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Eliminate the double tax on dividends.

For decades, CPAs, lawyers, economists and others have criticized the U.S. corporate tax system for taxing business profits twice. Corporate income is taxed first when a corporation earns it and again when profits are distributed to shareholders as dividends.

Renewed interest in integration repeats a flurry of activity in the 1970s. The American Institute of CPAs issued its first policy statement on integration, Elimination of the Double Tax on Dividends, in 1975. The Treasury Department's well-known Blueprints for Basic Tax Reform in 1977 recommended full integration of corporate profits.

More recently, several proposals to combine the corporate and individual tax systems were published in 1992. The Treasury issued its long-awaited report Integration of the Individual and Corporate Tax Systems: Taxing Business Income Once. The AICPA released an exposure draft of its proposed policy statement Integration of the Corporate and Shareholder Tax Systems. This article provides an overview and comparison of the Treasury and AICPA proposals and highlights some of the problems of implementing an integrated system.


Supporters of integration typically advocate tax neutrality--taxes should not influence business and investment decisions. The Treasury study identified three major economic distortions caused by the classical two-tier tax system that integration would eliminate.

Tax advantages to noncorporate forms of business. Because only corporate business income is taxed twice, corporations are at a competitive disadvantage when seeking new equity capital and investigating new investment possibilities.

Tax bias in favor of corporate debt financing. Under the current tax system, corporations can deduct interest payments on debt financing but cannot deduct dividend payments on equity financing.

Tax incentives for retaining, rather than distributing, corporate earnings. Corporations can choose to finance new investments with retained earnings at a lower cost of capital, while shareholders avoid taxes on dividend distributions.

The AICPA ED recognizes the same three reasons for adopting an integrated tax system, adding two others:

Coordination of the U.S. tax system with foreign tax systems. The United States is one of the few industrialized countries that has not adopted some form of corporate tax integration favoring domestic corporations and shareholders. As shown in the exhibit on page 90, by the 1980s most U.S. trading partners had reduced or eliminated the double tax on corporate profits, using the same methods being discussed today.

The United States is at a competitive disadvantage both in treaty negotiations and in attracting foreign investment and must maintain its position in the global economy. The AICPA study says it is difficult to convince foreign countries to extend integration benefits to U.S. shareholders when we cannot offer similar benefits to residents of those countries who invest in U.S. corporations.

Ease of administration. In keeping with its commitment to tax simplification, the AICPA would promote integration only if no significant complexity was added to the tax system.


Integrating the corporate and individual tax rules has the potential to simplify the tax code significantly. With integration, many provisions designed to prevent abuses by corporations trying to avoid double taxation no longer would be necessary. For example, if dividend and interest payments were treated similarly, complex rules that try to distinguish between debt and equity could be repealed.

Simplicity aside, other related tax questions must be considered before integration is adopted, including

Should shareholders benefit from tax preferences allowed to corporations? Most countries that adopted integration restrict the pass-through of corporate tax preferences to shareholders.

Should capital gains taxes be modified as part of integration? Under the current system, corporate income is taxed to shareholders in one of two ways. If dividends are paid, shareholders immediately pay tax on the distribution. If earnings are retained by the corporation, the value of the stock often reflects the resulting increase in equity and shareholders pay capital gains taxes on accumulated earnings when the stock is sold. If integration gives relief to distributed corporate earnings, the taxation of capital gains on stock sales must be reconsidered to ensure distributed and undistributed earnings are treated equally.

Should foreign investors reap the benefits of U.S. integration? In theory, the benefits of integration should be afforded to all investors--foreign or domestic--to promote the free flow of capital among countries. In other countries, however, integration has not been extended to foreign shareholders except by reciprocal treaties. Because foreign investors often escape taxation or are taxed at very low rates, some limitations are necessary to ensure corporate dividends paid to foreign shareholders continue to be taxed at least once.

Should tax-exempt investors reap the benefits of integration? Tax-exempt entities, such as pension funds and charities, are significant investors in corporate securities. The Treasury reported that at the end of 1990, tax-exempt organizations owned approximately 37% of corporate equity and 46% of outstanding corporate debt. If a shareholder is a tax-exempt entity, there is no double taxation of corporate profits. Corporate income is taxed only once--when earned by the corporation. To ensure that corporate earnings continue to be taxed at least once, the treatment of tax-exempt entities under an integrated system must be addressed. Some countries, such as Australia and New Zealand, imposed a tax on pension funds as part of integration reform.

Can the United States afford integration? In 1991, corporate dividends reported on individual tax returns exceeded $77 billion and probably would increase substantially under integration. The loss of this tax base would have a significant impact on tax revenues. Part of the loss could be offset by increased investment; a recent study estimates remaining revenue shortfalls could be recouped by modest increases in corporate tax rates.


The Treasury study discussed four methods of implementing integration. Of these, the study favored adopting a comprehensive business income tax (CBIT) or using the dividend exclusion method. The two other methods--shareholder allocation and imputation credit--were dismissed by the Treasury as unduly complex and administratively burdensome.

Dividend exclusion. Under this method, corporate tax rules would remain unchanged. Relief from double taxation on dividends would occur at the shareholder level by allowing individual taxpayers an exclusion for dividends received.

As proposed, the exclusion would be allowed only for dividends paid from income on which corporate taxes previously had been paid. The corporation would be required to maintain an excludable distributions account (EDA) and report to shareholders the amount of the available exclusion. The concept of accumulated earnings and profits, which currently measure the amount of corporate earnings available for dividend treatment, would be divided into two accounts. If an EDA approach was adopted, the corporation would record the equivalent amount of aftertax income based on the actual amount of taxes. The balance remaining in accumulated E&P would represent untaxed profits to be treated as dividends but not excluded when paid to shareholders.

CBIT. CBIT moves the dividend-exclusion model closer to equal treatment of corporate debt and equity. Corporations--which cannot deduct dividend payments--no longer would be allowed to deduct interest payments. Both interest and dividends would be excluded from investors' income. As with the dividend exclusion method, an EDA would be required to record and report dividend and interest amounts available for exclusion.

Shareholder allocation. The Treasury study rejected adopting a shareholder allocation method under which the corporatelevel tax would be retained. Corporations would report to shareholders their allocable shares of corporate income, tax and tax credits. Shareholders would use this information to calculate their taxable income. Corporate income would be included in individual taxable income and the corporate tax paid or tax credits would reduce the individual's tax liability.

This method is a modification of the fullintegration, or partnership, method considered by the AICPA. Unlike the partnership method, however, corporations would report only aggregate income to shareholders rather than report items separately. No losses could pass through to shareholders and a corporate tax, functioning as a withholding tax on corporate income, would be retained.

Imputation credit. The imputation credit method discussed by the Treasury was patterned after the New Zealand system. The Treasury recognized the shareholder credit method's principal advantage--flexibility--but rejected it because its undue complexity made other methods more attractive.

Under this method corporations would continue to compute and pay income tax. A corporation would maintain an account, the shareholder credit account (SCA), to record the cumulative federal income tax paid. Shareholders receiving a dividend distribution would include in income the amount of the dividend plus the amount of corporate taxes already paid on the dividend. Corporate taxes then would be allowed as a credit to offset the shareholder's individual tax liability.

Like the Treasury, the AICPA discussed three integration methods. However, the AICPA recommended adopting a shareholder credit, the method most strongly rejected by the Treasury study.

Integration outside the United States
Country Type of system Year implemented
Australia Shareholder credit 1987
Canada Shareholder credit 1972
France Shareholder credit 1965
Germany Split-rate system 1953
 Supplemental shareholder credit 1977
Italy Shareholder credit 1977
Japan Shareholder credit 1950
 Split-rate system 1961
 Shareholder credit 1990
New Zealand Shareholder credit 1988
United Kingdom Shareholder credit Pre-1965
 Nonintegrated system 1965
 Shareholder credit
 (advanced corporate tax) 1973

Flow-through method (the partnership model). Under the flow-through, or full-integration, method, the corporate-level income tax would be eliminated. Each shareholder would report his or her allocable share of corporate income, treating C corporations as partnerships (S corporations would not be affected because they already are taxed currently).

Dividend deduction. To ensure equal treatment of interest and dividends, corporations would be allowed a deduction for dividends paid, eliminating the corporatelevel tax on dividend distributions. Shareholders would continue to be taxed on dividends received.

Shareholder credit. The only method both the Treasury and the AICPA discussed in depth was the shareholder credit method. Rejected by the Treasury, this was considered the method of choice by the AICPA.

Popular worldwide, this method was rejected by the Treasury primarily because of its complexity. The difference of opinion is due in part to the different shareholder credits the two considered. While the Treasury based its analysis on the New Zealand approach, the AICPA said its study focused on a fixed-rate credit, reducing complexity. The AICPA also was concerned about international harmonization; because so many other countries have adopted the shareholder credit method, the AICPA concluded adopting this method would allow the United States to benefit from their experience and better interface with their systems.


The climate here and abroad has changed since integration was discussed in the 1970s. Globalization of the economy and international competition are much more important concerns and may force the United States to adopt integration. However, the budget deficit also must be considered. Any tax reform proposal that would reduce federal tax revenues is unlikely to be adopted. Such proposals would be viable only if they were part of a broader tax reform plan. Any tax loss caused by integration would have to be compensated for with other taxes or increased rates.

For corporations, integration would require new bookkeeping requirements. Under any of the methods proposed by the Treasury or the AICPA, corporations would have to report more information to shareholders. The benefits of integration for corporations, such as a lower cost of capital and, it is hoped, simplification of the tax rules, should offset any negative aspects.


* IN AN EFFORT TO END THE double taxation of corporate dividends, several proposals have been developed to integrate the individual and corporate tax systems.

* THE CURRENT DOUBLE TAX system puts corporations at a competitive disadvantage in raising equity capital; it creates a bias toward debt financing, since interest payments are deductible.

* INTEGRATION HAS THE potential to significantly simplify the tax code. Many aspects of an integrated tax system remain to be resolved, however, before such a system can be adopted--not the least of which is the need for any change to be revenue-neutral.

* SEVERAL METHODS EXIST FOR implementing integration, including a dividend exclusion, comprehensive business income tax, shareholder allocation and imputation credit. Other proposals include a flow-through method, a dividend deduction and a shareholder credit.

* GLOBALIZATION OF THE ECONOMY and international competition may force the United States to adopt integration. It seems likely, however, that integration would have to be part of broader tax reform and simplification.
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Author:Sellers, Keith F.
Publication:Journal of Accountancy
Date:Nov 1, 1994
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