A Recommendation for Integration 

of 

The Individual and Corporate 

Tax Systems 

Department of the Treasury 

December 1992 
&xx-rkc 11, 1992 

The Honorable Dan Rostenkowski 

Chairman 

Committee on Ways and Means 

U.S. House of Representatives

Washington, D.C. 20515 

Dear Mr. Chairman: 

Enclosed is a description of our recommended approach 

to integrating the corporate and individual income tax systems.

This material is a follow-up to the Report of the Treasury on 

Integration of the Individual and Corporate Income Tax 

Systems-Taxing Business Income Once (released in January 1992,

hereafter the Treasury Integration Report). The Treasury

Integration Report identified the distortions caused by our 

current system for taxing corporate profits and the substantial 

benefits to the economy that would result from integration, and 

described four alternative integration prototypes. At that time, 

we committed to recommending a specific integration system in 

late 1992.' 

1. Recommended prototype. Although each of the 

prototypes described in the Treasury Integration Report has 

merit, we are recommending a system similar to the dividend 

exclusion prototype for the following reasons: 

0 Relative to the shareholder allocation and 

imputation credit prototypes of relieving the 

double taxation of corporate equity income, the 

dividend exclusion approach is the most straightforward and easily administered. 

0 While there are strong arguments that some version 

of the Comprehensive Business Income Tax (CBIT) 

prototype may be preferable from a long-term

policy and administrative perspective, the 

dividend exclusion approach can be implemented

much more rapidly, with far less potential for 

disruption of financial markets and many fewer 

transition issues. 

0 The dividend exclusion approach is preferable to 

the shareholder allocation and imputation credit 

prototypes because it is consistent with our 

policy view that, over the long-term, it may be 
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desirable to move the tax system in the direction 

of a schedular tax on enterprise activity (e.g.,

the CBIT prototype or some version of a business 

cash flow tax or business transfer tax). 

The dividend exclusion model we recommend is simple and 

will generally tax corporate income once. A corporation will 

compute its taxable income and pay tax as under current law. Any

distribution out of the corporation's income that remains after 

paying tax and after making certain limited adjustments to 

taxable income (adjusted taxable income or ATI) is treated as a 

dividend and is excludable from gross income when received by

shareholders. Distributions in excess of AT1 are treated as a 

return of capital to the shareholders (or capital gain to the 

extent the distribution is in excess of basis). 

AT1 is defined as corporate taxable income reduced by 

U.S. federal income taxes and creditable foreign taxes paid or 

accrued and increased by excludable dividends received and by

items that are permanently excluded from income (e.g., tax-exempt

interest and percentage depletion in excess of basis). Because 

distributions in excess of AT1 will be treated as a return of 

capital, no distributions are ever treated as taxable dividends. 

Thus, under the proposal, earnings and profits (E&P) accounts 

will no longer be relevant for determining the character of 

distributions from U.S. corporations. Similarly, the dividends 

received deduction will no longer be necessary because dividends 

will be excludable. 

While the capital gains tax on the sale of stock will 

be retained, the proposal allows corporations to adopt Dividend 

Reinvestment Plans (DRIPS). Through the DRIP, a corporation will 

deem that a cash dividend was paid to its shareholders out of its 

AT1 and immediately reinvested by the shareholders. The 

shareholders will pay no tax on the deemed dividend (because

dividends are excludable), but will increase their bases in their 

shares by the amount of the deemed dividend. The effect will be 

to reduce the capital gains (or increase the capital losses)

realized when shareholders sell their stock by an amount equal to 

the corporation's retained previously-taxed earnings. 

2. Modifications to Treasury Integration Report

Version of Dividend Exclusion Prototype. The principal

differences between our current recommendation and the prototype

described in the Treasury Integration Report are: (a) we treat 

all distributions in excess of AT1 as returns of capital (even if 

the corporation has E&P); (b) we extend integration to foreign 

source income (by "flowing-through*Icreditable foreign taxes);

and (c) we recommend an immediate effective date (with limited,

elective transition relief for corporate shareholders). We have 

made these modifications for the following five reasons: 
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(1) They are more consistent with our stated policy

goals. 

(2) They create fewer character of income and timing

distortions, result in a system that is more 

easily administered, and permit other significant

simplifying changes in the tax law. 

(3) We believe that any objection to existing tax law 

preferences should be addressed directly, rather 

than through continued reliance on an E&P-based 

measure of dividends. 

(4) We believe that revenue concerns are more properly

addressed in a policy-neutral manner (e.g., by

scaling back underlying preferences; raising 

revenue elsewhere in the system; or, if necessary,

by scaling back the dividend exclusion). 

(5) While extending the benefits of integration to 

creditable foreign taxes is clearly justified on 

policy grounds, it also is based on the assumption

that reciprocal treatment will be provided by our 

major trading partners. This recommendation 

should be reconsidered, and alternatives should be 

explored, in the absence of reciprocity. 

3. Interaction with Other Tax Policy Issues. In 

developing our recommendations, it has become increasingly clear 

that an integration regime should not be developed in isolation 

(or under the assumption that other structures in the tax law 

will remain unchanged). Rather, the design of an integration 

system should be considered in the context of--and be addressed 

in a manner consistent with--long-term policy goals relating to 

the compelling case for international reform, the AMT and 

corporate preferences, the accumulation and investment of capital

by tax-exempt entities (including non-U.S. and taxpayers and 

companies with substantial net operating losses), and the 

overriding need for tax simplification and the reduction of 

taxpayer burden. 

4. Setting priorities. We recognize that other fiscal 

and tax policy issues may be given higher priority in the near 

term, that many of the specific technical issues arising under 

any integration proposal are yet to be resolved, and that any

specific legislation would require off-setting tax law changes to 

deal with revenue and distributional concerns. 

Nonetheless, we remain convinced that integration

should be a high-priority, tax policy objective. Current tax law 

distortions--which encourage debt financing by the corporate 
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sector, penalize businesses conducted in corporate form,

discourage dividend distributions, and leave us out of step with 

our primary international trading partners--impose very real 

costs on the economy. We believe that these costs are likely to 

increase in the years ahead and that the case for some form of 

corporate integration will be all the more compelling. 

I urge you to give the recommendation careful 

consideration in your deliberations on reform of the U.S. tax 

system. I am sending similar letters to Senator Lloyd Bentsen, 

Chairman of the Senate Committee on Finance; Senator Bob 

Packwood; Representative Bill Archer; and Representative Charles 

Rangel, Chairman of the Subcommittee on Select Revenue Measures. 

sincerely, 

Nicholas L F.ABrady k

Enclosure 
A RecommendatioII for Integratiori 

of the Individual and Corporate Tax Systems 

CURRENT LAW 

Two levels of income tax are generally imposcd on earnings froin investments in 

corporate equity. First, tax is imposed on the corporation’s taxable income. Second, if the 

corporation distributes earnings to shareholders, the earnings are taxed at the shareholder level, 

either as ordinary income in the case of dividend distributions, or as capital gain in the case of 

non-dividend distributions in excess of the shareholders’ stock bases. Retained earnings are taxed 

at the shareholder level through the capital gains tax on stock sales. 

By contrast, the income on debt investments in corporations is taxed only once because 

interest expense is generally deductible by the corporation and includable in income by the 

creditor. In addition, the income on equity investments in unincorporated businesses (such as 

proprietorships and partnerships), qualifying small business corporations (i.e., S corporations), 

and certain types of investment corporations (such as regulated investment companies) is 

generally taxed only once, at the investor level. Distributions from those types of businesses are 

generally tax-free to the extent they represent earnings that were previously taxed to the 

investors or are treated as a return of capital to the extent of any excess over previously taxed 

earnings. 

REASONS FOR CHANGE 

The disparities between the taxation of income from corporate equity investments and 

income from other types of investments cause three serious inefficiencies: 

A tax disincentive to incorporate, which causes many businesses to forego the 

non-tax benefits of operating a business in the corporate form, and a penalty on 

businesses that must operate in corporate form. 

A tax-motivated preference to use debt rather than equity capital, which 

encourages corporations to operate with higher debt-equity ratios than they 

otherwise would choose for non-tax reasons. 

A tax-motivated preference to retain rather than distribute corporate earnings to 

shareholders. 

As discussed in Chapter 13 of the Rcport oftlio Trc.cisu/yon Intcgrotion of the Individual 

and Corporate Tux Systms -Tbxing Business IncomJ Once (January 1992) (the Treasury 

Integrution Report), these biases reduce corporate investment, encourage artificially high debtequity ratios, and discourage dividend payments, all of which lead to significant inefficiencies 

and competitive disadvantages to the U.S. economy. An integrated tax system, in which 
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corporate earnings generally are taxed only once, will reduce these distortions and thus provide 

significant economic benefits. It also will bring our tax system more in line with those of our 

major trading partners, many of whom have adopted some form of integration of their individual 

and corporate tax systems. 

RECOMMENDATION 

Overview 

We recommend a corporate/shareholder tax integration scheme that will generally tax 

corporate income once. Under our recommendation, a corporation computes its taxable income 

and pays tax as under current law. Any distribution out of the corporation’s income that remains 

after paying tax and after inaking certain limited adjustments (adjusted taxable income or ATI) 

is treated as a dividend and is excludable from gross income when received by shareholders. 

Distributions in excess of AT1 are treated as returns of capital to the shareholders (or as capital 

gain to the extent the distribution exceeds their basis). 

AT1 is defined as corporate taxable income reduced by U.S. federal income taxes and 

creditable foreign taxes paid or accrued and increased by excludable dividends rcccivcd and by 

items that are permanently excluded from income (e.g., tax-exempt interest and percentage 

depletion in excess of basis). Because distributions in excess of AT1 will be treated as returns 

of capital, nu dibtributions are ever treated as taxable dividends. Thus, iinder our recommended 

approach, earnings and profits (E&P) accounts will no longer be relevant for determining the 

character of distributions from U.S. corporations. Similarly, the dividends received deduction 

will no longer be necessary because dividends will be excludable. 

The capital gains tax on the sale of stock will be retained. Standing alone, the 

combination of a dividend exclusion regime and a capital gains tax on stock sales would create 

artificial incentives to distribute previously taxed income (because dividends would be excludable 

but increases in stock value that represent retained earnings would be taxed to the selling 

shareholders) and would comparatively disadvantage corporations that retain earnings for further 

investment by raising their cost of capital. To minimize this distortion, corporations will be 

allowed to adopt Dividend Reinvestment Plans (DRIPS).Through the DRIP, a corporation will 

deem that a cash dividend was paid to its shareholders out of its AT1 and immediately reinvested 

by the shareholders. The shareholders will pay no tax on the deemed dividend (because 

dividends are excludable), but will increase their bases in their shares by the amount of the 

deemed dividend. The effect will be to reduce the capital gains (or increase the capital losses) 

realized when shareholders sell their stock by an amount equal to the corporation’s retained 

previously-taxed earnings. DRIP dividends may be declared at any time during the year. 

The AT1 system will be fully effective for each corporation in its first taxable year 

beginning after the date of enactment. A special rule will allow corporations to continue to claim 

the dividends received deduction for five years. 
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Discussion 

Our major goal in devising a system of integration is to reduce the distortions caused by 

the current two-level tax system while avoiding a system that was difficult to administer or 

overly complex. While the AT1 system does not eliminate all the distortions under current law, 

we believe it significantly reduces inany of them. The AT1 approach treats corporations more 

like other forms of business and thus reduces the tax disincentive to incorporate. It treats equity 

more favorably than does current law, reducing the disparity between debt and equity. Finally, 

it reduces the tax inccntivc to rctain earnings, because dividend distributions will be excludable 

by shareholders. 

In addition, the AT1 system is both administrable and understandable. By drawing heavily 

from existing rules, the AT1 system reduces the need to implement new sets of rules where 

existing law is well established. The recommended changes to current law should simplify the 

corporate tax system (e.g., AT1 is easier to compute than E&P, the concept it largely replaces). 

All distributions are either dividends (and therefore excludable) or returns of capital, simplifying 

shareholder level treatment as well. The DRIP provisions add some complexity because the 

DRIP allows upward adjustments of shareholder basis, but the DRIP rules are necessary to avoid 

creating tax incentives to distribute income. Finally, a number of existing tax rules will be 

repealed as unnecessary, further simplifying the tax laws. Thus, we believe that thc AT1 system 

reduces current law distortions within the context of an administrable system. 

Although each of the prototypes described in the Troasury Inregrc/r/on Report has its 

merits, the system we recommend is similar to the dividend exclusion prototype described in 

Chapter 2 of the Treusury Znregmrion Reporf. Relative to the shareholder allocation and 

imputation credit prototypes, the dividend exclusion system is the most easily administered 

approach to relieving the double taxation of equity earnings. While there are strong arguments 

that the Comprehensive Business Income Tax (CBIT) prototype may be preferable from a longterm policy (and administrative) perspective, the dividend exclusion approach can be 

implemented much more rapidly, with far less potential for disruption of financial markets and 

many fewer transition issues. In addition, the dividend exclusion system is prcfcrablc to the 

shareholder allocation and imputation credit prototypes because it is consistent with our policy 

view that, over the long term, it may be desirable to move the tax system in the direction of a 

schedular lax un enterprise activity (e.g., the CBIT approach or some version of a business 

transfer tax). 

There are two principal differences between the system we now recornmend and the 

dividend exclusion system described in the Trmsury Integrc/tion Rqorr. First, our recommended 

system treats all distributions in excess of previously taxed income a9 returns of capital (even 

if the corporation has E&P). Second, our recommended system extends integration to foreign 

source income by flowing through creditable foreign taxes although this extension of integration 

benefits to foreign taxes is predicated on the assumption that our major trading partncrs will, 

over time, provide reciprocal treatment. 
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The dividend exclusion system in the Tremuty Inregrution RL.port would have treated 

distributions in excess of previously taxed income (up to the amount of available E&P) as 

taxable dividends. Two basic considerations were implicit in that decision. First, to the extent 

that E&P is viewed as reflecting economic income, the Trc.usury Inregrotion Roport reasoned that 

the distribution of that income from corporate solution should trigger a tax at the investor level 

if a domestic corporate level tax had not already been imposed. Second, the TmIsury htegi-don 

Reporr gave significant weight to the revenue cost of repealing the E&P-based measure of 

dividends. 

Although these concerns remain valid, we are now placing greater emphasis on simplicity 

and economic efficiency, and therefore have concluded that the E&P-based measiire of dividends 

should be eliminated and replaced with the AT1 approach. Compared to the E&P approach, the 

AT1 system (i) more closely parallels a schedular tax on enterprise activity, (ii) reduces taxbased distortions among different forins of business enterprise, and (iii) reduces artificial 

incentives to retain earnings. In addition, the AT1 approach creates fewer character and timing 

distortions, is more easily administered, and permits other significant simplifying changes in the 

tax law. We also believe that any objection to exiyting tax preferences should be addressed 

directly, rather than through reliance on E&P. Finally, we recommend addressing revenue 

concerns in a policy-neutral manner (e.g., by scaling back the underlying preferences, raising 

revenue elsewhere in the system, or, if necessary, by allowing only a partial exclusion of 

dividends), rather than by retaining the E&P regime.' 

Thus, we reconiniend a dividend exclusion system based on AT1 rather than E&P.' 

Under this system, preference income will receive one of two possible treatments depending on 

whether the preference is a timing preference or a permanent exclusion. Corporate distributions 

attributable to a timing preference, such as accelerated depreciation, will reduce shareholder 

basis. If the shareholder holds the stock tititil the timing preference reverses, basis can be 

restored through a DRIP dividend when the corporation recognizes the deferred income. If the 

shareholder sells the stock before the timing preference reverses, the preference will be 

recaptured through a capital gains tax on the stock sale, approximating the result that would have 

' A partial dividend exclusion system would treat distributions out of AT1 iis part excludable and part returns 

of capital to shareholders. If the i-zvziiuz cost C J xicli ~ a partial dividend exclusion system is still too high, an 

alternative partial exclusion would treat distributions out of AT1 as partially excludable and partially taxable to 

shareholders. If the revenue cost needs to be reduced even further, we would recommend an E&P-based system 

modeled after the dividend exclusion prototype in the Twtrvrity /tirogurfio/t Rqiot'f. 

We also considered a regime that retained the E&P measiire of dividends, but provided that all distributions 

from E&P would be excluded from income at tht: shareholder level. We rejected this alternative for some of the 

same reasons that we decided not to retain E&P as a nieasiire of taxable dividend distributions (e.g., retention of 

the same tax base for all purposes; minimization of timing and character distortions; and ease of administration). 

Moreover, we were concerned that the E&P approach would further exacerbate the distinctions between inside and 

outside basis. The basis reduction approach we have adopted is admittedly rough justice, and will result in 

distortions in a number of real-world cases. While an exclusion based on E&P would mitigate some of these 

concerns, it would create other more troublesome distortions (e.g., a significant shifting in the nominal incidence 

of taxation on disposition of shares followiny distributions from E&P in excess of ATI). 
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followed if the corporation had sold a portion of the asset that created the preference. When the 

corporation eventually pays the deferred tax, the new shareholders will receive an offsetting 

basis adjustment. Distributions attributable to permanent exclusions will not reduce shareholder 

basis, because reducing basis would result in a recapture of preferences that were meant to be 

permanent. Thus, these preferences are made excludable by including them in ATI. 

The Trcmury Integrofion R(1pot-r also recommended against extending the benefit of 

integration to creditable foreign taxes. While we are continuing to study this issue as part of our 

International Tax Study, we believe that passing through foreign tax ci edits is consistent with 

the fundamental goals of integration. It also furthers the goal of capital export neutrality, because 

equivalent integration treatment applies to corporations earning foreign source income and 

corporations earning U.S. source income. We therefore recommend extending integration to 

creditable foreign taxes, provided that our major trading partners grant reciprocal treatment. At 

present, other countries with integrated tax systems generally do not pass through foreign tax 

credit^.^ If this continues to be the case, we will reconsider our recom~nendation.~An alternative would be to pass through foreign tax credits by treaty in cases where the treaty partner 

grants reciprocal benefits, although this could entail a qignificant level of complexity. The AT1 

system can be modified so that it does not extend integration to foreign taxes by providing for 

either a basis adjustment or shareholder-level income inclusion upon the distribution of income 

sheltered by foreign tax credits. 

TECHNICAL EXPLANATION 

Recommendation 1: Retention of Current Law 

(a) Corporations will continue to calculate their income under current law rules and 

will pay tax according to the existing graduated rate schedule. Credits, including 

foreign tax credits, will offset corporate tax as under current law. 

(b) Distributions in excess of basis will continue to be taxed as gains from the sale 

or exchange of property. The distinction under section 302 between redemptions 

that are treated as section 301 distributions (i.e., generally as dividends) and 

redemptions that are treated as in exchange for stock (i.e., generally as capital 

transactions) will remain. The rules governing corporate transactions, such as 

acquisitive and divisive reorganizations, liquidations, and taxable acquisitions will 

' The Rudiny Committee, however, has recommended that countries within the European Community with 

integrated tax systems extend integration benefits to foreign taxes levied by other members of the European 

Community. See Commission of the European Communities, Report oj'the Coiriirrirree clf' Itidopericlerrt Experrs on 

Corrrpatiy Tm-arion ( I 992). 

Excluding the pass-through of creditable foreign taxes from our integration recommendation could also be 

justified on revenue grounds. On balance, however, we reconmiend addressing revenue concerns in other ways. 
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generally be the same as under current law. Corporations will continue to be eligible to file consolidated returns as under current law, although the consolidated 

return regulations will be amended to conform to the integrated corporate tax. 

Discussion: The desire to retain current law was a major reason for choosing a dividend 

exclusion system. Retaining current law significantly simplifies the transition to integration by 

relying on established principles and rules. To the extent current law is modified, the changes 

generally result in simplification or repeal of existing rules and a reduction in taxpayer burdens. 

Recoinmendation 1 siininiarizes the iiiajor components of corporate tax law that are retained. 

Recommendation 2: Definition of Adjusted Taxable Income 

(a) In General: Each year, corporations will compute their addition to ATI. The 

addition to AT1 is equal to taxable income (calculated after the application of any 

loss carryforward), reduced by (i) the regular U. S. federal i ticonie tax liability 

before the application of any minimum tax credits and (ii) creditable foreign taxes 

paid, deemed paid or accrued during the taxable year, and increased by (i) 

excludable dividends received and (ii) item that are permanently excluded from 

income. Pcrniancnt cxclusions include tax-exempt interest under section 103 and 

percentage depletion in excess of basis. 

(b) Special Rule for the Alternative Minimuin Tax: Corporations paying alternative 

minimum tax (AMT) increase AT1 by the amount of their AMT liability, grossedup by a factor of 66/34, and decrease AT1 by an amount equal to 20 percent of 

the amount by which they increased AT1 for perinanent exclusions, grossed-up 

by a factor of 66/34. In addition, corporations must decrease AT1 by minimum 

tax credits used during the taxable year, grossed-up by a factor of 66/34. 

Discussion: By starting with taxable income, AT1 does not initially include any preference 

income. AT1 is then adjusted downward by U.S. federal income taxes paid after the application 

of credits other than the minimum tax credit. Creditable foreign taxes reduce the amount of 

after-tax income available for distribution, so AT1 is reduced by all creditable foreign taxes, 

including foreign taxes in excess of the amount that can be used to reduce U.S. tax liability for 

the taxable year. AT1 is then adjusted upward by certain permanent exclusions, In general, the 

practical effect of this definition is that preference income other than income sheltered by credits 

and by permanent exclusions will not be included in ATI. By including permanent exclusions 

and credits in ATI, Recommendation 2 allows shareholders to exclude distributions attributable 

to those itenis without a reduction in basis. This treatment is appropriate becarive basis reduction 

for permanent preferences would make the preferences 

We realize that AT1 may not accurately reflect all of the current rules that govem income and basis (e.g., 

sections 108 and 167(e)(3)). Nevertheless, to keep the system simple, we did not ad.just AT1 for these items. If 

significant distortions resiilt, the AT1 rule.; can he amrnclrd. 
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The calculation of AT1 begins with taxable income (which cannot be less than zero) and 

adds permanent exclusions. Thus, if the corporation has an overall loss for the year but has 

permanently excluded earnings, the corporation may still distribute excludable dividends during 

the year. For example, a corporation with a loss of $100 and tax-exempt interest of $10 has $10 

of AT1 and can distribute $10 of excludable dividends. The net operating loss of $100 can be 

carried forward against other years’ taxable income. 

As previously announced, we are studying the effects of the corporate AMT. While our 

study is not complete, it is clear that the AMT creates economic distortions, and that substantial 

reform or outright repeal of the AMT may be warranted. The AMT also complicates the 

calculation of AT1 because the AMT operates on a separate, parallel tax base (alternative 

minimum taxable income). We considered using alternative niininium taxable income for 

determining AT1 for AMT taxpayers, but this would add complexity, allow AMT taxpayers to 

pass through timing preferences without a basis reduction, and cause discontinuities whereby a 

modest change in items of income or deduction could cause an extraordinary fluctuation in ATI. 

We also considered ignoring the AMT and the minimum tax credit for purposes of computing 

ATT, both for reasons of simplicity and on the theory that the AMT is essentially a prepayment 

of regular tax. We rejected this approach because some taxpayers are subject to the AMT for 

many years. For these taxpayers, the AMT becomes their corporate-level tax regime. Ignoring 

AMT paid would inappropriately deny thcsc taxpaycrs the benefits of integration. 

We opted for an approach whereby AMT paid is grossed-up and added to ATI.6 The 

amount of permanent exclusions added to AT1 is reduced for corporations that pay AMT, so that 

permanent exclusions are not double counted in computing ATI. The 66/34 gross-up factor 

insures that dividends will be paid only out of fully taxed income. The alternative was to gross 

up AMT at the AMT rate (i.e., by a factor of 80/20). An 80/20 gross-up, however, allows the 

corporation to distribute preference income without a shareholder basis reduction. For example, 

suppose a corporation has no regular taxable income and $100 of alternative ininimum taxable 

income due to timing preferences. The corporation pays no regular tax and $20 of AMT. If the 

gross-up were 80/20, the corporation would generate $80 of AT1 and could pay $80 of 

excludable dividends to its shareholders. The earnings would not bc taxcd at a 34 percent rate 

until the preferences reversed and the corporation were subject to the regular tax, regardless of 

whether the shareholders sold their stock. With a 66/34 gross-up, the $20 of AMT will generate 

$38.82 of ATI. If the corporation makes an $80 distribution, the remaining $41.18 will reduce 

the shareholders’ bases. If the shareholders are taxable at a 34 percent rate, the difference 

between the 20 percent rate imposed through the AMT and the 34 percent rate of the regular tax 

will be recaptured if the shareholders sell their stock before the preferences reverse (34 percent 

Minimum tax credits are grossed up and subtracted from AT1 in the year they are applied to reduce regular 

tax liability. We considered not reducing AT1 by minimum tax credits that were earned before the effective date 

of the integration system. This would require all corporations to maintain a pre-enactment minimum tax credit 

accounl and apply a stacking rule (e.g., FIFO) to determine when the pre-enactnient credits were used and would 

result in significant complexity. Our rZcoiiimendation of an immediate effective date necessarily creates detriments 

to some taxpayers and windFalls for other taxpayers, and we are not generally recommending any correction for 

those losses or gains. 
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of $41.18 is $14). This treatment is consistent with our general rule that distributions from 

earnings that have not been fully taxed reduce basis. 

Recommendation 3: Dividends 

(a) Distributions will be classified as dividends to the extent they are paid (or deemed 

paid) out of current or accumulated ATI. E&P no longer controls the treatment 

of distributions from U.S. corporations and all distributions not out of AT1 are 

treated as returns of capital. If distributions in a given year exceed available ATI, 

AT1 will be allocated first by the priority of the classes of stock on which 

distributions were paid during the taxable year. For classes of equal priority, or 

for multiple distributions paid within a single class of stock, AT1 will be allocated 

under a "first-in-time" rule. 

(b) Shareholders will exclude all dividends from gross income. As under current law, 

shareholders will not reduce their share bases when dividends are received. 

(c) Distributions in excess of AT1 will not be classified as dividends, and will instead be 

treated as rcturns of capital. 

Discussion: The highest priority, first-in-time allocation of AT1 to distributions reduces 

potential uncertainty about the amount of a distribution that is treated as a dividend. Moreover, 

the allocation rule is consistent with non-tax rules governing priorities and claims, and as a 

practical matter allows preferred stock generally to continue paying non-taxable dividends. 

The disadvantage of the highest priority, first-in-time rule is that it may allow a 

corporation to "stream" its dividends by creating multiple classes of stock, some of which 

receive dividends (and are held by taxable shareholders) and some of which receive non-dividend 

distributions (and are held by tax-exempt shareholders). While the same issue arises under 

current law, its practical significance would increase substantially under the integration rcgiinc 

we are recommending because the dividend base will be reduced (AT1 will often be less than 

E&P on a year-to-year basis and, as noted below, the "nimble dividend rule" will be eliminated). 

In theory, this concern could be addressed by allocating AT1 pro rata among all 

distributions made during the taxable year. A pro rata approach would reduce the possibility of 

streaming in the case of routine distributions with respect to multiple classes of stock, but would 

create other problems. The amount of any given distribution that is a dividend would depend on 

the amount of distributions made later in the year. This would raise uncertainty and would inake 

declaring DRIP dividends difficult, except where there is a sufficiently large amount of ATI. On 

balance, we chose to use a highest priority, first-in-time rule and to address streaming concerns 

with other rules (many of which are in place under existing law) and a general anti-abuse rule. 
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We chose to allow dividends out of estimated AT1 for the current year. Any other rule 

would require dividends to be paid out of AT1 one year in arrears, a requirement inconsistent 

with the goals of our recommended approach. 

We did not adopt the nimble dividend rule of current law (which allows dividends out 

of current E&P notwithstanding a deficit of accumiilated E&P). We recognize that eliminating 

the nimble dividend rule may mean that corporations with large net operating loss carryforwards 

will be unable to pay dividends until the losses are used up because taxable income, the starting 

point for ATI, is calculated after the application of loss carryforwards. Nevertheless, where the 

estimated current year’s taxable income, after the application of any loss carryforwards, is zero, 

the corporation has not produced any taxable income for distribution as a dividend. Consequently, a distribution under those circumstances is more properly treated as a return of capital. 

We considered imposing a surrogate tax in cases where a corporation informs 

shareholders that a dividend is excludable but later finds that it has insufficient AT1 to support 

the dividend. The tax would have been refundable when the corporation produced AT1 and 

would have offset AT1 (when refunded) by a groffed-up amount. The effect would have been 

an interest charge on the reduced tax that shareholders would have paid if they had sold during 

the period between the erroneous dividend and the refund of the surrogate tax. We opted not to 

impose a surrogate tax bccausc of thc problcnis with dctcrinining the appropriate blended rate 

for the tax. Instead, the Commissioner will have the authority to impose a surrogate tax at the 

maximum shareholder tax rate (currently the 34 percent corporate tax rate) where AT1 has not 

been reported in good faith (e.g., where AT1 is not reported consistently with estimated tax 

payments). 

Although the amount of a distribution that is considered a dividend is determined by a 

corporation’s ATI, not its E&P, we do not recommend eliminating E&P for all purposes. In 

particular, E&P will be retained for various computations relating to foreign corporations. We 

are studying ways in which E&P coinpiitations under these other provisions can be simplified 

or eliminated. 

Recommendation 4: Treatment of Redemptions 

(a) In General: The distinction between a redemption that qualifies as a payment in 

exchange for stock under section 302(b) and a redemption that is treated as a 

section 301 distribution will remain as under current law. Redemptions that 

qualify under section 302(b) will generally not reduce AT1 even though such 

redemptions reduce a pro rata portion of E&P under current law. 

(b) Significant Redemptions: Section 302(b) redemptions of stock froin significant 

shareholders, defined as those shareholders holding at least five percent of a 

corporation’s equity (with attribution rules), will reduce AT1 pro rata and give 

rise to a corresponding increase in the basis of the redeemed shares. In addition, 
- 10 -

a corporation that redeems more than five percent of its stock (by vote or value) 

from any group of shareholders in section 302(b) redemptions will be subject to 

the same pro rata AT1 reduction, basis increase rules. All redemptions that take 

place within a one-year period will be aggregated for purposes of this rule. 

Special Rule: Corporations will be allowed to assume that there are no section 

3 18 relationships (which might cause redemptions that would otherwise qualify 

under section 302(b) not to qualify) among small shareholders (defined as those 

that hold less than one percent of the corporate equity). In addition, corporations 

will be allowed to assume that small shareholders are not purchasing stock at the 

time of a redemption in a manner that could cause a redemption to fail to qualify 

under section 302(b). 

Treatment of Shareholders: Shareholders will treat redemptions that qualify under 

section 302(b) as a sale or exchange of their stock. Shareholders will receive a 

statement from the corporation if they are entitled to a basis increase in 

connection with such sale or exchange (whether by reason of the significant 

redemptions rule described above, or because the corporation has declared one 

or more DRIP dividends prior to the redemption). 

Discussion: We chose generally to treat section 302(b) redemptions of stock like sales of stock 

and to retain the existing rules of section 302(b) for distinguishing a true redemption from a 

corporate distribi~tion.~A selling shareholder in a widely-held corporation generally will not 

distinguish between selling shares to a third party and selling shares to the corporation. Given 

this fact and our preference for retaining current law, we believe that sales of stock to the 

corporation that qualify under section 302(b) should generally be treated the same as sales to 

third parties. 

Nevertheless, some section 302(b) redemptions should be treated as a pro rata distribution 

of AT1 plus a return of capital to the redeemed shareholders. This rule is needed to prevent 

corporations from streaming through a combination of redemptions of tax-exempt shareholders 

and dividend payments to taxable shareholders. Thus, in redemptions of large shareholders and 

’ We recognize that the rules of section 302 retlect a bias towards treating redemptions as dividend 

distributions, a result that has historically been iinfivorable to individual shareholders, but favorable to corporate 

shareholders. Under our recommended system, all t;Ixiihle sharz.hnltlar<will pr&r rlividencl treatment, a result not 

contemplated by the drafters of section 302. Nevertheless, the section 302 rilles generally should produce the correct 

result under our recommended system. 

For example, consider a corporation with two shareholders, one taxable and one tax-exempt, each 

contributing $500 to the coi-poration. If the corporation earns $100 of after-tax profits (and therefore has $100 of 

ATI), it can redeem the tax-exempt shareholder for $550. This will leave the taxable shareholder with $500 of basis 

in a corporation with a value of $550 and AT1 of $100. The corporation can pay a $100 dividend and the taxable 

shareholder can sell its stock for a $50 loss. 

(continued.. .) 
- 11 -

in large redemptions, a corporation’s AT1 is reduced and the selling shareholders’ stock bases 

are correspondingly increased. For example, if a corporation redeems two percent of its stock 

from a five percent shareholder, the corporation will reduce its AT1 by two percent and the 

shareholder will correspondingly reduce its amount realized. Siinilarly, a successful public selftender for seven percent of a corporation’s stock will reduce the corporation’s AT1 by seven 

percent and the shareholders will correspondingly reduce their amounts realized. 

This treatment of significant redemptions may appear to be more favorable than the 

treatment of small redemptions of sinall shareholders. A corporation can eqiialize the treatment 

of redemptions, however, by declaring a DRIP dividend before purchasing its own stock. 

Moreover, because AT1 is not reduced in sinall redemptions of sinall shareholders, AT1 is 

retained in the corporation to support excludable dividends to all other shareholders. 

We recoininend special rules allowing a corporation to assume that there are no section 

318 relationships among sinall shareholders because of the new corporate level distinction 

between redemptions that qualify under section 302(b) and those that do not (i.e., the former 

generally will not reduce AT1 while the latter will). 

Rccommcndation 5: Sections 305 and 306 

(a) Section 305: Distributions of stock of the corporation to existing shareholders 

generally will not affect ATI. Nevertheless, the rules under section 303 for 

classifying certain stock distributions as distributions of property under section 

301 will remain. To the extent that, under section 305, stock dividends are 

characterized as distributions to which section 30 1 applies, shareholders receiving 

stock will be treated accordingly and the corporation will make appropriate 

adjustments to ATI. 

(b) Section 306 will be repealed. 

Discussion: We chose to retain section 305 to prevent streaming by paying excludable dividends 

on one class of stock (held by taxable investors) and stock distributions on another class (held 

by tax-exempt investors). In such a transaction, the distribution of stock would dilute the class 

receiving cash, creating a loss on that class when sold. The loss is theoretically offset by gain 

on the sale of the distributed stock, but if that stock is held by tax-exempts, the gain will 

never be taxed. Section 305 reduces this possibility by treating certain stock distributions as 

distributions of property under section 301. 

*(...continued) 

The pro rata AT1 reduction rule will not allow corporations to stream through the opposite transaction of 

redezming taxable shai-elioldei-s and leducing AT1 iii tlie icdeiiiption. In ihe above example, if the corporation 

redeems its taxable shareholder, AT1 will be reduced by $50 and the shareholder will recognize no gain or loss on 

the redemption. The tax-exempt shareholder will be left with $500 of basis in it corporation with a value of $550 

and AT1 of $50. 
- 12 -

Section 306 will be repealed because preferred stock bailouts will not offer the same 

benefits under the AT1 system as when dividends were taxable as ordinary income. 

Recommendation 6: Adjustments to Tax and Refunds 

(a) Adjustments to a corporation’s taxable income for a prior year will be reflected 

as adjustments to the corporation’s AT1 in the current year. An increase in a prior 

year’s taxable income, therefore, will increase the AT1 (by an amount net of the 

increased taxes paid) in the year the adjustment is made and the additional tax is 

paid. 

(b) AT1 may not be reduced below zero. To the extent that AT1 would be reduced 

below zero by a downward adjustment to taxable income that would give rise to 

a refund, the refund will not be paid to the corporation. Instead, adjustments to 

the corporation’s taxable income in excess of the amount necessary to reduce AT1 

to zero will be carried forward to reduce future taxable income. 

Discussion: Adjustments to a corporation’s tax liability for a prior year must be reflected in 

AT1 in the year the adjustment is inadc bccausc of thc practical problems with recharacterizing 

distributions made in prior years. If, for example, when a corporation agreed in 1998 to report 

additional net taxable income for 1993, the corporation’s AT1 were increased for 1993, actual 

1993 distributions that were reported as retiirns of capital to shareholders would become 

excludable dividends. The corporation’s shareholders might have to amend their returns for 1993 

(or for subsequent years prior to 1998, if they disposed of their shares during that period). The 

obvious problems with this approach led to the rule requiring AT1 to be adjusted in the year the 

additional taxes are paid or refunded. 

AT1 cannot be reduced below zero by losses or downward adjustments to taxable income. 

Allowing AT1 to be reduced below zero woiild be the equivalent of a loan from the Treasury 

to the shareholders who had received excludable dividends. The loan would bc rcpaid by the 

corporation only if and when it had paid sufficient corporate taxes to increase its AT1 to zero. 

If the corporation ceased doing business, the loan might never be repaid. We considered 

allowing corporations to receive tax refunds in excess of AT1 at the cost of reducing current 

shareholders’ stock bases. We rejected this approach because of problems where the stock has 

changed hands between the initial distribution of AT1 and the subsequent refund of tax. We 

therefore recommend requiring corporations to use the net operating loss or downward 

adjustment to taxable income against fiitiire taxable income. 

Recommendation 7: Dividend Reinvestment Plans 

(a) In General: Ifa corporation has an AT1 account with a balance greater than zero, 

the corporation may declare a DRIP dividend. The corporation will be deemed 

to have paid a cash dividend and the shareholders will be deemed to have 
- 13 -

received the cash and recontributed it to the corporation. Because a corporation 

may only declare DRIP dividends to the extent of ATI, DRIP dividends are 

always excludable by the shareholders. The only effects of a DRIP dividend are 

to increase the shareholders' share bases by the amount of the DRIP dividend and 

to reduce the corporation's AT1 by an identical amount. 

(b) Method of Declaring a DRIP Dividend: Corporations will declare DRIP 

dividends in the same manner that they declare actual dividends, including the 

amount of any such DRIP dividend and the class or classes of stock on which the 

DRIP dividend will be deemed paid. Allocations of AT1 to DRIP dividends are 

the same as allocations of AT1 to cash dividends. 

Discussion: We considered a number of ways to equalize the treatment of those corporations 

that choose to retain earnings and those that choose to distribute earnings. As noted in Chapter 

8 of the Trmsury fntc~grotionRoport, reducing or eliminating the tax on capital gains when stock 

is sold introduces other problems into the system. We therefore chose to allow corporations to 

declare DRTP dividends. While the DRIP mechanism adds complexity to our recommendation, 

it is needed for two reasons. First, it prevents a tax law bias favoring the current payout of 

dividends. Second, it equalizes the treatment of widely- and closely-held corporations (because 

the latter could replicate the DRIP result using actual dividend, rccontribution transactions).' 

We chose to allow corporations the same flexibility in declaring DRIP dividends that they 

possess in declaring actual dividends. Although it may increase opportunities for streaming, this 

flexibility is consistent with the corporation's ability to determine its own dividend policy under 

current law, and is necessary to permit corporations to implement cost-efficient capital 

structures. 

We considered requiring corporations to declare DRIP dividends with respect to 

otherwise undistributed ATI, at the latest, during the year following the year in which the AT1 

was generated (a mandatory DRIP). The practical effect of this rule would have been to limit 

AT1 accumulations to not more than the amount produced in the last two ycars. A mandatory 

DRIP would prevent large accumulated AT1 accounts in most cases, and thus would reduce 

corporations' interest in and opportunity for dividend stripping, streaming, "trafficking" in ATI, 

and other similar transactions. 

We concluded that a mandatory DRIP would not eliminate the need for anti-abuse rules, 

and that it might interfere with the attempts of corporations in cyclical businesses to maintain 

level dividend payment policies. As a residt of the mandatory DRIP, shareholders during upturns 

Unlike DRIP dividends, which increase the basis of shares pro rata, actual cash dividends followed by a 

purchase of new shares concentrite basis in the I-eczntly-I~iirchasedshares. This is similar to the result under 

dividend rcinvcstmcnl plans that some corporations have in place under current law. We considered allowing 

corporations to declare pro rata stock dividends instead of DRIP dividends, and thereby concentrate basis in the 

distributed shares. We rFjected this approach because of mechanical complexities and because corporations can 

achieve similar results iinclrr section 305. 
- 14 -

could receive both cash dividends and DRIP dividends resulting in basis increases, while 

shareholders during downturns could receive return of capital distributions. 

A second concern about mandatory DRIPS relates to the broader issue of net operating 

losses (NOLs).'' The practical effect of a mandatory DRIP, coupled with the rule limiting tax 

refunds attributable to adjiistnients and tax losses to available ATI, would be to eliminate the 

3-year NOL carryback period. While the same result would follow if the corporation voluntarily 

declared sufficient actual or deemed dividends, there is a difference between voluntary and 

mandatory imposition of this regime. 

On balance, we believe that the benefits of a mandatory DRIP (particularly in reducing 

the potential for streaming or other tax-motivated transactions) are outweighed by its detriments. 

We chose to address concerns about streaming and other tax-motivated transactions through a 

combination of existing law and a new general anti-abuse rule (see Recommendation 19). 

Recommendation 8: Corporate Transactions 

Distributions of Appreciated Property: Current law rules of section 31l(b), 

requiring recognition of gain on corporate distributions of apprcciatcd propcrty, 

will continue to apply. 

Liquidations: Liquidations will be taxed to the corporation as under current law. 

Upon a section 33 1 liquidation, the corporation may declare actual or DRIP dividends and thereby allocate its AT1 among its classes of stock. Liquidations that 

qualify under section 332 will continue to be tax-free, with appropriate 

adjustments to AT1 for minority shareholders. 

Taxable Acquisitions: Taxable acquisitions will be treated as under current law 

and section 338(h)(10) will remain available. As a result, a stock acquisition will 

not affect the target corporation's ATI. 

Acquisitive Reorganizations: Current law rules that treat a qualifying corporate 

reorganization as tax-free at the corporate level and at the shareholder level will 

remain available. Section 38 1, providing for the carryover of certain corporate 

attributes, will be extended to provide for the carryover of the target's AT1 

balance. 

Divisive Reorganizations: Current law rules governing tax-free divisive 

reorganizations will remain, except that the device restriction of section 355 will 

be repealed. Under current law, E&P of the distributing corporation in a division 

lo As discussed above, distributions from corporations with NOL carryforwards will generally represent 

returns of capital. 
- 15 -

that qualifies as a reorganization under section 368(a)( 1)(D)are divided between 

the distributing corporation and the controlled corporation based on the relative 

fair market values of their assets. Rules for the division of AT1 will follow these 

rules. 

Discussion: We chose to continue to impose a corporate level tax on distributions of appreciated 

property. The alternative was allowing a carryover or substituted basis for distributions of 

appreciated property, as under the partnership rules. Following the partnership rules would defer 

the tax and collect the tax at the shareholder rate. Collecting the tax at the corporate level rather 

than the shareholder level, however, is consistent with the policy of collecting a single level of 

tax at the corporate rate. While a comprehensive carryover basis regime governing the transfer 

of assets can be justified on policy grounds, it would be inappropriate (and unadministrable) to 

take a limited step in that direction solely in the context of corporate distributions to 

shareholders. 

Liquidations are treated as under current law, except that the corporation may allocate 

all of its AT1 to shareholders during the liquidation. The ability of corporations to allocate AT1 

upon a liquidation may present opportunities for streaming, but these opportunities should be no 

worse upon liquidation than for ongoing corporations. Moreover, the general anti-abuse rule will 

discourage tax ~ inot i vated a11ocations in 1iqti i dati on. 

Under a dividend exclusion system, existing section 338(a) is of minimal use because it 

imposes a tax on the buyer, not the seller. A rule modeled after section 338(h)(10) would be 

more effective, because the AT1 produced by the deemed asset sale could be used immediately 

by the selling shareholders. We considered extending section 338(h)(10) to all targets (instead 

of just targets in consolidated groups) and all buyers (instead of just corporate buyers). For now, 

we recommend retaining the existing litnits on section 338(h)(10) because of the complexity of 

extending section 338(h)(10) to all targets and all buyers. We are stiidying ways to broaden 

section 338(h)(lo). 

We recommend repealing the device restriction of section 355, because it is no longer 

necessary where dividends are not taxed. We retained the rest of section 355 because of the 

important distinction between divisive reorganizations and section 3 1 1 distributions. 

Recommendation 9: Consolidated Returns 

Affiliated groups of corporations will continue to be allowed to file consolidated 

returns. ATI, like E&P under current law, will be calculated separately for each 

member of a consolidated group. As under the current consolidated return 

regulations governing E&P, AT1 will flow up to the common parent. Special 

rules will apply to ensure that AT1 is not duplicated when a member leaves the 

consolidated group. 
- 16 -

Discussion: We continue to believe that affiliated groups of corporations should be permitted 

to file consolidated returns to reduce any remaining distortions between operating as separate 

divisions and operating as separate corporations. We are continuing to study what adjustments 

to the consolidated return regulations would be necessary under the AT1 system. This review is 

taking place in the context of our ongoing, broad-based reconsideration of the consolidated return 

regulations, as reflected in the recently proposed investment adjustment regulations, the 

forthcoming deferred intercompany transaction regulations, and our overall movement in the 

direction of a single entity approach for affiliated groups, as evidenced by the loss disallowance 

regulations. 

Kecomniendation 10: Pass-through Entities 

The current treatment of S corporations, partnerships, and other pass-through 

entities, such as regulated investment companies, real estate investment trusts and 

real estate mortgage investment conduits, will be retained. 

Discussion: We recognize that retaining current law treatment of S corporations, partnerships, 

and other pass-through entities is somewhat inconsistent with our long-term policy preference 

for a schedular tax on enterprise activity and our goal of tax simplification. Nonetheless, we 

believe that these alternative regimes should be retained at present. As a practical matter, they 

are so deeply embedded in the system that any effort to require uniformity of business forins 

would be exceedingly disruptive and require elaborate transition rules. In addition, certain of the 

passive conduit regimes (RICs, REITs, and REMICs) are mechanical devices for permitting risk 

pooling and portfolio diversification. As such they should be retained as part of any system. 

Finally, to the extent partnerships are viewed as permitting parties to tailor their economic 

arrangements, with the tax consequences merely reflecting those arrangements, their continued 

availability (at least in certain circiinistances) is warranted. 

Recommendation 11 : Stock Sales 

Shareholders will be taxed on sales of their stock. as under current law. 

Discussion: By increasing share basis, DRIP dividends prevent tax on that portion of the 

appreciation in stock value attributable to previously taxed income that the corporation has 

chosen to retain rather than distribute. The capital loss limitation will remain as under current 

law." 

" Some commentators have suggested that a r~ilt:disallowing losses to the extent of basis attributable to DRIP 

dividends may be necessary to prevent certain abuses. We have rejected this approach in favor of the more general 

anti-ahiise rule described below as Rrcoinmenclation 19. 
- 17-

Recommendation 12: Corporate Shareholders 

Corporate shareholders will no longer be entitled to a deduction for dividends 

received. Excludable dividends received by a corporation will increase the 

recipient corporation’s AT1 and will, therefore, remain excludable when 

distributed by the recipient corporation. 

Discussion: We recommend eliminating the dividends received deduction, because it is no 

longer needed to reduce the multiple levels of corporate tax that can be imposed under current 

law. To the extent that earnings have been taxed to a corporation, there will be AT1 to support 

dividends paid to corporate shareholders. The corporate shareholders will exclude the dividends 

from their income and will increase their own AT1 by the amount of excludable dividends 

received. To the extent that the distribution is in excess of ATI, the corporate shareholders will 

reduce their bases, which is consistent with the general treatment of preferences under the AT1 

system. 

Recommendation 13: Shareholder AMT 

The alternative minimum tax will be retained, but excludablc dividcnds are not 

an AMT adjustment or preference. 

Recommendation 14: Accumulated Earnings Tax 

The accumulated earnings tax will be repealed, because it is of diminished 

importance in a system that does not tax dividends. 

Recommendation 15: Personal Holding Companies 

The personal holding company rules will be retained. 

Discussion: While in general corporate tax rates are higher than individual tax rates and, 

therefore, there is no tax benefit to incorporation, graduated rates remain available to 

corporations. To the extent that the graduated rates are lower than the individual rates applicable 

to a specific taxpayer, an integrated tax system still presents the opportunity to use the corporate 

form to shelter personal income. Indeed, repeal of what amounts to a toll charge on distributions 

of that income may exacerbate the problem. Thus, the personal holding company rules will be 

retained. l2 

’’ Because the determination of whether ii corporation is a personal holding company is based on the 

corporation’s gross income, dividends received under our r~commzndationwill not affect whether a corporation is 

considered H persotxi1 holding company. 
- 18 -

Recommendation 16: Shareholder Level Debt 

Section 246A will not be extended to cover excludable dividends and is therefore 

repealed, and section 265 will not be extended to the purchase of corporate stock. 

Section 163(d) will continue to apply to individual shareholders. 

Discussion: The decision not to extend sections 246A and 265 is consistent with our decision 

not to recommend modifications to the rules governing debt, and OUI- policy bias against rules 

that are complex and difficult to administer. 

Section 163(d) limits individual interest deductions to net investment income. Because 

dividends are excludable, dividends will never result in investment income, so interest on debt 

used to purchase stock will be deductible only to the extent of other investment income. This 

is consistent with the purpose of section 163(d), to preclude the use of interest deductions to 

shelter personal expenses. 

Recommendation 17: Limitations on Dividend Exclusion 

Rules similar to those in section 246(c) will apply to all shareholders that receive 

dividends (including DRIP dividends). Section 1059 will be repealed. 

Discussion: We recoinmend a section 246(c)-type rule to prevent dividend stripping. Without 

such a rule, tax-exempt shareholders could sell their stock to taxable shareholders immediately 

before a dividend is paid. The taxable shareholders would receive the excludable dividend and 

immediately sell the stock for a loss. This is the same problem faced under current law with the 

dividends received deduction, except that inany more shareholders coiild take advantage of 

dividend stripping under the AT1 system. If the shareholder does not meet the holding period 

requirements, the shareholder also will be denied an increase in basis if a DRIP dividend is 

dcclarcd. Scction 246(c) must bc cxtcndcd to DRIP dividends to prevent tax arbitrage through 

the combination of a DRIP dividend (causing a basis step-up), an actual cash distribution in 

excess of AT1 (reducing basis by the amount of the step-up), and a sale of the stock at a loss. 

Retaining section 1059 would prevent payment of excludable dividends of pre-acquisition 

earnings followed by sale of the stock for a loss. We recommend repealing section 1059, 

however, because section 246(c), other elements of current law, and our general anti-abuse rule 

should adequately police this problem. 

If the current rules prove inadequate to prevent dividend stripping in particular cases 

(e.g., where the selling shareholder is a foreign person seeking to avoid U.S. withholding tax 

or where the corporation is privately held) and those cases cause significant distortions, we will 

consider additional rules. 
- 19-

Recommendation 18: Section 1014 

Section 1014 generally will continue to apply to stock held at death. Nevertheless, 

for decedents who owned at least five percent of the corporation’s equity on the 

date of death, the amount of the section 1014 basis step-up is reduced (but not 

below zero) by the decedent’s pro rata share of any increase in the corporation’s 

undistributed AT1 while the decedent owned the stock (as determined on the close 

of the taxable years that include the date of acquisition and the date of death). 

Discussion: This recommendation prevents heirs from receiving the double benefit of a basis 

step up and excludable dividends, which would result in a capital loss (or reduced capital gain) 

when the heirs sell the stock. The capital loss would effectively offset corporate tax paid prior 

to death, which would be an unwarranted extension of section 1014. We considered prohibiting 

heirs from claiming capital losses on inherited stock for several years after the date of death, but 

that alternative would deny heirs any tax benefit for post-death economic losses. We also 

considered treating dividends received by heirs as returns of capital for several years after the 

date of death, but that alternative was similarly arbitrary. Our recommendation requires 

significant shareholders to ascertain the corporation’s AT1 in the year they acquired a five 

percent interest in the corporation and forces the estate to ascertain the corporation’s AT1 in the 

year of death, but it retains the benefit of section 1014. If the heirs desire a full basis step-up, 

the corporation can declare a DRIP. 

Recommendation 19: General Anti-abuse Rule 

If a corporation creates multiple classes of stock or engages in a transaction (or 

series of transactions), a principal purpose or effect of which is to allocate 

dividend distributions to taxable r hare holder^ and parallel return of- capital 

distributions to tax-exempt shareholders (including foreign shareholders and shareholders with substantial NOLs), the Commissioner may treat all such distributions 

as having been made pro rata out of the corporation’s AT1 and, to the extent such 

distributions exceed ATI, as returns of capital. The Commissioner may impose 

a surrogate tax at the maximum shareholder rate (currently 34 percent) on the 

corporation or its successors, or, in the absence of sufficient corporate assets, on 

significant shareholders as transferees. 

Discussion: Neither the section 246(c)-type rules described above nor other specific rules may 

be sufficient to address the potential for tax-motivated transactions. Our general anti-abuse rule 

effectively codifies application of the step transaction and substance-over-form doctrines to 

streaming transactions and provides additional protection. By providing for collection at the 

corporate level of a surrogate tax at the maximum shareholder tax rate, the rule deters schemes 

that purport to generate a significant portion of their return by manipulating the integration rules. 

The surrogate tax applies to the incremental return of capital distribution that the Commissioner 

allocates to taxable shareholders. 
- 20 -

Because corporations may seek to engage in tax-motivated transactions as part of a 

liquidation, the rule assigns transferee liability for the surrogate tax to successors and significant 

shareholders (Le., those that hold at least five percent of the corporation's equity at the time of 

the abusive transaction), including tax-exempt shareholders. 

Recommendation 20: "Trafficking" in AT1 

Section 382-type rules will not apply to limit the use of AT1 following an 

ownership change. 

Discussion: 1'0the extent that section 269 prevents tax-motivated acquisitions, it will continue 

to apply. Should ATI-motivated acquisitions become a problem, a section 382-type rule can be 

added at that time. 

Recommendation 21 : Foreign Shareholden 

Integration benefits will not extend to foreign shareholders by statute. Thus, 

nonresident aliens and forcign corporations will continue to be subject to 

withholding tax on dividends. In addition, foreign corporations will continue to 

be subject to the branch profits tax. Integration benefits may, however, be granted 

to foreign shareholders by treaty. 

DRIP dividends will generally have no tax consequences to foreign shareholders. 

A DRIP dividend will not increase the bases of foreign shareholders' stock, but 

will reduce the corporation's ATI. 

Corporations will maintain an account of DRIP dividends paid (the deemed 

dividend account). Distributions in excess of AT1 will be considered made out of 

this account. To the extent distributions arc out of the dccmed dividend account, 

they will be considered dividends for withholding tax purposes (regardless of 

whether the foreign shareholder receiving the distributions was a shareholder at 

the time the DRIP dividend was declared). Distributions to foreign shareholders 

out of the deemed dividend account will not reduce stock basis for foreign 

shareholders. 

A distribution to a foreign shareholder will reduce corporate ATI. Distributions 

(to any shareholder) in excess of AT1 will reduce the deemed dividend accoiint. 

Discussion: We would like to extend integration benefits to foreign shareholders on a reciprocal 

basis with other nations. Nevertheless, in contrast to our recommendation on foreign taxes, we 

recommend that integration treatment be provided to foreign shareholders only by treaty, for two 

principal reasons. First, unilaterally extending the benefits of integration to foreign shareholders 
- Ll -

by statute may not achieve the intended purpose, because the tax policies of a shareholder’s 

country of residence will 111ti niately determine the shareholder’s total tax burden. Second, 

addressing the tax treatment of nonresidents through the treaty process is generally consistent 

with international norms concerning source-country taxing rights. Other countries, in certain 

cases, have extended integration benefits to nonresidents through bilateral income tax treaties. 

We are continuing to study foreign tax issues relating to integration as part of our International 

Tax Study. 

Under the recommended system, DRIP dividends will not be treated as dividends to 

foreign shareholders, because it would be administratively difficult and arguably unfair to impose 

withholding tax where no cash or other property is actually distributed to shareholders. We 

considered but rejected other methods of addressing this problem. One alternative (modeled after 

the taxation of original issue discount accruing to foreign persons under section 871(a)(l)(C)) 

would be to permit a basis increase for stock held by foreign shareholders and to collect a 

deferred withholding tax at the time the foreign shareholder either sells his stock or receives 

distributions from the corporation. We rejected this alternative in part because of potential 

administrative difficulties in collecting withholding tax at the time of sale and because imposing 

that tax arguably would contravene the general U.S. policy of exempting foreign shareholders 

from tax on capital gains. 

A foreign shareholder will be eligible for the benefits of DRIP dividends if the 

shareholder qiialifies for integration benefits by treaty. Additional rules will be necessary to 

implement the general exclusion of foreign shareholders from DRIPS, such as rules governing 

basis adjustments in connection with the transfer of stock by a foreign person to a U.S. person 

in a nonrecognition exchange. 

Recommendation 22: Compliance and Administration 

(a) Corporations will be required to keep AT1 accounts and deemed dividend 

accounts and will report the balance of those accounts to the IRS annually on their 

income tax retiirns. All information necessary to keep the accounts should be 

available to corporations in the ordinary course of preparing their income tax 

returns. Corporations also will be required to include additional information on 

Forms 1099. Revised Forms 1099 will indicate the amounts by which actual or 

deemed distributions are excludable, reduce basis, or increase basis. 

(b) Shareholders will keep track of increases in basis as well as decreases in basis. 

Each shareholder will receive a revised Form 1099 to assist with this recordkeeping burden. 

Discussion: Minimizing recordkeeping was a significant goal in designing our integration 

system. Although shareholders will now have to track basis increases as well as basis reductions, 

this additional recordkeeping requirement should not be overly burdensome because it is 
- 22 -

augmented by information reporting. Recordkeeping at the corporate level should not be 

significantly increased. 

Recommendation 23: Transition Rules 

(a) In General: The AT1 system will be effective for a corporation in its first taxable 

year beginning after the year of enactment. 

(b) Dividend Received Deduction: During their first five taxable years beginning 

after the date of enactment, corporations may elect to continue reporting their 

E&P to their shareholders. Corporate shareholders may elect, for each class of 

stock in a corporation that reports E&P, to treat all distributions out of E&P as 

taxable dividends and claim a dividends received deduction, as under current law. 

The AT1 regime would continue to apply for all other purposes to electing 

corporations and their non-electing shareholders. Neither pre-enactment nor postenactment ERrP will affect the treatment of distribution$ by corporationr that do 

not elect to report E&P. 

Discussion: The Trcwsury Inregt-crrionRc.porr recominended a phase-in period for its prototypes. 

For several reasons, we are now recommending an immediate effective date. First, the 

substantial benefits that will flow from integration can be realized more quickly through an 

immediate effective date. We believe that these benefits outweigh the potential adverse impact 

of short-term disruptions in the market. Second, an immediate effective date minimizes 

distortions in taxpayer behavior that might otherwise occur during a five year transition period. 

Finally, we believe that an immediate effective date minimizes complexity and taxpayer burdens. 

Retention of taxable dividends during a phase-in period would require a complex set of interim 

rules, in effect requiring a complete and separate integration system during the phase-in. Based 

on these reasons, we believe that an immediate effective date is warranted. 

We recognize that the value of certain stocks may be dependent on the dividends received 

deduction. We therefore recommend a special rule to phase out the dividends received deduction 

in a manner intended to reduce the volatility in the value of stock held by corporations. 

REVENUE COST 

Fiscal Years 

1993 1994 1995 1996 1997 1993-97 

Cost (billions of dollars) 17 31 33 34 35 150