The Senate Finance Committee hearing on May 17, 2016, on "Integrating the Corporate and Individual Tax Systems: The Dividends Paid Deduction Considered" featured discussion from witnesses and members about potential unintended consequences of corporate integration proposals, including on retirement plans, and the preference for a more comprehensive approach to tax reform that directly addresses the international competitiveness of US-based corporations.

In an opening statement, Chairman Orrin Hatch (R-UT) said a significant portion of corporate income is taxed twice at the corporate rate and, upon distribution to shareholders, at the top dividend rate. He listed the benefits of a dividends paid deduction (i.e., allowing companies to deduct the dividends they pay out) under corporate integration, including greater parity between debt and equity, and reducing international tax problems like the lock-out effect. Hatch said he will include such a deduction in the corporate integration proposal he will unveil in the next several weeks, which is also expected to include a 35% withholding tax on dividends and interest.

Ranking Member Ron Wyden (D-OR) said corporate integration could result in a switch from "double taxing corporate income to double taxing retirement plans" because a withholding tax on dividends and interest would affect retirement plan investments in stocks and bonds. "Their special tax-deferred status — which today is the key that unlocks opportunities to save for millions of Americans — would go away," he said.

Senator Rob Portman (R-OH), who focused his questioning on how corporate integration would affect the international tax crisis that has led to inversions and US companies becoming vulnerable acquisition targets, said he hoped the Committee would hold a hearing on the unintended consequences of the Administration's Section 385 regulations, which he said are an "overreach." Chairman Hatch said he is pushing for such a hearing.

Witnesses at the hearing were:

— Michael J. Graetz, Wilbur H. Friedman Professor of Tax Law and Columbia Alumni Professor of Tax Law, Columbia University, New York, NY

— Judy A. Miller, Director of Retirement Policy for the American Retirement Association and Executive Director of the American Society of Pension Professionals and Actuaries College of Pension Actuaries, Arlington, VA

— Steven M. Rosenthal, Senior Fellow, Urban-Brookings Tax Policy Center, Urban Institute, Washington, DC

— Bret Wells, Associate Professor of Law, Law Center, University of Houston, Houston, TX

Testimony

In testimony, Graetz said transforming the corporate tax into a withholding levy would reduce or eliminate some domestic and international tax distortions, though problems such as those associated international transfer pricing would remain. He said imposing a nonrefundable withholding tax on corporate interest payments but not interest paid by Treasury bonds, banks, or foreign corporations could be problematic; a less disruptive option might be to deny deductions for all or part of interest payments at the corporate level.

Elaborating on Senator Wyden's point, Miller said corporate integration would result in taxation of dividends and interest earned by a retirement plan's investments while held in the plan, with the contributions and remaining investment earnings taxed again when the amounts are withdrawn from the plan. "The result would be a substantial reduction in the tax incentive to save through a qualified retirement plan relative to current law," she said.

Rosenthal highlighted research showing that the share of corporate stock issued by US corporations that is held in taxable accounts fell from 83.6% in 1965 to 24.2% in 2015, attributable to the increase in stock held in tax-favored retirement accounts and the increase in portfolio investment by foreigners. With only about a quarter of dividends paid to taxable accounts, allowing corporations to deduct dividends paid to shareholders might generate relatively little revenue from the corporate tax base and therefore require an increase in the tax rate on dividends and capital gains to maintain revenue neutrality, he said.

Wells said there is much to commend about corporate integration, but the United States must nevertheless ensure that the dividends paid deduction regime is structured to withstand systemic international tax challenges such as inbound earnings stripping, inversions and the lock-out effect. He said the dividends paid deduction regime does not eliminate the financial advantages that motivate earnings stripping or that fuel corporate inversions; doing so would require an equivalent withholding tax, or a surtax, on all of the related party base erosion strategies. Wells said a dividends paid deduction regime should substantially eliminate the lock-out effect with respect to the repatriation of low-tax foreign earnings, but outside of the low foreign tax context, the interplay with the US foreign tax credit regime creates complex trade-offs. He also said if such a regime were adopted, it would be important to ensure that the incidence of the shareholder dividend withholding tax cannot be shifted, cross-credited against other shareholder income, monetized or reduced.

Questions & answers

During questioning from Chairman Hatch, Graetz said a dividends paid deduction would reduce the lockout effect, and could work well with the foreign tax credit system the US has now or a territorial system. Hatch also asked how the current debt-equity distortion could be eliminated. Rosenthal said, under present law, corporations can deduct interest they pay to bondholders but cannot deduct dividends to shareholders, meaning there is an incentive to issue debt, to reduce corporate taxes, over equity. Effectively, the US collects most taxes at corporate level and few at the shareholder level, which exacerbates the incentive to issue debt over equity; collecting taxes at the shareholder level through a dividends paid deduction and a withholding tax would alleviate the debt-equity bias, he said.

Senator John Thune (R-SD) said he would like to see comprehensive tax reform and a move to a territorial system, and asked if it is possible to do corporate integration without creating a lot of unintended consequences that could do more harm than good. "Can this be done in a vacuum — can we rifle shot this, or does it have to be done in a broader context?" he asked. Wells said it has to be done in a broader context: when you have a deduction at the corporate level under the dividends paid deduction that creates a 35% withholding tax, you have to compare that to other earnings stripping opportunities. If an inbound company has the opportunity to create a tax deduction at the same benefit but through interest stripping, royalties, etc., and those are not subject to a withholding tax, then there is a structural competitive advantage for that foreign-based multinational in the United States.

"If we want to have horizontal equity between domestic corporations and foreign corporations, we need to ensure that the tax base will not be reduced through a deduction that avoids the withholding tax through intercompany arrangements for the inbound foreign company that does not exist for the US multinational … " Wells said. "Many of those earnings stripping techniques, if tried by a US multinational, would be subject to the US subpart F regime and would be currently taxed. So today, there are earnings stripping opportunities to the inbound foreign-based multinational that give them [sic] a deduction with no withholding."

Senator Tim Scott (R-SC) asked no questions but said he is concerned that, absent a total overhaul of the tax code, the United States is going to become more uncompetitive in the global economy. As that happens and fewer domestic profits are realized, there will be a negative effect on middle-income Americans and poor and economically disadvantaged communities, he said, adding that the inability to reach a bipartisan agreement to reduce the corporate tax rate and move to territorial taxation is crippling job creators. Senator Scott said he appreciated the hearing, but ultimately, until lawmakers have a "panoramic view" of the tax code, they will continue struggling to fix the tax system.

Chairman Hatch asked whether there would be a behavioral response to corporate integration. Graetz said it would reduce the burden for repatriations because of the deductibility of dividends at the corporate level; it would increase the distribution of earnings as dividends, especially relative to share repurchases; and hopefully it would change the debt-equity balance.

Chairman Hatch concluded the hearing by saying clearly comprehensive tax reform will not get done this year with the current makeup of Congress, but something like corporate integration would demonstrate the potential for true tax reform.

Next Hearing

The Committee has announced a second corporate integration hearing, scheduled for May 24, focused on debt-versus-equity considerations. Witnesses at that hearing will be:

— John Buckley, Former Chief Tax Counsel, Committee on Ways and Means, United States House of Representatives, Washington, DC

— Jody K. Lurie, CFA, Vice President, Corporate Credit Analyst, Fixed Income Strategy and Research, Janney Montgomery Scott LLC, Philadelphia, PA

— John McDonald, Partner, Baker & McKenzie LLP, Chicago, Il

— Alvin C. Warren, Jr., Ropes & Gray Professor of Law, Harvard Law School, Harvard University, Cambridge , MA

Member statements and witness testimony from today's hearing are attached.

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ATTACHMENTS

Graetz statement

Hatch statement

Miller statement

Rosenthal statement

Wells statement

Wyden statement