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New AICPA position on corporate integration.

The AICPA Tax Division recently recommended that the double tax on dividends should be eliminated by integrating the corporate and shareholder income tax systems. The preferred approach would be a shareholder-credit method. The Tax Division asserts that elimination of the double tax would increase incentives for investment in U.S. corporations; reduce the use of debt (rather than equity) financing, thereby fostering more stable capital structures; and foster more efficient and tax neutral decisions as to the retention of corporate earnings.

These recommendations are contained in the exposure draft of Statement of Tax Policy 10, Integration of the Corporate and Shareholder Tax Systems. The Statement was developed by the Corporate Integration Task Force and approved by the Tax Policy and Planning Committee and the Tax Executive Committee. It is based in part on a reconsideration of the 1975 edition of Statement of Tax Policy 3, Elimination of the Double Tax on Dividends. (Statements of Tax Policy represent the AICPA's view on key policy issues.)

Historical background

The AICPA Tax Division first studied this issue in 1975. At that time, the AICPA published its findings in Statement of Tax Policy 3, which recommended the adoption of an integration system that used either the dividends-paid deduction method or the shareholder-credit method.

Since then, the economic conditions and tax laws in the United States have changed significantly, generating renewed interest in examining the feasibility of integrating the corporate and individual tax systems. Relevant changes include the growth of international trade and competition, the increased use of debt financing, a lowering of tax rates for both corporations and individuals, and the inversion of the individual and corporate income tax rates.

During this same period, most of the United States' major trading partners have adopted some form of integration. In reducing (or eliminating) the double taxation of corporate earnings, these countries have sought to reduce the cost of capital for domestic investment. By adopting a comparable system, the United States would similarly seek to increase the incentives for investment in the U.S. corporate sector.

The use of corporate debt financing increased dramatically during the 1980s. One reason for this increase is the fact that under the current tax system the deductibility of interest expense by corporations encourages the use of debt financing. The rise in the issuance of debt has created greater risks of financial instability. Integration would decrease the tax advantages of debt over equity, thereby reducing the use of debt and fostering more stable capital structures.

Another significant difference relates to the changes made in the tax rate structure for both corporations and individuals. The Tax Reform Act of 1986 (TRA) substantially reduced the tax rates for both corporations and individuals; also, for the first time since 1923, the maximum corporate tax rate is now higher than the maximum individual rate. in the past, the higher individual rates encouraged corporations to retain rather than distribute their profits. Now, the lower maximum individual tax rate has reduced (but not eliminated) the bias against corporate distributions.

Several Federal governmental attempts to adopt some measure of integration have been made since 1975. The concept of an integrated system was proposed by both the Ford and Carter Administrations, but the idea was never formally included in a legislative bill. Subsequent proposals were included in the 1984 study, Tax Reform for Fairness, Simplicity and Economic Growth: The Treasury Department Report to the President (popularly known as Treasury 1), and in the 1985 study, President's Tax Proposals to the Congress for Fairness, Growth and Simplicity (Treasury II). These two reports were the genesis of the TRA.

Although the TRA did not include an integration provision, it directed the Treasury Department to undertake a study of different approaches to achieving integration. The results of this study were released in January 1992.(1)

In late December 1992, the Treasury Department released its legislative recommendations for integration through a dividend- exclusion approach. The Treasury approach would cost $150 billion and have an immediate effective date.

Because of the renewed interest in integration and the existence of sound policy arguments in favor of its adoption, the AICPA has addressed the issue again.


Under the current system, the United States imposes two levels of tax on corporate earnings: A corporation pays a first tax on income when it is earned, and the shareholders pay a second tax when the corporation distributes its earnings. It is generally agreed that the double tax on corporate earnings results in a number of serious economic distortions and raises several tax policy issues: (1) it reduces the incentive for equity investment in U.S. corporations because of an increased cost of capital; (2) it favors debt financing over equity financing by allowing a deduction for interest expense without permitting a similar deduction for dividends; (3) it misallocates resources between corporate and noncorporate sectors because investment decisions are likely to be made on the basis of the respective tax burdens; (4) it negatively affects capital accumulation and the savings rate, with a resulting decline in economic growth; (5) it encourages earnings retention at the corporate level to fund operations, resulting in the potential misallocation of resources; (6) it lacks both horizontal and vertical equity because of the inequality in the tax treatment between earnings from different types of investment and the reduction in the progressivity of the tax system; and (7) it increases the use of tax-avoidance methods to minimize the effect of the double tax, resulting in controversies between taxpayers and the IRS.

Given the distortions and inequities inherent in the current tax system, the United States seriously needs to explore the advisability of implementing an integrated tax system. Integration would increase the after-tax amount available for investment and better balance the use of equity-versus-debt financing. Integration would also make the tax system more equitable, and it could be expected to promote increased efficiencies and growth in the U.S. economy.

The AICPA analyzed six alternative methods of integrating the corporate and individual tax systems. Each method was evaluated on the basis of whether it achieved the following five basic objectives. 1. Does the method lessen the relative tax advantages favoring investment in the noncorporate sector? 2. Does the method reduce the tax bias in favor of corporate debt financing? 3. Does the method reduce the incentives to retain, rather than distribute, corporate earnings? 4. Does the method facilitate interaction with foreign tax systems? 5. Does the method allow for ease of administration?

Each method was also reviewed to determine whether and how easily it could be designed to address other issues, such as the treatment of foreign investment, tax-exempt shareholders and corporate tax preferences.

The AICPA study primarily considered the three principal alternative methods of achieving integration: the flowthrough method; the dividends-paid deduction method; and the shareholder-credit method. The study also described three variants of the principal methods: the repeal of the corporate tax; the split-rate tax method; and the dividend-exclusion method.

The shareholder-credit method and the dividends-paid deduction method both provide integration benefits only for distributed earnings. These methods can be structured to produce substantially equivalent tax results. The principal difference between the two methods is that the shareholder-credit method provides tax relief at the shareholder level, while the dividends-paid deduction provides tax relief to the corporation.

The flowthrough method is the purest form of integration. Under this method, a single level of tax is imposed on corporate income at the shareholder level. Therefore, unlike the two other methods, the flowthrough method extends integration benefits to both distributed and retained earnings.

Advocates for the adoption of the shareholder-credit method argue that it is preferable because it achieves a higher level of compliance with less effort, and because it is more flexible in dealing with the key issues of the treatment of foreign and tax-exempt shareholders and the passthrough of corporate tax preferences. Those who favor the dividends-paid deduction method contend that it is simpler and easier to administer and that it more effectively deals with the tax bias favoring debt over equity capital. Proponents of the flowthrough method point out that it is the only method that achieves complete integration of both distributed and retained earnings. However, it is the most difficult of the three methods to administer.

All major industrialized countries that have adopted an integration system have opted for some form of the shareholder-credit method. Therefore, if the United States adopts the shareholder-credit method, it should benefit from prior international experience. Also, the adoption of this method should simplify interaction between the U.S. system and other integrated foreign tax systems and facilitate treaty negotiations with these countries.


Integration should mitigate the economic distortions and inequities inherent in the present classical system. To the extent that it lowers the cost of capital, it should increase domestic corporate investment in the United States. To the extent that it reduces the tax bias toward debt financing, it should help establish more stable capital structures. And to the extent that it lessens the incentives to retain earnings, it should foster more efficient decisions as to the application of corporate earnings.

In the interest of sound tax policy, the AICPA recommends that the United States adopt a system of corporate integration. On the basis of its analysis of the alternatives available, the Institute believes that, on balance, the shareholder-credit method best achieves the five basic objectives of integration. The AICPA further believes that it is the most flexible method for dealing with the key issues of foreign investment, tax-exempt shareholders and the passthrough of corporate tax preferences. Moreover, administration of the shareholder-credit method will be no more complicated (it may, in fact, be less complex) than the other alternative methods.(2)
Abbreviations Commonly Used in The Tax Adviser
TTA The Tax Adviser
AFTR2D American Federal Tax Reports,
 second series (Prentice-Hall)
Ann. IRS Announcement
CB Cumulative Bulletin
Cir. Court of Appeals
Cl. Ct. Claims Court
COBRA Consolidated Omnibus Budget
 Reconciliation Act of 1985
Cong. Rec. Congressional Record
DC District Court
DRA Deficit Reduction Act of 1984
ERISA Employee Retirement Income
 Security Act of 1974
ERTA Economic Recovery Tax Act of 1981
Fed. Reg. Federal Register
F2d Federal Reports, second series
F Supp Federal Supplement
H. Rep. House Ways and Means'
 Committee Report
IRB Internal Revenue Bulletin
LTR IRS Letter Ruling
PL Public Law
Regs. Sec. Treasury Regulation
Rev. Pro. Revenue Procedure
Rev. Rul. Revenue Ruling
RRA Revenue Reconciliation Act of 1990
Sec. Section (refers to the Internal
 Revenue Code of 1986 unless
 otherwise indicated)
S. Rep. Senate Finance Committee Report
SSRA Subchapter S Revision Act of 1982
Sup. Ct. Supreme Court
TAM Technical Advice Memorandum
TAMRA Technical and Miscellaneous
 Revenue Act of 1988
TC Tax Court (regular decision)
TC Memo Tax Court (memorandum decision)
TD Treasury Decision
TEFRA Tax Equity and Fiscal
 Responsibility Act of 1982
TRA Tax Reform Act of 1986
USTC United States Tax Cases
 (Commerce Clearing House)

(1)The Treasury Department January 1992 report, Integration of the Individual and Corporate Tax Systems: Taxing Business Income Only Once, recommends the adoption of a dividend-exclusion method. The report also recommends the long-range consideration of the comprehensive business income tax (CBIT), a more comprehensive integration prototype. Under the CBIT, shareholders and bondholders would exclude dividends and interest from income; however, neither type of payment would be deductible by the corporation. (2)The AICPA recognizes there are significant economic issues (including the effect on capital markets and the Federal deficit) and significant implementation issues (including the treatment of foreign and tax-exempt investors) associated with the adoption of a shareholder-credit method. The Institute takes no specific positions with respect to these issues in its Statement of Tax Policy.
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Title Annotation:American Institute of Certified Public Accountants
Author:Ferguson, Carol B.
Publication:The Tax Adviser
Date:Feb 1, 1993
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