. American 

multinationalspay taxes on repatriated income to the United States in excess of foreign taxes paid. The U.S. corporate tax, 

in fact, is both residence-based and source-based, since taxes on earnings retained and reinvested abroad can be deferred. 
243 Notes 

80. Other assumptions have sometimes been used by other analysts. While Pechman (1987) allocated the corporate income 

tax to all capital income, Pechman and Okner (1974) and Pechman (1985) used five different assumptions to allocate the 

corporate income tax: (1) to dividends, (2) to property income in general, (3) half to dividends and half to property income 

in general, (4) one-half to dividends, one-fourth to consumption, and one-fourth to employee compensation, and (5) half to 

property income in general and half to consumption. In its original (1987) study of tax burdens and in the (1988) update, 

the Congressional Budget Office allocated the corporate tax burden in two ways: (1) entirely to capital income and (2) half 

to capital income and half to labor income. The Joint Committee on Taxation has not attempted to allocate the burden of 

corporate income tax to individuals. 

The assumptionscorrespond to those conventionally employed incontemporaryanalyses of the distributional implications 

of tax changes. Early analyses by the Department of the Treasury in the 1930s and 1940s allocated the burden of the 

corporate income tax by income class on the basis of dividends or stockholdings. More recently, Department of the Treasury 

analyses of the distribution by income class of federal income taxes have consistently allocated the burden of the corporate 

tax to owners of capital. In Blueurints, the corporate income tax was allocated on the basis of total capital income. Similarly, 

in constructing Family Economic Income, the Department of the Treasury has allocated the corporate tax to families on the 

basis of their total capital income. 

81. The tax rates reflect the burden of the corporate tax borne by foreign investors and tax-exempt institutions, other than 

pensions, through their ownership of U.S. capital. The portion of the corporate tax falling on assets owned by pension funds 

is allocated to the individuals with rights to the pension reserves. 

82. Family economic income is constructedby adding to adjusted gross income: unreported and underreported income; IRA 

and Keogh deductions; nontaxable transfer payments such as Social Security and AFDC; employer-provided fringe benefits; 

inside buildup on pensions, life insurance, and IRAand Keogh accounts; tax-exempt interest; and imputed rent on owneroccupied housing. Capital gains are computed on an accrual basis, adjusted for inflation to the extent reliable data allow. 

Inflationary losses of lenders are subtracted and gains of borrowers are added. The economic incomes of all members of a 

family unit are summed to produce the family economic income used in the distributional analysis. 

83. The rate of inflation is assumed to be 3.5 percent per annum. 

84. The revenue estimates have assumed an average excludability rate of 56 percent, implying that 56 percent of the 

distributions of corporations will be excluded from income have tax credits attached that can be used by the recipient of the 

distribution to offset taxes. This rate consists of a base rate of 51 percent and an additional 5 percent representing carryovers 

of excess amounts in Earnings Distribution Accounts from prior years to exclude dividends in the current year. 

The low average excludability rate is accounted for by the fact that many corporations that distributed income to 

shareholders have paid no (or little) tax on that income. That is, much of the income distributed represents preference or 

foreign source income not taxed at the corporate level. Moreover, many corporations whose income is taxed more fully have 

low dividend payout ratios. The assumed excludability rate of 56 percent is based on Department of the Treasury 

calculations. 

85. The EDA is calculated as taxes after credits multiplied by (1-tJt,, where t, is the corporate tax rate, to gross up the 

amount of income available to pay excludable dividends. For example, for income of $100 and taxes paid of $34, $66 is 

available to pay dividends. The EDA also is $66 [(0.66/0.34) X$34]. 

86. Thus, individuals cannot exclude dividends from foreign source income except to the extent that U.S. tax is paid. 

APPENDICES 

Appendix A 

1. Treas. Reg. 0 301.7701-2(a)(l). Two characteristics, associates and an objective to carry on business and divide the 

profits, are common to partnerships and corporations and are therefore not material in distinguishing between partnerships 

and corporations. 

2. IRC 0 7704. 

3. IRC 0 851 et seq. 
Notes 244 

4. IRC 9 856 et seq. 

5. IRC 9 860A et seq. 

6. Exceptions include: (1) interest on purported debt that is properly viewed as equity (see, e.g., IRC 0 163(e)(5)), (2) 

interest on debt used to finance certain tax-favored income (see, e.g., 0 265(a)(2)), and (3) interest that must be capitalized 

because the debt relates to the production of future income (see, e.g., IRC 0 263A(f)). 

7. The Code treats a distribution as a dividend to the extent of current and accumulated earnings and profits of the 

distributing corporation. Distributions that exceed earnings and profits are treated as a tax-free return of basis to the extent 

of the shareholder’s basis in the stock. To the extent that the distributions exceed basis, they are generally treated as capital 

gains. IRC 0 301(c). 

8.Capital gains of individuals are subject to a maximum tax rate of 28 percent. IRC 0 101). 

9. A domestic corporation also is entitled to a dividends received deduction (in the percentage specified in IRC 0 243) for 

the U.S. source portion of dividends received from a foreign corporation that is at least 10 percent owned by the U.S. 

corporation. The deduction is 100 percent for a wholly owned subsidiary whose income is all effectively connected with a 

U.S. trade or business. IRC 0 245. 

10. IRC 0 385(b). 

11, The data reflect corporate taxes at both the central government and local levels. Comparisons of corporate tax receipts 

for central governments only would be misleading because some countries have much greater corporate taxation at the local 

level than others. Organisation for Economic Co-operation and Development (1991), Table 13, p. 78. 

Appendix B 

1. We believe that the descriptions that follow are complete as of December 1991. They are based in part on secondary 

sources. We are grateful to those government officials, academics, and practitioners who gave us their comments. 

2. The amount of the imputation credit is [F/(1- .39)] x .39, where F equals the amount of the distribution from the franking 

account. 

3. The amount added to the franking account each year is (61/39xQ+D, where T is the total Australian tax paid by the 

corporation in the relevant period and D is the amount of franked dividends received from other resident corporations that 

period. 

4. For example, an individual shareholder owns a share with a paid-up value of AU$1.00 and a market value of AU$2.50. 

The shareholder’s basis in the share is AU$2.00. The corporation buys the share (and has taxable income sufficient to frank 

fully all dividends paid that year). If the buyback is off-market, then the difference between AU$2.50 (amount paid) and 

AU$1.00 (paid up value) is a dividend (AU$1.50). That part of the purchase price not treated as a dividend (the paid up 

value of AU$1.00) is consideration received in the sale. Thus, the shareholder also has a capital loss of AU$1.00 (AU$l.OO 

paid up value minus AU$2.00 basis). If the buyback is instead on-market, the total purchase price (AU$2.50) is consideration 

in the sale, and the shareholder has a capital gain of AU$0.50 (AU$2.50 minus AU$2.00 basis). The corporation, however, 

must debit its franking account by AU$1.50, the amount that would have been a dividend if the purchase were off-market. 

5. The required franking amount equals: CD X [RFS/(TD+CFD+SDD)], where CD is the current dividend and RFS is the 

franking surplus. RFS is reduced by any unpaid dividends with an earlier reckoning day. (The reckoning day is normally 

the day that the dividendis paid, but sometimes dividends that are part of the same distribution are not paid on the same day. 

In that case the reckoning day is the day that the first of those dividends is paid.) TD is the total amount of dividends paid 

or to be paid on the same class of shares and under the same resolution as the current dividend. CFD is the amount of the 

committed future dividends (not in TD) at the beginning of the reckoning day for the current dividend. SDD (same day 

dividends) have the same reckoning day but are paid or to be paid under a different resolution or under the same resolution 

on a different class of shares. 

6. Thus, the corporation pays a franking deficit tax equal to the franking deficit grossed-up at the corporate rate and then 

multiplied by that rate: [FD/(1-.39)] X .39, where FD equals the amount of the franking deficit. 
245 Notes 

7.Implementation of an accompanying foreign investment fund regime recently was postponed to July 1, 1992.This regime 

is similar in purpose, though not in details, to the U.S. PFIC rules of IRC $8 1291-1297. 

8. For example, if a shareholder receives a taxable dividend of $100,he includes $125 in income and receives a Federal tax 

credit of $16.75.Assuming the provincial rate is 50 percent of the Federal liability, the $16.75 Federal credit reduces 

provincial tax liability by $8.38 ($16.75/2).The total tax saved as a result of the credit is $25.13. 

9.The following table illustrates the Canadian system with respect to the business income of a Canadian corporation. (This 

analysis does not deal with the investment income of a Canadian private corporation, which is subject to a somewhat different 

regime.) The table assumes, for purposes of the provincial tax, that the dividend paying corporation is both resident in, and 

doing business in, Ontario, and that the individual Canadian shareholder also is resident in Ontario. Three cases are shown: 

a normal Canadian corporation, subject to a 28 percent Federal tax plus a 3 percent surtax and a 15.5 percent Ontario tax; 

a Canadian manufacturing company, subject to a 23 percent Federal tax plus a 3 percent surtax and a 14.5percent Ontario 

tax; and a small business corporation subject to a 12 percent Federal tax on its business income (not exceeding $200,000 

per year) plus a 3 percent surtax and a 10percent Ontario tax. The shareholder is assumed to be subject to Federal income 

tax at the top rate of 29 percent (before credit) plus a 5 percent surtax, and an Ontario tax equal to 53 percent of the Federal 

tax (after shareholder credit). For simplicity, these rates do not reflect the Federal and provincial surtax on high-income 

individuals. 

Normal Manufacturing Small Business 

Corporation Corporation Corporation 

Net income of Canadian corporation 

Federal tax 

Federal surtax (3%) 

Ontario tax 

Total Federal and provincial tax 

Maximum distribution to shareholder 

25 percent gross-up 

Taxable income of shareholder 

Federal pie-shareholder credit income tax 

Dividend received credit (67% of gross-up) 

Federal tax after shareholder credit 

Federal surtax (5%) 

Ontario tax 

(53% of pre-surtax, post-credit, Federal tax) 

Total Federal and provincial shareholder tax 

Total value of credit to shareholder 

(Federal credit plus .53% of Federal credit) 

Value of credit as a percentage of gross-up 

Credit as a percentage of Federal and provincial 

corporate tax 

10.These amounts are indexed for inflation. 

100.00 100.00 100.00 

28.00 23.OO 12.00 

0.84 0.84 0.84 

15.50 14.50 10.00 

44.34 38.34 22.84 

55.66 61.66 77.16 

13.92 15.42 19.29 

69.58 77.08 96.45 

20.18 22.35 22.97 

9.28 10.28 12.86 

10.90 12.07 15.11 

0.55 0.60 0.76 

5.78 6.40 8.01 

17.23 19.07 23.88 

14.20 15.73 19.68 

102.0% 102.0% 102.0% 

32.0% 41.0% 86.2% 

11. Assume, for example, that a regular corporation earns $25of preference income and $100of taxable income. Assume, 

in addition, that a regular corporation is subject to Federal tax at a net rate of 28 percent (Le., after the provincial abatement) 

and that a shareholder is subject to Federal tax at a rate of 29 percent (both assumptions disregard surtaxes). Taking into 

account only Federal tax, the corporation pays $28of tax. When net income of $97 is distributed, the shareholder includes 

$121.25in income ($97x 125percent), has tax liability of $35.16and is entitled to a credit of $16.25,reducing shareholder 

tax to $18.91.The total Federal tax burden on $125of economic income is thus $46.91($28+$18.91),or 47 percent. Thus, 

the income has been taxed at a rate greater than either the shareholder or the corporatk rate. If, on the other hand, the 

corporation had earned $125 of preference income and $100 of taxable income, the total Federal tax burden on $225 of 

economic income would be $46.91,or 21 percent. 
Notes 246 

12. Special rules apply with respect to dividends on redeemable preference shares. 

13. When the avoir fiscal was enacted in 1965, the French corporate tax rate on distributed (and retained) profits was 50 

percent. The 50 percent avoir fiscal percentage was chosen in order to provide shareholders with a partial imputation credit 

equal to 50 percent of the taxes actually paid by a corporation on distributed profits. When the corporate tax rate was reduced 

to 42 percent in 1988, however, the avoir fiscal percentage also was not reduced to preserve the 50 percent relationship 

between the avoir fiscal and actual corporate tax payments. Instead, the avoir fiscal percentagewas maintained at 50 percent 

as a means of introducing a greater degree of integration. As a result, the avoir fiscal represented a greater percentage (69 

percent) of actual corporate tax payments on distributed profits. With the further reduction of the tax rate on distributed 

profits to 34 percent for 1992, the avoir fiscal will represent almost the entire amount of corporate level tax paid on 

distributed profits. 

14. Net operating losses generally may be camed forward for 5 years, although net operating losses attributable to 

depreciation may be carried forward indefinitely. If a net operating loss fully offsets taxable income in a carryover year, a 

dividend distribution out of carryover year income will incur the precompte mobilier. A corporation may elect, however, 

to spread a net operating loss carryover over the 5 year carryover period in order to leave some fully-taxed income in each 

year of the carryover period from which to make dividend distributions. 

Alternatively, a corporation may elect to carry back over a 3 year period a tax credit calculated by applying to the 

amount of the loss the standard corporate tax rate in effect at the end of the loss year. The tax credit may be used to offset 

income tax liability on undistributed fully-taxed profits realized during the 3 year carryback period. Any excess credit 

remaining thereafter is refunded. 

Net operating losses cannot be carried back to offset any portion of the prior years’ income for which tax liability was 

satisfied using avoir fiscal or other tax credits. 

15. Rather than separating income into fully-taxed and untaxed baskets, France effectively relies on the ability of French 

corporations to avoid the precompte mobilier out of retained earnings with respect to income taxed at rates less than 34 

percent. For example, assume that a corporation has FlOOO of gross income, F500 of which is taxable at 34 percent and 

F500 of which effectively is taxable at 19 percent, e.g., a dividend from a foreign corporation resident in a treaty country 

paid to a French nonparent corporation that is subject to a 15 percent foreign withholdingtax. If the corporation distributes 

its entire after-tax income of F735, this amount will be subdivided into two parts: a dividend of F330, which has borne 

regular corporate tax, and a dividend of F405, which has not borne corporate tax. The precompte mobilier will be imposed 

on F405 at a rate of 50 percent, resulting in an additional tax liability of F202.50. Thus, the total tax liability of the 

corporation will be F467.50, and the corporation will be required to pay the additional F202.50 liability out of retained 

earnings. 

As a practical matter, a corporation wishing to distribute tax-sheltered income will reduce the amount of its dividend 

so it can pay its precompte mobilier liability out of current after-tax income. In the above example, the corporation would 

pay a dividend of F600, equal to F330 (income that has borne regular 34 percent corporate tax) plus F270 (income that is 

subject to a precompte mobilier of 50 percent). The corporation’s total tax liability would be F400, equal to F265 regular 

corporate tax plus F135 precompte mobilier. 

16. The participation exemption results in an effective tax rate of (1) 2.55 percent on the gross amount of a dividend 

(including the amount of the avoir fiscal) received from a 10 percent-owned French subsidiary, and (2) 1.70 percent on the 

gross amount of a dividend (including the amount of a credit for foreign withholdingtax) received from a 10 percent-owned 

subsidiary in a treaty country. 

17. In some circumstances, a French company may elect to be taxed on all foreign branch income. In such cases, the 

precompte mobilier is not imposed upon distribution of the foreign branch income. 

18. The purpose of the special rules is to avoid an effective tax surcharge that arose under pre-1990 law. Dividendsreceived 

by a French holding company from a foreign subsidiary are exempt from French income tax in the hands of the holding 

company by virtue of the participation exemption. Prior to 1990, however, the foreign source dividend income was subject 

to the precompte mobilier upon redistribution by the holding company. Payment of the precompte mobilier by the holding 

company entitled the recipient to claim an avoir fiscal credit with respect to the redistribution. If the recipient was a French 

10 percent shareholder of the holding company, however, the participation exemption would exempt the income again in the 

hands of the 10 percent shareholder. Thus, the avoir fiscal was not needed to offset income tax liability of the 10 percent 

shareholder with respect to the dividend income. Under pre-1990 law, moreover, the avoir fiscal could not be used to offset 

income tax liability of the 10 percent shareholder with respect to other types of income. Pre-1990 law did permit the 10 
247 Notes 

percent shareholder to use the avoir fiscal to offset any precompte mobilier liability that it might incur upon a subsequent 

distribution of preference income; if the 10 percent shareholder did not have sufficient preference income however, all or 

a portion of the avoir fiscal (which had been "paid for" by the French holding company) was lost. 

19. The amount of the excess tax equals the amount distributed out of EK 50 (or EK 56), grossed-up to its pre-tax equivalent, 

and then multiplied by the difference between 50 percent (or 56 percent) and 36 percent (the distribution rate). Accordingly, 

if D equals distributions out of EK 50 (or EK 56), the corporation receives a refund of D/.50 x .14 (or D/.44 X -20). For 

example, if a corporation earns DMl00 and pays tax of DM50, it will have DM50 in its EK 50 account. If it then 

redistributes DM50 out of EK 50, the corporation will receive a refund equal to DM14 (DM501.50X .14). 

20. The followingtable illustrates the application of the German split rate and imputation credit systems. For simplicity, the 

table ignores any surtaxes. 

Income before taxes DM1OO.OO 

Tentative corporate tax DM50.00 

Decrease in corporate tax on full distribution DM14.00 

Amount available for distribution 

Withholding tax (25 percent) 

Shareholder includes in income 

Cash dividend 

Withholding tax credit 

Imputation credit 

Shareholder tax liability (53 percent rate) 

Shareholder credit 

Withholding tax credit 

Imputation credit 

Net amount due 

DM64.00 

DM16.00 

DM1OO.OO 

DM48.00 

DM16.00 

DM36.00 

DM100.00 

DM53.OO 

DM52.00 

DM16.00 

DM36.00 

DM52.00 

DM1.00 

21. The followingequation converts pre-tax income subject to tax at some non-EK rate into equivalent amounts of pre-tax 

income subject to tax at the distribution rate (36 percent) and either the statutory rate (50 percent) or the zero rate: 

.36X+(.5 0)x(Y -X) = T, where Y equals the total amount of pre-tax income (known) subject to some non-EK rate, 

X equals pre-tax income subject to the distribution rate, (Y -X) equals pre-tax income subject to either the statutory rate or 

zero rate, and T equals the amount of tax paid with respect to Y (known). Because X and (Y-X) must be positive, the 

effective tax rate, T/Y, determines whether the equation must contain the statutory rate or zero rate (and whether the residual 

amount of income is ultimately converted into EK 50 or EK 0). 

The following equations convert the pre-tax amounts, X and (Y-X), into their after-tax EK amounts: 

EK 36 = (1-.36)XX 

EK 50 (if T/Y > -36) = (1-.5O)X(Y-X) 

EK 0 (if T/Y < .36) = Y-X 

22. Specifically, the calculation converts the DMl00 into DM71.4 of income subject to the 36 percent distributionrate (.36+ 

Sx(DM100-X) = DM40) and the remainder, DM28.6, into income subject to the 50 percent statutory rate (DM100-

DM71.4 = DM28.6). This translates into available net equity of DM45.7 in the EK 36 category (.64xDM71.4) and 

DM14.3 in the EK 50 category (.50XDM28.6). 

23. Specifically, the calculation converts the DM100 into DM69.4 of income subject to the 36 percent distribution rate (.36X 

= DM25) and the remainder, DM30.6, into income subject to the zero rate (DM100-DM69.4 = DM30.6)). This translates 

into available net equity of DM44.4 in the EK 36 category (-64XDM69.4)and DM30.6 in the EK 0 category (DMlOODM69.4). 

24. The rules for carrybacks and carryforwards of net operating losses are designed to prevent the refund of an amount of 

tax that, by virtue of the imputationcredit, has already been used to offset shareholder taxes. In summary, when a German 

corporation suffers a net operating loss for a year, it first enters the full amount of the loss as a negative adjustment to its 
Notes 248 

EK 02 account. The corporation may then carry back the loss for two years and (to the extent the loss is not absorbed in 

these years) may cany forward the loss indefmitely. 

With respect to carrybacks, the loss may be deducted in the earlier year, and generate a refund, only to the extent of 

taxable income in that year less the sum of (1)any distributions in that year and (2) the distribution tax (36 percent) on such 

distributions. In effect, a carryback deduction is only allowed against taxable income if the tax on such income has not 

already been returned to shareholders by way of credit. 

If the NOL is not absorbed through carrybacks, it is carried forward and deducted in later years. As the loss is deducted 

(and is thereby automatically reflected in the EK 50 account), it is credited against the original negative adjustment to the 

EK 02 account. 

25. All German enterprises (including foreign corporations with permanent establishments in Germany) also are subject to 

the municipal "trade tax.I' This tax has both income tax and capital tax components. The basic trade tax rates are set by the 

Federal Government, but the local governments (which collect the tax) have considerable discretion to increase them. The 

income tax component is typically 15 percent. The trade tax is deductible in computing a corporation's normal taxliability. 

The trade tax is not taken into account in the examples in this summary. 

26. Tax is always withheld on dividendsat the statutory 25 percent rate at the time of distribution (except as noted below), 

Shareholders entitled to reduced withholding under a treaty must apply the German tax authorities for a refund of the excess 

withholding. This rule applies even to publicly traded shares. 

Some treaties contain an anti-avoidance rule designed to discourage corporations from distributing profits to nonresident 

shareholders who reinvest these profits in the same corporation in order to gain the benefit of the lower distribution rate on 

what are, in effect, retained profits. Such distributions are subject to a higher withholdingtax than normal distributions. (The 

1954 U.S.-Germany treaty had such a provision, but it was unilaterally waived by Germany in 1981.) 

27. The following example illustrates the treatment of foreign source income and foreign stockholders. Assume a German 

corporation has two foreign branches, the first in a treaty country (Country 1)and the second in a nontreaty country (Country 

2). The corporation has DMlOO of German profits, DMlOO of Country 1 profits, and DMlOO of Country 2 profits (all pretax). The German profits are taxed at the statutory rate of 50percent. The Country 1 profits are taxed in Country 1 at a rate 

of 25 percent and are exempt in Germany (under the Business Profits and Double Taxation articles of the treaty). The 

Country 2 profits are taxed in Country 2 at a rate of 30 percent and are subject to tax in Germany, but the German tax is 

reduced by a foreign tax credit. During the next year (when the corporation has no profits anywhere), all of the prior year 

profits are distributed to a foreign shareholder (who enjoys no treaty benefits). 

The German profits of DMlOO produced equity of DM50 in the EK 50 account. When these profits are distributed, the 

corporation receives a refund of DM14, also distributed to the foreign shareholder. The distribution of DM64 is subject to 

25 percent withholdingof DM16. The foreign shareholder receives no imputation credit with respect to this distribution. 

The Country 1 profits of DMlOO produced equity of DM75 in the EK 01 account. When this equity is distributed, it 

is subject to the 36 percent distribution tax (DM27), but the tax is credited and refunded to the foreign shareholder. The 

entire distribution (DM75-DM27 +DM27) is subject to 25 percent withholding (DM18.75). 

The Country 2 profits of DMlOO were reduced by DM30 of Country 2 tax, and then by an additional DM20 of German 

tax (at the statutory rate of 50 percent after the foreign tax credit). In allocating this income to EK accounts, the corporation 

is considered to have paid tax of DM20 on profits of DM70 (an overall tax rate of 28.6 percent). Specifically, the 

corporation is treated as having paid a 36 percent tax on DM55.6 and a 0 percent tax on DM14.4. This produced equity of 

DM35.6 in EK 36 (55.6 -(55.6 X36%))and DM14.4 in EK 01. When the profits are distributed, the distribution out of EK 

36 is not subject to any further tax and produces a refunded credit of 36/64, or DM20. The distribution out of EK 01 is 

subject to the 36 percent distribution tax, which is refunded. This results in a distribution, including refunds, of DM70 

(DM35.6+DM20+DM14.4-DM5.2+DM5.2= DM70). The total distribution is subject to statutory withholding of 25 

percent (DM17.5). 

The treatment of pre-1977 profits is illustrated by the following. Assume the corporation in the above example had only 

DMlOO of German profits, which were earned in 1976 and were subject to a tax of 56 percent at that time. The net profits 

of DM44 were placed in EK 03 in 1977, when the integration system was implemented. When these profits are distributed 

to a foreign shareholder in 1990, they are subject to a distribution tax of 36 percent (DM15.8), which is credited and 

refunded to the shareholder, producing a total distribution of DM44. This total distribution is subject to statutory Withholding 

of 25 percent (DMl1). 
249 Notes 

28. The following example illustrates the mechanics of New Zealand's credit system. A corporation earns income of 

NZ$100, of which NZ$60 is taxable, and the tax is NZ$19.80 (at a 33 percent rate). The corporation distributes the 

remaining NZ$81.20 to its shareholders. The payment of tax of NZ$19.80 gives rise to a credit to the ICA in the same 

amount. The maximum amount of credits that can be allocated to the distribution is NZ$33.99 (NZ$60X.33/(1-.33)). 

However, the corporation only allocates a credit of NZ$19.80 to the distribution to avoid having a negative ICA and 

incurring penalties. Not taking into account the refundable resident withholdingtax, the shareholder would include NZ$100 

in income (the cash distribution plus the attached credits), and have tax liability of NZ$33 and a credit of NZ$19.80. As a 

result, the shareholder has additional tax liability of NZ$13.20. 

29. Until March 3 1, 1991, the CFC regime applied only to a transitional list of low-tax countries (the "black list" countries). 

As of April 1, 1991, the new regime applies in full to a CFC resident in any country other than Australia, the United States, 

the United Kingdom, Japan, France, Germany or Canada (the ''grey list" countries). The CFC rules apply to investors in 

a CFC resident in a grey list country only if the CFC has taken advantage of overseas "specified tax preferences," and only 

if New Zealand tax exceeds the foreign tax that would be payable if the item were not a preference under that foreign 

country's tax laws. To date, there is only one scheduled specified tax preference, namely, any exemption from income tax 

for income derived from a business carried on outside the country. 

30. The shareholder continuity rules do not apply to any corporation whose shares are listed on the New Zealand Stock 

Exchange. 

31. The amount of the imputation credit is [(D/(1-.25)]x.25 = D/3 where D equals the amount of net qualifying 

distributions. 

32. The following example illustrates the mechanics of the imputationcredit and ACT. The example assumes: (1) a corporate 

tax rate of 33 percent, (2) a basic personal rate of 25 percent, (3) that all shareholders are taxed at a marginal rate of 25 

percent, and (4) that the corporation distributes to shareholders all after-tax (including ACT) earnings. 

A. Corporate income before preferences �100.00 

B. Preference deductions or exclusions (e.g., accelerated cost recovery 40.00 

in excess of book depreciation) 

C. Corporate taxable income (A -B) 60.00 

D. Corporate tax (.33 XC) 19.50 

E. Cash distributions to shareholders ((A-F-I) or (A-[(.33 -.25)/ 71.40 

1.33) 

F. ACT (E X .25/(1-.25)) 23.80 

G. Limit on use of ACT (.25 XC) 15.00 

H. ACT applied against mainstream corporate tax (lesser of F and G) 15.00 

I. Net mainstream tax (D-H) 4.80 

J. Total tax paid by corporation (F+I) 28.60 

K. Retained earnings (A-E-J) 0.00 

L. Surplus ACT credit available for carryback or carryforward (F-H) 8.80 

M. Shareholder income (E+F) 95.20 

N. Shareholder tax (.25 X M) 23.80 

0. Shareholder tax net of imputation credit (N-F) 0.00 

P. Total corporate and shareholder tax paid (J +0) 28.60 

If the shareholder in the example were instead a tax-exempt entity, the shareholder would be eligible for a refund of the 

entire imputation credit of �23.80. Accordingly, the total tax paid by the corporation and the shareholder would be �4.80, 

the net mainstream tax paid by the corporation. 

33. An indirect foreign tax credit is allowed with respect to taxes paid by a foreign corporation to a U.K. corporation that 

owns at least 10 percent of the foreign corporation. A similar credit is allowed if the foreign corporation is a controlled 

foreign corporation the income of which is taxed currently to a U.K. shareholder. 

34. Assume that a corporation eams El00 (of which �70 is U.K. source and BO is foreign source income) and pays foreign 

tax of E9 on the foreign source income (at a 30 percent rate). The corporation's mainstream tax is f24, of which �23.10 is 

attributable to U.K. income (.33Xf70) and fO.90 is attributable to to foreign source income ((.33Xf30)-�9). The 

corporation distributes E60 and pays ACT of f20. Under the general limit described in Section B.6.b, the corporation may 

apply the ACT of �20 against its mainstream tax on U.K.-source income only to the extent of 25 percent of f70, or f17.50. 

The corporation also may apply ACT against the fO.90 of U.K. mainstream tax payable on the foreign source income (the 
Notes 250 

lesser of the mainstream tax payable and 25 percent of �30 of foreign source income). Thus, the corporation offsets �18.40 

(�17.5O+fO.W) of ACT against its mainstream tax liability of �24 and therefore must make an additionalpayment of S.60. 

The corporation’s total U.K. tax liability is �25.60. 

35. The following example illustrates the difference in treatment of shareholders in countries with such treaties and 

shareholders in countries without such treaties. 

Example. A corporation distributes a total of BOO, consisting of �75 to each of the following: Shareholder A, a 

national of a nontreaty country, Shareholder B, a U.S. national owning less than 10 percent of the stock, 

Shareholder C, a U.K. resident, and Shareholder D, a U.S. national owning at least 10 percent of the stock. 

Shareholders A and C are subject to tax in the United Kingdom at a marginal rate of 40 percent, Shareholder B is 

subject only to the 15 percent withholding tax, and Shareholder D is subject only to the 5 percent withholding tax. 

The corporation pays ACT of El00 (B00X .25/(1-.25), or �25 on each distribution. 

Shareholder A is treated as receiving a distribution of only the �75 actually paid to him and is liable for tax of �30 

(.40X�75). Shareholder A is treated as having paid tax of �18.75 (.25X�75) due to the ACT paid by the 

corporation. Thus, Shareholder A must pay an additional �12.25. 

Shareholder B is treated as receiving a distribution of �100 and is liable for tax of �15 (.15X�100). Shareholder 

B is treated as having paid �25 (ACT paid on the distribution), and thus is entitled to a refund of �10. 

Shareholder C also is treated as receiving a distribution of �100 and is liable for tax of �40. Shareholder C is 

treated as having paid �25, and thus must pay an additional �15. 

Shareholder D is treated as receiving a distribution of f87.50 (�75 actually distributed plus one-half of the ACT) 

and is liable for tax of f4.38 (.05XB7.50). Shareholder D is treated as having paid �12.50 (one-half of the ACT), 

and thus is entitled to a refund of fS.13. 

Appendix C 

1. In that case, the credit would not only be nonrefundable but also would not be allowed to offset tax on other income of 

shareholders subject to tax at less than the maximum rate. The imputation credit prototype, described in Chapter 11, is a 

hybrid of these two approaches. It allows credits at the maximum shareholder rate but permits low-bracket shareholders to 

use excess credits against other tax liability. 

2. The second to last column of the example that follows in the text illustrates that this approach will pass through 

preferences if the corporate and shareholder rates are identical. 

3. Corporate tax credits could be passed through by treating credits as equivalent to corporate taxes paid. Corporate 

preferences that are exclusions from income could be passed through to shareholders by a separate accounting at the 

corporate level and exclusionat the shareholder level. Passing through deferral preferences, however, would be more difficult 

because some account would have to be taken of their reversal over time. The corporate AMT, for example, has a credit 

for Ah4T taxes against future regular income taxes. Alternatively, asset basis might be adjusted. Either of these approaches 

would be complicated at the shareholder level. See McLure (1979), pp. 95-99. 

4. There may be an indirect benefit to tax-exempt shareholders if a dividend exclusion system results in increased stock 

prices. 
GLOSSARY 

AFCE: Allowance for Corporate Equity. See Section 12.B. 

ACT: Advance Corporation Tax (United Kingdom). See Appendix B, Section B.6. 

ALI: American Law Institute. 

AMT: Alternative minimum tax. See Appendix A, Section A. 1, 

AMTI: Alternative minimum taxable income. See Appendix A, Section A. 1. 

Capital export neutrality: The principle that investors should pay equivalent taxes on capital income, 

regardless of the country in which the income is earned. See Section 7.B. 

Capital import neutrality: The principle that all investments within a country should face the same tax 

burden, regardless of whether they are owned by a domestic or a foreign investor. See Section 7.B. 

CBIT: Comprehensive Business Income Tax. See Chapter 4. 

C corporation: A corporation taxed under the classical system as set forth in Subchapter C of the 

Internal Revenue Code. See Appendix A, Section A. 1. 

CGE model: Computable general equilibrium model. See Section 13.C. 

Classical system: The two-tier corporate tax system, which taxes earnings on equity capital at both the 

corporate and sharehdder level. 

Code: The Internal Revenue Code of 1986, as amended. 

DRD: Dividends received deduction. See Appendix A, Section A. 1. 

DRIP: Dividend reinvestment plan. See Chapter 9. 

EDA: Excludable Distributions Account. See Sections 2.B and 4.B. 

EK: Eigencapital (equity capital) (Germany). See Appendix B, Section B.4. 

FEI: Family Economic Income. See Section 13.G. 

GDP: Gross domestic product. The value of final goods and services produced by factors of production 

in the United States. 

GNP: Gross national product. The value of final goods and services produced by U.S. owned factors 

of production, including factors that are actually used overseas. 

ICA: Imputation Credit Account (New Zealand). See Appendix B, Section B.5. 

25 1 
Glossary 252 

Inbound investment: Investment by foreign persons in the United States. See Section 7.A. 

IRS: Internal Revenue Service. 

MPM: Mutual production model. See Section 13.F. 

MTD: Minimum tax on distributions. See Section 12.C. 

NNP:Net national product. GNP minus capital consumption (depreciation). 

NOL:Net operating loss. See Appendix A, Section A. 1. 

OECD: Organisation for Economic Co-operation and Development 

OD: Original issue discount. The OID rules govern the accrual of discount on debt. Discount is 

economically equivalent to interest. 

Outbound investment: Investment by U.S. persons in foreign countries. See Section 7.A. 

PA model: Portfolio allocation model. See Section 13.F. 

REIT: Real estate investment trust. See Appendix A, Section A.1. 

REMIC: Real estate mortgage investment conduit. See Appendix A, Section A. 1. 

RIC: Regulated investment company. See Appendix A, Section A.l. 

R&D: Research and development. 

S corporation: A corporation which bears no corporate tax and whose shareholders are taxed under the 

passthrough regime set forth in Subchapter S of the Internal Revenue Code. See Appendix A, 

Section A. 1. 

SCA: Shareholder Credit Account. See Section 11.B. 

S&L: Savings and loan association. 

Subchapter C: The portion of the Internal Revenue Code that governs the taxation of corporations 

under the classical system. See Appendix A, Section A. 1. 

DIT: Unrelated business income tax.A tax-exempt entity is subject to UBIT on income derived from 

a business unrelated to the entity's exempt purpose and on certain passive income to the extent it 

is financed with debt. 
BIBLIOGRAPHY 

Aaron, Henry J., "A new view of property tax incidence," American Economic Review, Vol. 64 (May 1974). p. 212. 

Aaron, Henry J. and Harvey Galper, Assessing Tax Reform. Washington: The Brookings Institution (1985). 

Accounting Principles Board, Opinion No. 11, Accounting for Income Taxes (1967). 

Accounting Principles Board, Opinion No. 23. Accounting for Income Taxes -- Special Areas (1972). 

Agrawal, Anup and Gershon N. Mandelker, "Managerial incentives and corporate investment and financing decisions, " The 

Journal of Finance, Vol. 42 (September 1987). p. 823. 

Ambarish, Ramasastry, Kose John, and Joseph Williams, "Efficient signalling with dividends and investments, " Re Journal 

of Finance, Vol. 42 (June 1987). p. 321. 

American Bar Association, Section on Taxation, "Banking and savings institutions," Tax Lawyer, Vol. 37 (1984). p. 795. 

American Bar Association, Section on Taxation, "Banking and savings institutions," Tax Lawyer, Vol. 38 (1985). p. 819. 

American Bar Association, Section on Taxation, Earnings and Profits Work Group, "Elimination of 'earnings and profits' 

from the Internal Revenue Code," Tax Lawyer, Vol. 39 (1986). p. 285. 

American Bar Association, Section on Taxation, and New York State Bar Association, Tax Section, Comorate Tax Reform: 

A Report of the Invitational Conference on Subchapter C (1988). 

American Law Institute, Federal Income Tax Project, Reporter's Studv Draft, Subchapter C (Supplemental Studv). 

Philadelphia (1989). The Memorandum was written by Professor William D. Andrews of the Harvard Law School. 

American Law Institute, Federal Income Tax Project, Integration of the Individual and Comorate Income Taxes, Reuorter's 

Memorandum No. 1. Philadelphia (1990). The Memorandum was written by Professor Alvin C. Warren of the Harvard 

Law School. 

American Law Institute, Federal Income Tax Project, Integration of the Individual and Comorate Income Taxes, Reporter's 

Memorandum No. 2. Philadelphia (January 15, 1991). The Memorandum was written by Professor Alvin C. Warren 

of the Harvard Law School. 

American Law Institute, Federal Income Tax Project, Integration of the Individual and Comorate Income Taxes, Reporter's 

Memorandum No. 3. Philadelphia (draft of April 7, 1991). The Reporter is Professor Alvin C. Warren of the Harvard 

Law School. 

Ando, Albert and Franco Modigliani, 'The life cycle' hypothesis of saving: aggregate implications and tests, " American 

Economic Review, Vol. 53 (March 1963). p. 55. 

Andrews, William D., "Out of its earnings and profits: some reflections on the taxation of dividends," Harvard Law Review, 

Vol. 69 (1956). p. 1403. 

Andrews, William D., "Tax neutrality between equity capital and debt," Wayne Law Review, Vol. 30 (1984). p. 1057. 

Andrews, William D., "A consumption-type or cash flow personal income tax," Harvard Law Review, Vol. 87 (1974). p. 

1113. 

Ang, James and David Peterson, "Optimal debt versus debt capacity: a disequilibrium model of corporate behavior," 

Research in Finance, Vol. 6, A. Chen, editor. Greenwich, CT: JAI Press (1986). 

Auerbach, Alan J., "Wealth maximization and the cost of capital," QuarterlyJournal of Economics, Vol. 93 (August 1979). 

p. 433. 

Auerbach, Alan J., "Tax integration and the new view of the corporate tax: a 1980 perspective," Proceedings of the 74th 

Annual Conference. Columbus: National Tax Association and Tax Institute of America (1981). 

Auerbach, Alan J., "Corporate taxation in the United States," Brookings Papers on Economic Activity, Vol. 2 (1983). p. 

451. 

Auerbach, Alan J., "Taxation, corporate financial policy, and the cost of capital," Journal of Economic Literature, Vol. 21 

(September 1983). p. 905. 

Auerbach, Alan J., "Real determinants of corporate leverage, " Comorate Capital Structures in the United States, Benjamin 

Friedman, editor. Chicago: The University of Chicago Press (1985). 

253 
Bibliography 254 

Auerbach, Alan J., "Tax policy and corporate borrowing," Are the Distinctions Between Debt and Eauitv Disamearing? 

Richard Kopcke and Eric Rosengren, editors. Boston: Federal Reserve Bank of Boston (1989). 

Auerbach, Alan J., "Debt, equity, and the taxation of corporate cash flows," Taxes, Debt and Coruorate Restructuring, John 

B. Shoven and Joel Waldfogel, editors. Washington: The Brookings Institution (1990). 

Auerbach, Alan J. and Kevin Hassett, "Tax policy and business fixed investment in the United States," unpublished paper 

(1990). 

Auerbach, Alan J. and Kevin Hassett, "Recent U.S. behavior and the Tax Reform Act of 1986: a disaggregate view," 

Working PaDer No. 3626, Cambridge: National Bureau of Economic Research (February 1991). 

Auerbach, Alan J. and James M. Poterba, "Why have corporate revenues declined?" Tax Policy and the Economy, Vol. 1. 

Lawrence H. Summers, editor. Cambridge: MIT Press (1987). 

Auerbach, Alan and David Reishus, "Taxes and the merger decision, " Knights, Raiders. and Targets: The Imuact of Hostile 

Takeovers, John Coffee, Louis Lowenstein, and Susan Rose-Ackerman, editors. New York: Oxford University Press 

(1988). 

Ault, Hugh J., "International issues in corporate tax integration," Law and Policy in International Business, Vol. 10 (1978). 

p. 461. 

Avi-Yonah, Reuven S., "The treatment of corporate preference items under an integrated tax system: a comparative 

analysis," Tar Lawyer, Vol. 44 (1990). p. 195. 

Bagwell, Laurie Simon and John B. Shoven, "Cash distributions to shareholders, " The Journal of Economic Perspectives, 

Vol. 3 (Summer 1989). p. 129. 

Ballard, Charles L., Don Fullerton, John B. Shoven, and John Whalley, A General Eauilibrium Model for Tax Policy 

Evaluation. Chicago: University of Chicago Press (1985). 

Ballard, Charles L., John B. Shoven, and John Whalley, "The total welfare cost of the United States tax system: a general 

equilibrium approach," National Tar Journal, Vol. 38 (June 1988). p. 125. 

Barro, Robert and Xavier Sala-i-Martin, "World real interest rates, " NBER Macroeconomics Annual 1990. Cambridge: MIT 

Press (1990). p. 15. 

Bartholdy, J., G. Fisher and Jack Mintz, "Some theory of taxation and financial policy with application to Canadian 

corporate data. " Paper presented at the Econometric Society Fifth World Congress, Cambridge (1985). 

Batten, Dallas S. and Mack Ott, "The President's proposed corporate tax reforms: a move toward tax neutrality," Federal 

Reserve Bank of St. Louis Review, Vol. 67 (August/September 1985). p. 5. 

Benge, Matt and Tim Robinson, How to Integrate Comuanv and Shareholder Taxation: Why Full Imuutation is the Best 

Answer. Wellington: Victoria University Press for the Institute of Policy Studies (1986). 

Bergsten, C. Fred, Thomas Horst, and Theodore H. Moran, American Multinationals and American Interests. Washington: 

The Brookings Institution (1978). 

Bemanke, Ben S., "Is there too much corporate debt?" Federal Reserve Bank of Philadelphia Quarterly Review (September - October 1989). p. 3. 

Bemanke, Ben S. and John Y. Campbell, "Is there a corporate debt crisis?" Brookings Papers on Economic Activity 1 

(1988). p. 83. 

Bemanke, Ben S., John Y. Campbell, and Toni M. Whited, "U.S. corporate leverage: developments in 1987 and 1988," 

Brookings Papers on Economic Activity 1 (1990). p. 255. 

Bhattachaya, Sudipto, "Imperfect information, dividend policy, and the 'bird in the hand' fallacy," Bell Journal of 

Economics, Vol. 10 (Spring 1979). p. 259. 

Bird, Richard M., "International aspects of integration," National Tar Journal, Vol. 28 (1975). p. 302. 

Bittker, Boris I., "A 'comprehensive tax base' as a goal of income tax reform," Haward Law Review, Vol. 80 (1967). p. 

925. 

Blair, Margaret and Robert Litan, "Corporate leverage and leveraged buyouts in the eighties, " Taxes, Debt, and Coruorate 

Restructuring, John B. Shoven and Joel Waldfogel, editors. Washington: The Brookings Institution (1990). 
255 Bibliography 

Blazenko, George W., "Managerial preference, asymmetric information, and financial structure, " The Journal of Finance, 

Vol. 42 (September 1987). p. 839. 

Blinder, Alan and Angus Deaton, "The time series consumption function revisited, " Brookings Papers on Economic Activity 

2 (1985). p. 465 

Blum, Walter J., "The earnings and profits limitation on dividend income: a reappraisal," Tuxes, Vol. 53 (1975). p. 68. 

Boskin, Michael J., "Taxation, saving and the rate of interest," Journal of Political Economy, Vol. 86 (April 1978). p. S3. 

Bosworth, Barry P., Tax Incentives and Economic Growth. Washington: The Brookings Institution (1984). 

Bradford, David F., "The incidence and allocation effects of a tax on corporate distributions, " Journal of Public Economics 

Vol. 15 (February 1981). p. 1. 

Bradford, David F., Untangling the Income Tax. Cambridge: Harvard University Press (1986). 

Bradford, William D., "The issue decision of manager-owners under information asymmetry," The Journal of Finance, Vol. 

42 (December 1987). p. 1245. 

Bradley, Michael, Gregg Jarrell, and E. Han Kim, "On the existence of an optimal capital structure: theory and evidence," 

The Journal of Finance, Vol. 39 (July 1984). p. 857. 

Bravenec, Lorence L., "A nontraditional approach to corporate integration," Tax Notes (March 13, 1989). p. 1381. 

Break, George F., "Integrating corporate and personal income taxes: the Carter Commission proposals, " Law and 

Contemporary Problems, Vol. 34 (1969). p. 726. 

Break, George F., "Integration of corporate and personal income taxes," National Tar Journal, Vol. 22 (1969). p. 39. 

Break, George F., "Corporate tax integration: radical revisions or common sense?" Federal Tax Reform Myths and Realities, 

Michael J. Boskin, editor. San Francisco: Institute for Contemporary Studies (1978). 

Break, George F. and Joseph A. Pechman, "Relationship between the corporation and individual income taxes, " National 

Tar Journal Vol. 28 (1975). p. 341. 

Break, George F. and Joseph A. Pechman, Federal Tax Reform: the Impossible Dream? Washington: The Brookings 

Institution (1975). 

Breeden Douglas, "Anintertemporal capital asset pricing model with stochastic consumption and investment opportunities, 'I 

Journal of Financial Economics, Vol. 7 (1979). p. 265. 

Brittain, John, Comorate Dividend Policy. Washington: The Brookings Institution (1966). p. 74. 

Brown, E. Cary , "Business-income taxation and investment incentives," Income. Employment. and Public Policy: Essays 

in Honor of Alvin H. Hanson, New York: W. W. Norton & Company, Inc. (1948). 

Bulow, Jeremy I., Lawrence H. Summers, and Victoria P. Summers, "Distinguishing debt from equity in the junk bond 

era," Debt, Taxes, and Comorate Restructuring, John B. Shoven and Joel Waldfogel, editors. Washington: The 

Brookings Institution (1990). 

Campbell, John Y. and Richard Clarida, "The term structure of Euromarket interest rates: an empirical investigation," 

Journal of Monetary Economics, Vol. 19 (1987). p. 25. 

Canellos, Peter C., "Corporate tax integration: by design or by default," Tar Notes (June 8, 1987). p. 999. 

Caprio, Gerard and David Howard, "Domestic saving, current accounts, and international capital mobility, " International 

Finance Discussion Papers No. 244. Washington: Federal Reserve Board (1984). 

Caves, Richard E., Multinational Enterprises and Economic Analysis. Cambridge: Cambridge University Press (1983). 

Chirelstein, Marvin A., "Optional redemptions and optional dividends: taxing the repurchase of common shares, " Yale Law 

Journal, Vol. 78 (1969). p. 739. 

Chirinko, Robert S., "Business investment and tax policy: a perspective on existing models and empirical results, " National 

Tar Journal, Vol. 39 (June 1986). p. 137. 

Chirinko, Robert S., "The ineffectiveness of effective tax rates on business investment: A critique of Feldstein's FisherSchultz lecture," Journal of Public Economics, Vol. 32 (April 1987). p. 369. 
Bibliography 256 

Chirinko, Robert S. and Robert Eisner, "Tax policy and investment in major U.S. macroeconomic econometric models," 

Journal of Public Economics, Vol. 20 (March 1983). p. 139. 

Clark, Robert C., "The morphogenesis of Subchapter C: an essay in statutory evolution and reform, " Yale Law Journal, Vol. 

87 (1977). p.90. 

Cohen, Edwin S., "Possible solutions to practical problems in integration of the corporate and shareholders income tax," 

National Tar Journal, Vol. 28 (1975). p. 359. 

Cohen, Edwin S., Alvin C. Warren, and William D. Andrews, "The meaning of changes within the framework of 

Subchapter C and the impact on proposals for integration of the corporate and individual income tax, " Sun Diego Law 

Review, Vol. 22 (1985). p. 317. 

Congressional Budget Office, The Changing Distribution of Federal Taxes: 1975-1990 (October 1987). 

Congressional Budget Office, The Changing Distribution of Federal Taxes: A Closer Look at 1980 (July 1988). 

Consultative Committee on Full Imputation and International Tax Reform (The Valabh Committee), Full Imputation, an 

independent report to the New Zealand Government. Wellington (April 1988). 

Consultative Committee on Full Imputation and International Tax Reform (The Valabh Committee), International Tax 

Reform: Full Imputation, an independent report to the New Zealand Government. Wellington (July 1988). 

Consultative Committee on the Taxation of Income from Capital (The Valabh Committee), The Taxation of Distributions 

from Companies, an independent report to the New Zealand Government. Wellington (July 1991). 

Cooper, R., R. Krever, and R. Vann, Income Taxation. Sydney: The Law Book Company Limited (1989). 

Cutler, David M. and Lawrence Summers, "The costs of conflict resolution and financial distress: evidence from the TexacoPenzoil litigation." Rand Journal of Economics, Vol. 19 (Summer 1988). p. 157. 

Daily Tar Report, "EC Commissioner Scrivener vows to fight proposed environment taxes," (November 8, 1991). p. G-2. 

Dooley, Michael, Jeffrey Frankel, and Donald J. Mathieson, "International capital mobility: what do saving-investment 

correlations tell us?" International Monetary Fund Staff Papers, Vol. 34 (1987). p. 503. 

Douglas, R., Consultative Document on Full Imputation. Wellington: New Zealand Ministry of Finance (1987). 

Easterbrook, Frank H., "Two agency-cost explanations of dividends, " American Economic Review, Vol. 74, (September 

1984). p. 650. 

Ebrill, Liam P. and David G. Hartman, "On the incidence and excess burden of the corporation income tax," Public 

Finance, Vol. 37 (1982). p. 48. 

Eisner, Robert, "Tax policy and investment behavior: comment," American Economic Review, Vol. 59 (June 1969). p. 379. 

Eisner, Robert and M. Nadiri, "Investment behavior and neoclassical theory," Review of Economics and Statistics, Vol. 50 

(August 1968). p. 369. 

Engel, Charles and Kenneth Kletzer, "Saving and investment in an open economy with non-traded goods," Working Paper 

no. 2141, Cambridge: National Bureau of Economic Research (1987). 

Fazzari, Steven, R. Glenn Hubbard, and Bruce Petersen, "Financing constraints and corporate investment, " Brookings Papers 

on Economic Activity 1, (1988). p. 141. 

Federal Reserve Board, Flow of Funds Accounts, Financial Assets and Liabilities, Year End, Board of Governors of the 

Federal Reserve System (various issues). 

Feenberg, Daniel R. and Jonathan Skinner, "Sources of IRA savings," Tax Policv and the Economv, Vol. 3, Lawrence H. 

Summers, editor. Cambridge: MIT Press (1988). 

Feldstein, Martin, "Corporate taxation and dividend behaviour, " Review of Economic Studies, Vol. 37 (February 1970). p. 

57. 

Feldstein, Martin, "Corporate taxation and dividend behaviour: a reply and extension," Review of Economic Studies, Vol. 

39 (April 1972). p. 235. 

Feldstein, Martin, "The incidence of the social security payroll tax: comment," American Economic Review, Vol. 62 

(September 1972). p. 735. 
257 Bibliography 

Feldstein, Martin, "The income tax and charitable contributions: part I1 - the impact on religious, educational, and other 

organizations," National Tar Journal, Vol. 28 (June 1975). p. 209. 

Feldstein, Martin, "Inflation, tax rules, and investment: some econometric evidence," Econometrica, Vol. 50 (July 1982). 

p. 825. 

Feldstein, Martin, "Domestic saving and international capital movements in the long run and the short run," European 

Economic Review, Vol. 21 (1983). p. 139. 

Feldstein, Martin, "Imputing corporate tax liabilities to individual taxpayers, " Working Paper No. 2349. Cambridge: 

National Bureau of Economic Research (1987). 

Feldstein, Martin, "Testimony on tax policy aspects of mergers and acquisitions, " House of Representatives, Committee on 

Ways and Means, Serial No. 101-10, Tax Policv Aspects of Mergers and Acauisitions. Part I (January 31, 1989). p. 

192. 

Feldstein, Martin and Phillipe Bacchetta, "National saving and international investment, " Working Paper No. 3164. 

Cambridge: National Bureau of Economic Research (1989). 

Feldstein, Martin, Louis Dicks-Mireaux, and James M. Poterba, "The effective tax rate and the pre-tax rate of return," 

Journal of Public Economics, Vol. 21 (July 1983). p. 129. 

Feldstein, Martin and Daniel Frisch, "Corporate tax integration: the estimated effects on capital accumulation and tax 

distribution of two integration proposals," National Tar Journal, Vol. 30 (1977). p. 37. 

Feldstein, Martin and Charles Horioka, "Domestic saving and international capital flows, " me EconomicJournal, Vol. 

90 (June 1980). p. 314. 

Feldstein, Martin and Joosung Jun, "The effects of tax rules on nonresidential fixed investment: some preliminary evidence 

from the 1980s," The Effects of Taxation on CaDital Accumulation, Martin Feldstein, editor. Chicago: University of 

Chicago Press (1987). 

Feldstein, Martin and Joel Slemrod, "Inflation and the excess taxation of capital gains on corporate stock," National Tax 

Journal, Vol. 31 (1978). p. 107. 

Feldstein Martin, Joel Slemrod, and Shlomo Yitzhaki, "The effects of taxation on the selling of corporate stock and the 

realization of capital gains: reply," The Quarterly Journal of Economics, Vol. 99 (February 1984). p. 111. 

Fieleke, Norman S., "National saving and international investment, " Saving and Government Policv, Conference Series No. 

-25. Boston: Federal Reserve Bank of Boston (1982). 

Financial Accounting Standards Board, Statement of Financial Accounting Standards No. 96, Accounting for Income Taxes 

(1987). 

First Boston Corporation, New York, High Yield Handbook (various issues). 

Frankel, Jeffrey, "International capital mobility and crowding-out in the U. S. economy: imperfect integration of financial 

markets or of goods markets?" How hen is the U.S. Economy?, R. Hafer editor. Lexington: Lexington Books (1986). 

p. 33. 

Frankel, Jeffrey, "Quantifying international capital mobility in the 1980s," Current Issues in International Trade and 

International Finance, Dilip Das, editor. Oxford: Oxford University Press. (forthcoming). 

Frankel, Jeffrey and A. MacArthur, "Political vs. currency premia in international real interest differentials: a study of 

forward rates for 24 countries," European Economic Review, Vol. 32 (1988). p. 1083. 

Frankel, Jeffrey and Kenneth Froot, "Using survey data to test standard propositions regarding exchange rate expectations, " 

American Economic Review, Vol. 77 (1987). p. 133. 

Freemen, Louis S., "Some Early Strategies for the methodical disincorporation of America after the Tax Reform Act of 

1986: grafting partnerships onto C corporations, running amok with the master limited partnership concept, and generally 

endeavoring to defeat the intention of the draftsmen of the repeal of General Utilities," Taxes, Vol. 64 (1986). p. 962. 

Friedman, Benjamin J., "Views on the likelihood of financial crisis," Reducing the Risk of Financial Crisis, Martin 

Feldstein, editor. Chicago: University of Chicago Press (1990). 

French, Kenneth R. and James M. Poterba, "Investor diversification and international equity markets, " Working Pauer No. 

-3609. Cambridge: National Bureau of Economic Research (January 1991). 
Bibliography 258 

Frenkel, J. and R. Levich, "Transaction costs and interest arbitrage: tranquil versus turbulent periods, " Journal of Political 

Economy, Vol. 85 (1977). p. 1209. 

Froot, Kenneth and Jeffrey Frankel, "Forward discount bias: is it an exchange risk premium?" Quarterly Journal of 

Economics, Vol. 104 (1989). p. 139. 

Fullerton, Don, "Which effective tax rate?" National Tar Journal, Vol. 37 (March 1984). p. 23. 

Fullerton, Don, Robert Gillette, and James Mackie, "Investment incentives under the Tax Reform Act of 1986," 

Compendium of Tax Research 1987. Washington: U.S. Govt. Print. Off. (1987). 

Fullerton, Don and Roger H. Gordon, "A reexamination of tax distortions in general equilibrium models," Behavioral 

Simulation Methods in Tax Policv Analysis, Martin Feldstein, editor. Chicago: University of Chicago Press (1983). 

Fullerton, Don, Yolanda Henderson, and James Mackie, "Investment allocation and growth under the Tax Reform Act of 

1986," Compendium of Tax Research 1987. Washington: U.S. Govt. Print. Off. (1987). 

Fullerton, Don and Yolanda Henderson, "A dissagregate equilibrium model of tax distortions among assets, sectors and 

industries," International Economic Review, Vol. 30 (May 1989). p. 391. 

Fullerton, Don, John B. Shoven, and John Whalley, "Replacing the U.S. income with a progressive consumption tax," 

Journal of Public Economics, Vol. 20 (1983). p. 3. 

Fullerton, Don, A. Thomas King, John B. Shoven, and John Whalley, "Corporate tax integration in the United States: a 

general equilibrium approach," The American Economic Review, Vol. 71 (September 1981). p. 677. 

Gaffrey, Dennis J. and James E. Wheeler, "The double taxation of corporate source income: reality or illusion?" Tar 

Advisor, Vol. 8 (1977). p. 523. 

Gale, William G. and John Karl Scholz, "IRAs and household saving, " unpublished paper (1990). 

Galper, Harvey, Robert Lucke, and Eric Toder, "A general equilibrium analysis of tax reform," Uneasy Comuromise: 

Problems of a Hybrid Income-Consumption Tax, Henry J. Aaron, Harvey Galper and Joseph A. Pechman, editors. 

Washington: The Brookings Institution (1988). 

Gammie, Malcolm, "Corporate tax harmonisation: an 'ACE' proposal," IBFD European Taxation, Vol. 12 (1991). p. 545. 

Gertler, Mark and R. Glenn Hubbard, "Taxation, corporate capital structure, and financial distress, " Tax Policy and the 

Economy 4, Lawrence Summers, editor. Cambridge: MIT Press (1990). 

Gertler, Mark and R. Glenn Hubbard, "Corporate financial policy, taxation, and macroeconomic risk. " Unpublished paper 

(1991). 

Gertler, Mark and Kenneth Rogoff, "North-south lending and endogenous domestic capital market inefficiencies, 'I Journal 

of Monetary Economics, Vol. 26 (1990). p. 245. 

Gilbert, Richard J. and David M. Newbery, "Entry, acquisition, and the value of shark repellent," Working Paper 8888, 

University of California, Berkeley, (August 1988). 

Gilson, Ronald J., Myron S. Scholes, and Mark A. Wolfson, "Taxation and the dynamics of corporate control: the uncertain 

case for tax motivated acquisitions, " Working Paper No. 24, Stanford Law School (January 1986). 

Giovannini, Alberto, "Capital taxation: national tax systems versus the European capital market, " Economic Policy, Vol. 

4 (Oct. 1989). p. 345. 

Giovannini, Alberto and Philippe Jorion, "Interest rates and risk premia in the stock market and the foreign exchange 

market," Journal of International Money and Finance, Vol. 6 (1987). p. 107. 

Gordon, Roger H., "Uncertainty and the analysis of corporate tax distortions, " Proceedings of the 74th Annual Conference. 

Columbus: National Tax Association-Tax Institute of America (1981). 

Gordon, Roger H., "An optimal taxation approach to fiscal federalism," Quarterly Journal of Economics, Vol. 98 (Nov. 

1983). p. 567. 

Gordon, Roger H., "Taxation of investment and savings in world economy: the certainty case, 'I American Economic Review, 

Vol. 76 (Dec. 1986). p. 1086. 

Gordon, Roger H. and Jeffrey MacKie-Mason, "Effects of the tax reform act of 1986 on corporate financial policy and 

organizational form, " Do Taxes Matter? J. Slemrod, editor. Cambridge: MIT Press (1990). 
259 Bibliography 

Gordon, Roger H. and Jeffrey K. MacKie-Mason, "Taxes and the choice of organizational form," Working Paper No. 3781. 

Cambridge: National Bureau of Economic Research (July 1991). 

Gordon, Roger H. and Burton Malkiel, "Corporation finance," How Taxes Affect Economic Behavior, Henry J. Aaron and 

Joseph A. Pechman, editors. Washington: The Brookings Institution (1981). 

Gourevitch, Harry G., "Corporate tax integration: the European experience," Tar Lawyer, Vol. 31 (1977). p. 65. 

Graetz, Michael J., "Legal transitions: the case of retroactivity in income tax revision, " University of Pennsylvania Law 

Review, Vol. 47 (1977). p. 126. 

Graetz, Michael J., "Implementing a progressive consumption tax," Haward Law Review, Vol. 92 (1979). p. 1575. 

Gravelle, Jane G., Effective Tax Rates in the Administration and Ways and Means Tax Proposal: Updated Tables, 

Congressional Research Service Report for Congress No. 85-1006E, Congressional Research Service, Washington, D.C. 

(1985). 

Gravelle, Jane G., Effective Comorate Tax Rates in the Major Revision Plans: A Comparison of the House. Senate, and 

Conference Committee Versions, Congressional Research Service Report for Congress No. 85-1099E, Congressional 

Research Service, Washington, D.C. (1986). 

Gravelle, Jane G., "Differential taxation of capital income: another look at the 1986 Tax Reform Act, " National Tar Journal, 

Vol. 47(2) (December 1989). pp. 441. 

Gravelle, Jane G., Comorate Tax Integration: Issues and Options, Congressional Research Service, Washington, D.C. 

(199 1). 

Gravelle, Jane G. and Laurence Kotlikoff, "The incidence and efficiency costs of corporate taxation when corporate and 

noncorporate firms produce the same good," Journal of Political Economy, Vol. 97 (Aug. 1989). p. 749. 

Griffith, Thomas D., "Integration of the corporate and personal income taxes and the ALI proposal," Santa Clara Law 

Review, Vol. 23 (1983). p. 715. 

Goldsworth, John G., "Status report on harmonization of direct taxation," Tux Notes Znternational (February 14, 1990). p. 

15. 

Hall, Robert E., "Intertemporal substitution in consumption," Journal of Political Economy, Vol. 96 (April 1988). p. 339. 

Hall, Robert E. and Dale W. Jorgenson, "Tax policy and investment behavior," American Economic Review, Vol. 57 (June 

1967). p. 391. 

Hall, Robert E. and Dale W. Jorgenson, "Application of the theory of optimal capital accumulation," Tax Incentives and 

Capital Spending, Gary From, editor. Washington: The Brookings Institution (1971). 

Halperin, Daniel I., "Interest in disguise: taxing the time value of money," Yale Law Journal, Vol. 95 (1986). p. 506. 

Halperin, Daniel I. and C. Eugene Steuerle, "Indexing the tax system for inflation," Uneasy Compromise: Problems of a 

Hybrid Income-Consumption Tax, Harvey Galper and Joseph A. Pechman, editors. Washington: The Brookings 

Institution (1988). 

Hammer, Richard M., "The taxation of income from corporate shareholders: review of present systems in Canada, France, 

Germany, Japan and the U.K.," National Tar Journal, Vol. 28 (1975). p. 315. 

Hansen, Lars and Robert Hodrick, "Risk averse speculation in the forward foreign exchange market," Exchange Rates and 

International Macroeconomics, Jacob Frenkel, editor. Chicago: University of Chicago Press (1983). 

Harberger, Arnold C., "The incidence of the corporation income tax," Journal of Political Economy, Vol. 70 (June 1962). 

p. 215. 

Harberger, Arnold C., "Efficiency effects of taxes on income from capital," Effects of the Comoration Tax, Marian 

Krzyzaniak, editor. Detroit: Wayne State University Press (1966). 

Harberger, Amold C., "Vignettes on the world capital market," American Economic Review, Vol. 70 (1980). p. 331. 

Harberger, Arnold C., "The state of the corporate income tax: who pays? Should it be repealed?" New Directions in Federal 

Tax Policv for the 1980's, Charles E. Walker and Mark A. Bloomfield, editors. Cambridge: Ballinger Publishing 

Company (1983). 
Bibliography 260 

Hatta, Tatsuo, "Welfare effects of changing commodity tax rates toward uniformity, " Journal of Public Economics, Vol. 

29 (February 1986). p. 99. 

Haugen, Robert A. and Lemma W. Senbet, "On the resolution of agency problems by complex financial instruments: a 

reply," i?ze Journal of Finance, Vol. 42 (September 1987). pp. 1091. 

Henderson, Yolanda K., "The taxation of banks: particular privileges or objectionable burden?" New England Economic 

Review (May/June 1987). p. 3. 

Hervey, Richard J., Taxation of Regulated Investment Companies. Washington: Tax Management (1987). 

Hines, James and R. Glenn Hubbard, "Coming home to America: dividend repatriations by U.S. multinationals," Taxation 

in the Global Economy, Assaf Rain and Joel Slemrod, editors. Chicago: University of Chicago Press (1990). 

Hoffman, Amold, "Pension funds and the economy, 1950-87," Trends in Pensions, Daniel Beller and John Tumer, editors. 

Department of Labor (1989). 

Holland, Daniel M., "Some observations on full integration," National Tax Journal, Vol. 28 (1975). p. 353. 

Horst, Thomas, "A note on the optimal taxation of international investment income, " Quarterly Journal of Economics, Vol. 

44 (June 1980). p. 793. 

House of Representatives, Committee on Ways and Means, The President's 1978 Tax Reduction and Reform ProDosals, 95th 

Cong., 2d Sess. (1978), pt. 6. 

House of Representatives, Committee on Ways and Means, Tax Reform Act of 1985: Report of the Committee on Ways 

and Means, House of Representatives. on H.R. 3838 Together With Dissenting and Additional Dissenting Views (Report 

No. 426), 99th Cong., 1st Sess. (December 7, 1985). pp. 234-242, 302-328. 

Howry, Phillip and Saul Hymans, "The measurement and determinants of loanable funds saving," What Should be Taxed: 

Income or Expenditure? Joseph A. Pechman, editor. Washington: The Brookings Institution (1978). p. 1. 

Hubbard, R. Glenn, "Do IRAs and Keoghs increase saving?" National Tax Journal, Vol. 37 (March 1984). p. 43. 

Hubbard, R. Glenn, "Tax corporate cash flow, not income," Re Wall Street Journal (February 16, 1989). 

Hubbard, R. Glenn, "Introduction, " Asymmetric Information, Corporate Finance, and Investment. R. Glenn Hubbard, editor. 

Chicago: University of Chicago Press (1990). 

Hubbard, R. Glenn and Kenneth L. Judd, "Liquidity constraints, fiscal policy, and consumption, " Brookings Papers on 

Economic Activity 1 (1986). p. 1. 

Hubbard, R. Glenn and Kenneth L. Judd, "Social security and individual welfare: precautionary saving, borrowing 

constraints, and the payroll tax," American Economic Review, Vol. 77 (September 1987). p. 630. 

Institute for Fiscal Studies, The Structure and Reform of Direct Taxation: The Report of a Committee Chaired by Professor 

J.E. Meade. London: George Allen and Unwin (1978). 

Institute for Fiscal Studies, Equity for Companies: A Corporation Tax for the 1990s. Fourth Report of the IFS Capital Taxes 

Group, Commentary No. 26. London: Institute for Fiscal Studies (1991). 

Investment Company Institute, Mutual Fund Fact Books (various editions). 

Jensen, Michael, "Agency costs of free cash flow, corporate finance, and takeovers," American Economic Review, Vol. 32 

(1986). p. 323. 

John, Kose, "Risk-shifting incentives and signalling through corporate capital structure, " TheJournal ofFinance, Vol. 42 

(1987). p. 623. 

Jorgenson, Dale W., "Capital theory and investment behavior," American Economic Review, Vol. 53 (May 1983). 

Jorion, Phillipe and Eduardo Schwartz, "Integration vs. segmentation in the Canadian stock market, " TheJournal of Finance, 

Vol. 41 (1986). p. 603. 

King, Mervyn A., "Corporate taxation and dividend behavior: a comment," Review of Economic Studies (1971). p. 377. 

King, Mervyn A., "Corporate taxation and dividend behavior: a further comment," Review of Economic Studies, Vol. 39 

(1972). p. 231. 

King, Mervyn A., Public Policv and the Corporation. London: Chapman and Hall (1977). 
26 1 Bibliography 

King, Mervyn A., "The cash flow corporate income tax," The Effects of Taxes on Capital Accumulation, Martin Feldstein, 

editor. Chicago: University of Chicago Press (1987). 

Kitchen, Harry M., "Canada," Comparative Tax Systems: Euroue. Canada and Jauan, Joseph A. Pechman, editor. 

Arlington: Tax Analysts (1987). 

Konstas, Panos, "Bank and tax-exempt securities in the new tax environment," Banking and Economic Review 

(NovembedDecember 1986). 

Lakonishok, Josef and Baruch Lev, "Stock splits and stock dividends: why, who, and when," The Journal of Finance, 

Vol. 42 (September 1987). p. 913. 

Lamoureux, Christopher G. and Percy Poon, "The market reaction to stock splits," The Journal of Finance, Vol. 42 

(December 1987). p. 1347. 

Lander, Joel, "Optimal taxation policies which affect capital structure, " Law and Economics Workshop, UCLA Economics 

Dept. (May 12, 1989). 

Larum, J. "The taxation of superannuation in Australia," presented at the policy forum Assessing the Implications of 

Proposalsfor Pension Fund Taration, Employee Benefits Research Institute--Educationand Research Fund, Washington, 

D.C. (1990). 

Lee, William, "Corporate leverage and the consequences of macroeconomic instability, " Studies in Financial Changes and 

the Transmission of Monetarv Policy. New York: Federal Reserve Bank of New York: (May 1990). 

Leonard, Robert J., "A pragmatic view of corporate integration," Tax Notes (June 1, 1987). p. 889. 

Levmore, Saul, "The positive role of tax law in corporate and capital markets." Journal of Corporate Law, Vol. 12 (1987). 

p. 483. 

Lichtenberg, Frank R. and Donald Siegel, "The effects of leveraged buyouts on productivity and related aspects of firm 

behavior, " Working Pauer No. 3022, Cambridge: National Bureau of Economic Research (June 1989). 

Lintner, John V., "The distribution of incomes of corporations among dividends, retained earnings, and taxes," American 

Economic Review, Vol. 46 (May 1956). p. 97. 

Litzenberger, Robert H. and James C. Van Home, "Elimination of the double taxation of dividends and corporate financial 

policy, The Journal of Finance, Vol. 33 (June 1978). p. 737. 

Lodin, Sven-Olof, The Swedish Tax Reform of 1991 - An Overview, Stockholm: Federation of Swedish Industries (1990). 

Long, Michael S. and Ileen B. Malitz, "Investment patterns and financial leverage," Corporate Capital Structures in the 

United States, Benjamin Friedman, editor. Chicago: University of Chicago Press (1985). 

Mackie, James B., "Real and financial distortions of the corporate income tax," mimeo, Office of Tax Analysis, U.S. 

Treasury (1991, forthcoming). 

MacKie-Mason, Jeffrey, "Do taxes affect corporate financing decisions?" The Journal of Finance, Vol. 45 (December 1990). 

p. 1471. 

MacKie-Mason, Jeffrey K., "Do firms care who provides their financing, " Asvmmetric Information, Coruorate Finance, 

and Investment, R. Glenn Hubbard, editor. Chicago: University of Chicago Press (1990). 

Mark, Nelson, "Some evidence on the international equality of real interest rates, " Journal of International Money and 

Finance, Vol. 4, (1985). p. 189. 

Marsh, Paul, "The choice between equity and debt: an empirical study," The Journal of Finance, Vol. 37 (March 1982). 

p. 121. 

Masulis, Ronald W., "Impact of capital structure changes on firm value: some estimates," The Journal of Finance, Vol. 38 

(March 1983). p. 107. 

Maule, James Edward, "The effect of federal income tax integration on state tax systems," Tar Notes (July 12, 1982). p. 

99. 

Mayer, Colin, "Corporation tax, finance and the cost of capital," Review of Economic Studies, Vol. 153 (1986). p. 93. 

McIntyre, Michael J., "Pensees on integration: where's the reform?" Tax Notes (Sept. 5, 1977). p. 11. 
Bibliography 262 

McLure, Charles E., Jr., "Integration of the personal and corporate income taxes: the missing element in recent tax reform 

proposals," Harvard Law Review, Vol. 88 (1975). p. 532. 

McLure, Charles E., Jr., "The case for integrating the income taxes," National Tar Journal, Vol. 28 (September 1975). 

p. 255. 

McLure, Charles E., Jr., "Integration of the income taxes: why and how," Journal of Corporate Taration, Vol. 2 (1976). 

p. 458. 

McLure, Charles E., Jr., "Integrating the income taxes: how to do it right," Tar Notes (September 5, 1977). p. 3. 

McLure, Charles E., Jr., "A status report on tax integration in the United States," National Tar Journal, Vol. 31 (1978). 

p. 313. 

McLure, Charles E., Jr., Must Comorate Income Be Taxed Twice? Washington: The Brookings Institution (1979). 

McLure, Charles E., Jr., "International aspects of dividend relief," Journal of Corporate Taration, Vol. 7 (Summer 1980). 

p. 137. 

McLure, Charles E., Jr. and Stanley S. Surrey, "Integration of income taxes-issues for debate," Harvard Business Review, 

Vol. 55 (September-October 1977). p. 169. 

McNulty, John K., "Integrating the corporate income tax," American Journal of Comparative Law, Vol. 31 (1983). p. 661. 

Mieszkowski, Peter, "Tax incidence theory: the effects of taxes on the distribution of income," Journal of Economic 

Literature, Vol. 7 (December 1969). p. 1103. 

Miller, Merton H. and Kevin Rock, "Dividend policy under asymmetric information," The Journal of Finance, Vol. 40 

(September 1985). p. 103. 

Miller, Merton H. and Myron S. Scholes, "Dividends and taxes," Journal of Financial Economics, Vol. 7 (August 1979). 

p. 433. 

Minarik, Joseph J., "The effects of taxation on the selling of corporate stock and the realization of capital gains: Comment, " 

Quarterly Journal of Economics, Vol. 99, No. 1 (February 1984). p. 93. 

Mishkin, Frederic S., "Are real interest rates equal across countries? An empirical investigation of international panty 

conditions," The Journal of Finance, Vol. 39 (1984a). p. 1345. 

Mishkin, Frederic S., "The real interest rate: a multi-country empirical study," Canadian Journal of Economics, Vol. 17 

(1984b). p. 283. 

Moody's Bond Survey, (various editions). Published by Moody's Investors Service, New York. 

Mundstock, George, "The mistaxation of rent: eliminating the lease/loan distinction," Tar Notes (October 21, 1991). p. 353. 

Murphy, R., "Capital mobility and the relationship between saving and investment in OECD countries," Journal of 

International Money and Finance, Vol. 3 (1984). p. 327. 

Murthy, N.R.Vasudeva, "The effects of taxes and rates of return on foreign direct investment in the United States: some 

econometric comments," National Tar Journal, Vol. 42 (June 1989). p. 205. 

Musgrave, Peggy B., United States Taxation of Foreign Investment Income: Issues and Arguments, Cambridge: International 

Tax Program, Harvard Law School (1969). 

Musgrave, Richard A. and Peggy B. Musgrave, Public Finance in Theorv and Practice. New York: McGraw Hill Inc. 

(1984). p. 268. 

Mutti, John and Harry Grubert, "The taxation of capital income in an open economy: the importance or resident-nonresident 

tax treatment," Journal of Public Economies, Vol. 27 (1985). p. 291. 

Myers, Stewart C., "The capital structure puzzle," The Journal of Finance, Vol. 39 (July 1984). p. 575. 

Nadeau, Serge, "A model to measure the effects of taxes on the real and financial decisions of the firm," National Tar 

Journal, Vol. 41 (December 1988). p. 467. 

Nagle, F. R., "Scrivener and Brittan urge progress on indirect tax harmonization during U.S.visits," Tar Notes International 

(June 10, 1990). p. 322. 
263 Bibliography 

Narayanan, M. P., "On the resolution of agency problems by complex financial instruments: a comment," The Journal of 

Finance, Vol. 42 (September 1987). p. 1083. 

Neese, Beth, "Thrifts and taxes: a never-ending battle (or does it only seem that way?)," Bottomline, Vol. 5 (November 

1988). p. 45. 

Neubig, Thomas S., "The taxation of financial institutions after deregulation," National Tar Journal, Vol. 37 (September 

1984). p. 351. 

Neubig, Thomas S. and Martin A. Sullivan, "The effect of the Tax Reform Act of 1986 on commercial banks," 

Compendium of Tax Research 1987, Department of the Treasury, Washington: U.S. Govt. Print. Off. (1987). 

New York State Bar Association, Tax Section, Committee on Corporations, "Report on the integration of the corporate and 

individual income taxes," Tax Lawyer, Vol. 31 (1977). p. 37. 

Nolan, John S., "Integration of the corporate and individual income taxes," 1978 University of Southern California Tar 

Institute (1978). p. 899. 

Obstfeld, Maurice, "Capital mobility in the world economy: theory and measurement, " Carnegie-Rochester Conference Series 

on Public Policy, Vol. 31 (1986). 

Obstfeld, Maurice, "How integrated are world capital markets? Some New Tests," Working Paper No. 2075 (1986). 

Organisation for Economic Co-operation and Development, National Accounts, Detailed Tables. Volume 11. 1976 - 1988. 

Organisation for Economic Co-operation and Development, Revenue Statistics of OECD Member Countries. 1965-1990. 

Paris (1991). p. 78. 

Ofer, Aharon R. and hjan V. Thakor, "A theory of stock price responses to alternative corporate cash disbursement 

methods: stock repurchases and dividends," The Journal of Finance, Vol. 42 (June 1987). p. 365. 

Ofer, Aharon R. and Daniel R. Siegel, "Corporate financial policy, information, and market expectations: an empirical 

investigation of dividends." The Journal of Finance, Vol. 42 (September 1987). p. 889. 

Parker, James E., "Evaluating proposals for eliminating double taxation in the U.S.," Tar Executive, Vol. 30 (April 1978). 

p. 210. 

Pechman, Joseph A. and Benjamin A. Okner, Who Bears the Tax Burden? Washington: The Brookings Institution (1974). 

Pechman, Joseph A., Who Paid the Taxes?, 1966-85. Washington: The Brookings Institution (1985). 

Pechman, Joseph A., Federal Tax Policy, 5th edition. Washington: The Brookings Institution (1987). 

Pechman, Joseph A., "Tax reform: theory and practice," Journal of Economic Perspectives Vol. 1 (Summer 1987). p. 11. 

Peel, Fred W., "A proposal for eliminating double taxation of corporate dividends," Tar Lawyer, Vol. 39 (1985). p. 1. 

Penati, A. and M. Dooley, "Current account imbalances and capital formation in industrial countries, 1949-1981," 

International Monetary Fund StagPapers, Vol. 31 (1984) p. 1. 

Platt, Joseph S., "Integration and correlation--the Treasury proposal," Tar Law Review, Vol. 3 (1947). p. 59. 

Polito, Anthony P., "A proposal for an integrated income tax," Harvard Journal of Law and Public Policy, Vol. 12 (1989). 

p. 1009. 

Popper, H., "The term structure of interest rates in the onshore markets of the United States, Germany, and Japan," 

International Finance Discussion Papers No. 382, Washington: Federal Reserve Board (1990). 

Poterba, James M., "How burdensome are capital gains taxes: evidence from the United States?" Journal of Public 

Economics, Vol. 33 (July 1987). p, 157. 

Poterba, James M., "Tax policy and corporate saving," Brookings Papers on Economic Activity 2 (1987). p. 455. 

Poterba, James M. and Lawrence Summers, "The economic effects of dividend taxes," Recent Advances in Coruorate 

Finance, Edward Altman and Marti Subrahmanyam, editors. Homewood: Richard D. Irwin (1985). 

Rangazas, Peter and Dewan Abdullah, "Taxes and the corporate sector debt ratio: some time series evidence," Review of 

Economics and Statistics, Vol. 69 (1987). p. 357. 

Richardson, R. (New Zealand Minister of Finance), and W. Creech (New Zealand Minister of Revenue), Taxing Income 

Across International Borders: A Policy Framework (July 30, 1991). 
Bibliography 264 

Richardson, R. (New Zealand Minister of Finance), and W. Creech (New Zealand Minister of Revenue), Taxation Policy: 

Business Tax Policy 1991 (July 30, 1991). 

Roach, Stephen, "Living with corporate debt," Morgan Stanley Essay (November 1988). 

Royal Commission on Taxation, Report of the Roval Canadian Commission on Taxation, Vol. 4, Chapter 19. Ottawa: 

Queen's Printer (1966). 

Rudnick, Rebecca S., "Who should pay the corporate tax in a flat tax world?" 39 Case Western Reserve Law Review, Vol. 

39 (1988-89). p. 965. 

Sato, Mitsuo, and R. Bird, "International aspects of the taxation of corporations and shareholders," International Monetary 

Fund Staffpaper, Vol. 22 (1975). p. 384. 

Schaffer, Daniel C., "The income tax on intercorporate dividends," Tar Lawyer, Vol. 33 (Fall, 1979). p. 161. 

Seidel, Jeffrey B. and Joseph V. Zolofra, "Banks are increasingly offering their clients advice on mutual funds and may soon 

be able to sell the vehicles widely," Bankers Monthly, Vol. 105 (1988). p. 109. 

Seidman, L. William, "Integration of corporate and individual income tax system," remarks to AICPA Tax Committee 

(March 22, 1990). 

Senate, Committee on Finance, Tax Reform Act of 1986: Report of the Committee on Finance. United States Senate. to 

Accompany H.R. 3838. toeether with Additional Views, (Report No. 313), 99th Cong., 2nd Sess. (May 29, 1986). 

Shakow, "Taxation without realization: a proposal for accrual taxation," University of Pennsylvania Law Reviews, Vol. 134 

(1986). p. 1111. 

Shefrin, Hersh M. and Meir Statman, "Explaininginvestor preference for cash dividends," Journal of Financial Economics, 

Vol. 13 (June 1984). p. 253. 

Sheppard, Lee A., "Corporate tax integration, the proper way to eliminate the corporate tax," Tar Notes (May 6, 1985). 

p. 637. 

Shleifer, Andrei and Robert W. Vishny, "Large shareholder and corporate control," Journal of Political Economy, Vol. 94 

(June 1986). p. 461. 

Shoven, John B. and John Whalley, "A general equilibrium calculation of the effects of differential taxation of income from 

capital in the U.S.," Journal of Public Economics, Vol. 1 (1972). p. 281. 

Shoven, John B., "The incidence and efficiency effects of taxes on income from capital, " Journal of Political Economy, Vol. 

84 (December 1976). p. 1261. 

Shoven, John B., "The tax consequences of share repurchases and other non-dividend cash payments to equity owners, " 

Policv and the Economy, Vol. 1, Lawrence Summers, editor. Cambridge: The MIT Press (1987). 

Shoven, John B. and John Whalley, "Applied general equilibrium models of taxation and international trade: introduction 

and survey," Journal of Economic Literature, Vol. 22 (September 1984). p. 1001. 

Simon, William E., "Testimony," Tax Reform. Hearings before Committee on Ways and Means, House of Representatives, 

94th Cong., 1st Sess. (1975), pt. 5, p. 3846. 

Sinai, Allen, Andrew Lin, and Russell Robins, "Taxes, saving, and investment: some empirical evidence," National Tar 

Journal, Vol. 36 (1983). p. 321. 

Smith, Dan Throop, "Relief from double taxation of dividend income," Harvard Business Review, Vol. 55 (January-February 

1977). p. 87. 

Smith, Janet Kiholm, "Trade credit and informational asymmetry," Re Journal of Finance, Vol. 42 (September 1987). p. 

863. 

Staff of the Joint Committee on Taxation, Tax Reform Proposals: Comorate Taxation, (JCS-40-85) 99th Cong., 1st Sess. 

(September 19, 1985). 

Staff of the Joint Committee on Taxation, Federal Income Tax Aspects of Comorate Financial Structures, (JCS-1-89) lOlst 

Cong., 1st Sess. (January 18, 1989), p. 92. 

Staff of the Joint Committee on Taxation, Tax Policv and Capital Formation 95th Cong., 1st Sess., (JCS-14-77), (1977). 
265 Bibliography 

Staff of the Joint Committee on Taxation, Factors Affecting the International Competitivenessof the United States, (JCS-6-

91), 102nd Cong., 1st Sess. (May 30, 1991). 

Staff of the Senate Finance Committee, The Reform and Simplification of the Income Taxation of Comorations, (S.Prt. 98-

95) 98th Cong., 1st Sess. (1983). 

Staff of the Senate Finance Committee, The Subchapter C Revision Act of 1985: A Final Report Prepared by the Staff of 

the Senate Finance Committee, (Report 99-47), 99th Cong., 1st Sess. 45 (1985). 

Stehle, R., "Anempirical test of the alternative hypotheses of national and international pricing of risky assets," Re Journal 

of Finance, Vol. 32 (1977). p. 493. 

Steuerle, C. Eugene, "A simplified integrated tax," Tar Notes (July 17, 1989). p. 335. 

Stiglitz, Joseph, "Taxation, corporate financial policy, and the cost of capital, " Journal Public Economics, Vol. 2 (1973). 

p. 1. 

Strongin, Steven, "Credit flows and the credit crunch," Chicago Fed Letter. Chicago: Federal Reserve Bank of Chicago 

(November 1991). 

Summers, Lawrence H., "Taxationand corporate investment: a q-theory approach," Brookings Papers on Economic Activity 

l(l981). p. 67. 

Summers, Lawrence H., "Tax policy and international competitiveness," Working Paper No. 2007. Cambridge: National 

Bureau of Economic Research (1986). 

Surrey, Stanley S., Pathways to Tax Reform: the Concept of Tax Expenditures. Cambridge: Harvard University Press 

(1973). 

Surrey, Stanley S., "Reflections on 'integration' of corporate and individual taxes, " National Tax Journal, Vol. 28 

(September 1975). p. 335. 

Swedish Ministry of Finance, The Swedish Tax Reform of 1991 (April 1991). 

Taylor, Willard B., "Report on the integration of corporate and individual income taxes," Tar Lawyer, Vol. 31 (1977). p. 

37. 

Tehranian, Hasan, Nickolaos G. Travlos, and James F. Waegelein, "The effect of long-term performance plans on corporate 

sell-off-induced abnormal returns, " The Journal of Finance, Vol. 42 (September 1987). p. 933. 

Thuronyi, Victor, "The taxation of corporate income -- a proposal for reform," American Journal of Tar Policy, Vol. 2 

(1983). p. 109. 

Travlos, Nickolaos G., "Corporate takeover bids, methods of payment and bidding firms' stock returns, " The Journal of 

Finance, Vol. 42 (September 1987). p. 943. 

Turro, John, "The demise of the unified European Community withholding tax," Tar Notes International (August 9, 1989). 

p. 3. 

U.S. Department of Commerce, Bureau of Economic Analysis, National Income and Product Accounts. 

U.S. Department of Commerce, Bureau of Economic Analysis, Survey of Current Business. U.S. Govt. Print. Off. (various 

issues). 

U.S. Department of the Treasury, Blueprints for Basic Tax Reform, U.S. Govt. Print. Off. (1977). 

U.S. Department of the Treasury, Tax Reform Options Papers (1977). 

U.S. Department of the Treasury, Tax Reform for Fairness, Simplicity, and Economic Growth: The Treasury Department 

Report to the President, U.S. Govt. Print. Off. (1984). 

U.S. Department of the Treasury, Report to the Congress on Life Insurance Company Taxation (August 1989). 

U.S. Department of the Treasury, Report to the Congress on Taxation of Life Insurance Company Products (1990). 

U. S. Department of the Treasury, Widely Held Partnerships: Compliance and Administrative Issues (1990). 

U.S. Department of the Treasury, Report to the Congress on Property and Casualty Insurance Company Taxation (1991). 

Vann, R., Trans-Tasman Taxation of Ecluitv Investment. Wellington: Victoria University Press for the Institute of Policy 

Studies (1989). 
Bibliography 266 

Venti, Steven F. and David A. Wise, “Tax-deferred accounts, constrained choice, and estimation of individual saving,“ 

Review of Economic Studies, Vol. 53 (1986). p. 579. 

Warren, Alvin C., “Fairness and a consumption-type or cash flow personal income tax,“ Harvard Law Review, Vol. 88 

(1975). p. 931. 

Warren, Alvin C., Jr., “The relation and integration of individual and corporate income taxes, ” Harvard Law Review, Vol. 

94 (198lj. p. 719. 

Warren, Alvin C., Jr., “Corporate integration proposals and ACRS,” Sun Diego Law Review, Vol. 22 (1985). p. 325. 

Warshawsky, Mark, “Is there a corporate debt crisis? Another look,” Financial Markets and Financial Crises, R. Glenn 

Hubbard, editor. Chicago: University of Chicago Press (1991). 

Weiss, Randall D. “Effective corporation income tax rates,” National Tax Journal, Vol. 32 (September 1979). p. 380. 

The White House, The President’s Tax ProDosals to the Congress for Fairness, Growth, and Simdicity, U.S. Govt. Print. 

Off. (1985). p. 12. 

Wiesenberger Financial Services, Investment Companies Service, 1989. New York: Warren, Gorham, and Lamont. p. 10. 

Williamson, Oliver E., “Mergers, acquisitions, and leveraged buyouts: an efficiency assessment, ” Working PaDer No. 60, 

Yale University Center for Studies in Law, Economics and Public Policy, Program in Law and Organization (January 

1987). 

Young, Kan H., “The effects of taxes and rates of return on foreign direct investment in the United States,” National Tax 

Journal, Vol. 41 (March 1988). p. 109. 

Zolt, Eric M., “Corporate taxation after the Tax Reform Act of 1986: a state of disequilibrium,” North Carolina Law 

Review, Vol. 66 (June 1988). p. 839. 
ACKNOWLEDGEMENTS 

This Report reflects a great deal of effort by virtually the entire professional staff of the 

Office of Tax Policy. It is therefore impossible to acknowledge properly all the individual 

contributions to a truly team effort. The names of those who contributed are listed on the next 

page. 

A few contributions require special mention, however. Deputy Assistant Secretaries 

Glenn Hubbard and Harvey Rosen have drafted, edited, and discussed the substance and the 

structure of the Report with our staff and us through countless hours and many drafts. Eric Zolt, 

while Deputy Tax Legislative Counsel, shouldered the enormous burden of creating and 

synthesizing the initial drafts and has remained a major contributor to the Report even after 

assuming his new duties in Europe. James Mackie of the Office of Tax Analysis staff made 

major contributionsto the economic analyses presented in the Report. Anne Alstott, an AttorneyAdvisor in the Office of Tax Legislative Counsel, spent untold hours analyzing unresolved 

issues, synthesizing the many comments and transforming drafts into publishable text. 

Production of a document of this size and complexity requires the assistance of a talented 

staff combining word-processing knowledge, editorial care, and infinite patience. For all this, 

we gratefully acknowledge the contributions of Rudie Slaughter, Ros Baker, Jacqueline Fritsch, 

and Peggy McConkey. 

Finally, we thank our colleagues in the Treasury Department who reviewed our work and 

assisted us with their comments. 

January 1992 Kenneth W. Gideon 

Michael J. Graetz 

267 
26 8 

Office of Tax Analysis 

B.K. Atrostic 

Gerald Auten 

Edith Brashares 

David Braze11 

James Cilke 

Paul Dobbins 

James Dutrow 

Lowell Dworin 

Mordecai Feinberg 

Marcia Field 

Geraldine Gerardi 

Robert Gillette 

Tracy Gomes 

Harry Grubert 

David Joulfaian 

Michael Kaufman 

John Linton 

James Mackie 

Michael McDonald 

Hudson Milner 

Susan Nelson 

Scott Newlon 

James Nunns 

William Randolph 

Donald Rousslang 

Gerald Silverstein 

Jerry Tempalski 

William Trdutman 

David Weiner 

David Wentworth 

Les Whitaker 

Gordon Wilson 

Roy Wyscarver 

Robert Yuskavage 

Seymour Fiekowsky 

Sa1I y Wallace 

Tax Legislative Counsel 

Anne Alstott 

Jose Berra 

Evelyn Brody 

Andrew Dubroff 

Heidi Ebel 

Hal Gann 

Larry Garrett 

Terrill Hyde 

Terry Jacobs 

Jud Kelley 

Joan Leonard 

James Miller 

Barksdale Penick 

Roy Strowd 

Kathleen Ferrell 

Gregory Marich 

Robert Scarborough 

Robert Wootton 

Eric Zolt 

International Tax Counsel 

Charles Cope 

Emily McMahon 

Philip Morrison 

Marlin Risinger 

Rom Watson 

Peter Barnes 

Benefits Tax Counsel 

Catherine Creech 

Kurt Lawson 

Evelyn Petschek 

Tom Terry 

Richard Shea 

On detail from the 

Congressional 

Research Service 

Jane Gravelle