Anti-dividend-stripping rules.

When a corporation receives a dividend from another corporation, the recipient is entitled to a deduction (known as the dividends-received deduction or DRD) equal to 70% of the amount of the dividend. The DRD's purpose is to mitigate the double taxation of corporate income--the income is taxed only once until it is finally distributed to the recipient's noncorporate shareholders. The DRD therefore, allows a corporation's dividend income to be taxed at an effective rate of only 10.5% (30% of a dividend is taxed at a 35% rate; .30 x .35 = 10.5%).

The existence of the DRD led to the practice of"dividend stripping," whereby a corporation would (1) purchase stock in another corporation, (2) receive a dividend and claim a DRD and (3) promptly sell the stock and sustain a capital loss on the sale, measured by the amount of the dividend (assuming there were no other price fluctuations). This capital loss could be used to offset other capital gains. The corporation also would have "converted" capital gains (taxed at a 35% rate) into 10.5% dividend income.

To combat dividend stripping, Congress made the DRD unavailable unless the stock (on which the dividend was paid) had been held for more than 45 days. Moreover, "credit" toward the 45-day holding period requirement could not be earned for days on which the corporation had diminished its risk of loss (from holding the stock) through the use of options, short sales and other hedging tactics.

Until the Taxpayer Relief Act of 1997 was passed, a corporation that had satisfied the 45-day standard was entitled to a DRD for all subsequent dividends even if it then held the stock on a fully hedged basis. However, the 1997 act changed this favorable rule. The new law requires the 45-day rule to be applied on a dividend-by-dividend basis. It accomplishes this by stating that no DRD will be allowed for dividends on stock not held for more than 45 days during the 90-day period beginning on a date that is 45 days before the "ax-dividend" date (the dine of demarcation for dividend entitlement). Accordingly, to earn a DRD with respect to a dividend, a corporate investor must be at "the risk of the market" throughout the period the underlying stock is owned.

Observation: This more stringent 45-day rule will make corporate treasurers somewhat less likely to invest surplus cash in the stock of other corporations.

Robert Willens, CPA, managing director at Lehman Brothers, New York City.