The Dividends-Received Deduction We have seen that corporate income distributed to shareholders (in the

The Dividends-Received Deduction We have seen that corporate income distributed to shareholders (in the

form of dividends) is taxed twice—first as corporate income and then as shareholders’ income—and then if the shareholder is another corpora- tion, that income could be taxed a third time. To minimize the chance of triple (or even quadruple) taxation of the same income, the tax laws per- mit a dividends-received deduction: A corporate recipient of dividends may deduct a portion of its dividend income from its taxable income.

With respect to dividend income received by corporations, the 1997 tax law, for example, specifies deductions of either 100%, 80%, or 70%, as follows:

■ Deduction of 100% of dividends received may be deducted if the cor- poration is (1) a small business investment company operated under the Small Business Investment Act or (2) a member of an affiliated group of corporations, as in the case of a parent corporation and its wholly owned subsidiaries.

FOUNDATIONS

■ Deduction of 80% if the dividends are received from a 20% or more owned corporation. ■ Deduction of 70% if none of the conditions above applies.

Fox example, suppose the Inc. Corporation has operating income of $2 million. Further suppose that it received $1 million in dividends and $500,000 in interest, and it paid $800,000 dividends and $600,000 inter- est. If the dividends received deduction is 70%, Inc’s taxable income is:

Operating income $2,000,000 Plus: Included dividend income (30% of $1,000,000)

300,000 Plus: Interest income

500,000 Less: Interest expense

(600,000) Taxable income

$2,200,000 EXHIBIT 5.3 Corporate Taxable Income Gross receipts

− Cost of goods sold Gross profit + Dividend income + Interest income + Gross rents + Gross royalties + Capital gain income + Other income Total income − Salaries and wages − Repairs and maintenance − Bad debt expense − Rents − Taxes and licenses − Interest − Charitable contributions − Depreciation − Depletion − Advertising − Pension, profit-sharing plans − Employee benefit programs − Other deductions Total deductions

Taxable income

Taxation

The remaining $700,000 in dividends received are not taxed—these div- idends are excluded from income. The $800,000 dividends paid do not affect taxable income.

The dividends-received deduction either eliminates the tax on divi- dend income or reduces the effective tax rate considerably. Suppose a corporation has a marginal tax rate of 34% and the dividends it receives qualify for the 80% deduction. Then the effective tax rate on that divi- dend income is 20% of 34%, or 6.8%.

The dividends-received deduction increases the after-tax return of a corporation investing in another corporation’s stock. Since corporate investors get a tax break on dividend income, they require a lower return on these securities, thus lowering the cost of capital for the cor- poration that issues these securities. The recent trend in tax law is to reduce the dividends-received deduction, increasing the multiple taxa- tion effect and increasing the cost of capital to issuers of these securities.

While a corporation’s dividend income receives special treatment, its interest income does not: Interest received by a corporation is taxed like any other income. Dividends and interest paid by a corporation receive different treatment as well: Interest paid by a corporation is fully deductible when computing taxable income, whereas dividends paid are not deductible. The taxation of dividend and interest received and paid enters into financial decision-making since it affects the cost of capital.