Not all dividends are going to be tax free....
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MARKET PLACE
Bush's Plan Taxes Certain Dividends, Fine Print Reveals
By FLOYD NORRIS
[N] ot all corporate profits are created equal under President Bush's tax plan. Neither are all dividends.
Details of the president's plan show that dividends will continue to be taxed when paid by companies that do not pay federal income taxes themselves. Companies with losses or those that use various techniques that eliminate taxable income will find they have no tax-free dividends to hand out.
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For the first time, in other words, companies that pay federal income taxes may seem more attractive to investors than those that find ways to avoid paying the taxes.
"There is less pressure on the company to shelter its income, because it will inhibit its ability to pay out dividends without tax," said Pam Olson, the assistant Treasury secretary for tax policy.
The president's plan also came up with a way for shareholders of profitable tax-paying companies to get a break even if the companies decide to distribute little or no cash in dividend payments. Companies that choose to reinvest in their businesses rather than pay dividends will pass on to their shareholders a tax break that will reduce the capital gain they report when they sell their stock.
That twist, not widely understood when the plan's details were first disclosed, means that the tax bill may benefit holders of new-economy companies like Microsoft that pay no dividends as well as owners of old-economy companies like General Motors that do pay them. But owners of companies like Tyco International that move offshore to reduce their tax bills will not benefit.
"What we are trying to do is eliminate the double tax on corporate dividends," said Ms. Olson, referring to the fact that under current law companies pay tax on corporate profits and then shareholders pay taxes on dividends distributed from those profits. But she said the government did not want to give breaks to investors in companies that did not pay corporate taxes.
But gaining what the administration views as equity in that regard means that something that sounded simple ? ending taxes on dividends ? will create more complexity in the tax law. Companies that pay dividends would have to inform investors just how much of the payout can be deemed to come from taxed profits earned in 2002 or later. That part of the payout would be tax exempt; the rest would be taxable.
One unfortunate impact would be that companies that are temporarily unprofitable ? perhaps because of a recession ? could find their dividends suddenly taxable, making them less attractive to investors and further depressing their share prices.
"Going unprofitable is really the unfortunate part," said Ms. Olson in an interview yesterday. "Shareholders would be happy to continue to get the dividends."
Ms. Olson emphasized that only if companies paid taxes, in 2002 and later, would their dividends take on a tax-free status for shareholders.
Another surprise for many taxpayers may be that many securities called preferred stock will not pay dividends, at least as defined by the tax law. Those payouts, considered interest, will continue to be taxable under the law. Investors choosing among preferred issues will need to investigate carefully which issues qualify.
The complexity stems from the need to prevent what some officials see as abuses, and to assure that shareholders of companies that retain and reinvest their profits are not treated worse than those of companies that pay out dividends.
"Failure to provide for all these things could result in windfall receipts of tax-free accumulated earnings, or create undesirable pressure on corporations to distribute accumulated earnings," said David Hariton, a tax partner at Sullivan & Cromwell. "But implementation of all of these rules might prove complex and difficult to administer."
The only exception to companies having paid income tax would be the use of the foreign tax credit. Companies would be able to treat taxes paid to foreign governments, and reflected in that credit, as if they were taxes paid to the United States.
But companies that use other methods to avoid paying federal income taxes would discover that they had also eliminated the right of their shareholders to get tax breaks.
Treasury officials said the proposal largely followed a plan laid out in a 1992 Treasury study, during the administration of the first President Bush.
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The most striking new addition to the pantheon of corporate finance, were the new proposal to be enacted, would be the "deemed dividend." A company that did not pay out all the dividends that it could pay on a tax-exempt basis ? choosing instead to reinvest the money in its business ? would be able to declare a deemed dividend. That deemed dividend would be treated as if the shareholder had immediately reinvested it and would allow the investor to claim she had spent that extra money buying the stock. That would provide an investor with a tax break when the stock was sold.
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Just how much a company could pay in tax-free dividends would be based on the taxes it actually paid. For example, assume a company paid $35 million in federal income taxes. Because there is a 35 percent corporate income tax rate, that would indicate it had a $100 million pretax profit, and had $65 million it could distribute in tax-free dividends. Any more payments would be taxable.
If, on the other hand, the company did not pay federal income taxes, then all its dividends would be taxable.
Ms. Olson said any company that paid some taxable dividends and some nontaxable would have to do so for all its shareholders. It could not assert that the tax-free dividends went to one group of shareholders, while the tax-exempt ones went to another group, like preferred shareholders or owners of one class of common stock. "This is pro rata," she said. "There are no games being played."
Here's how it might work: If a company had the right to pay $65 million in taxable dividends, and paid just that amount in cash dividends, all the dividends would be tax exempt. If it chose to pay $130 million in dividends, however, half of the dividends would be subject to tax at the investor's ordinary income tax rate.
On the other hand, if the company chose to pay out just $15 million in cash dividends, it could declare a deemed dividend of $50 million. Shareholders would then be able to increase their tax basis. For example, if that deemed dividend came to $1 a share, the tax basis for an investor who had paid $40 a share for the stock would be raised to $41. When the stock was sold, any capital gain would be only the amount above $41.
Ms. Olson said she expected that companies would arrange to pay out, as real or deemed dividends, the entire amount they were eligible to pay out every year. She noted that a company that did otherwise would be needlessly penalizing an investor who sold stock.
It is possible that some companies might not want to declare the entire amount every year, however, arguing that was beneficial to long-term holders. A Treasury official said it had not been decided if that would be allowed. If it was allowed, the company could then use the undeclared reserves to allow it to pay a tax-free dividend in a year when the company lost money and did not pay any taxes. In that way, it could create an expectation of a continuing stream of tax-exempt cash dividends.
Wall Street has devoted a lot of effort in recent years to creating hybrid securities that would look like preferred stock on corporate balance sheets and thereby make the company appear to have more equity, but whose payments would qualify as tax-deductible interest payments for the company.
In fact, said William Scapell, a fixed-income analyst at Merrill Lynch, 72 percent of the existing securities that are called preferred stock fall into that category. Ms. Olson said that since companies were deducting interest on the payments, the dividends would not be tax free.
Another 13 percent of preferred issues either come from foreign companies or from real estate investment trusts, and would not be eligible for tax-free status.
Only the remaining 15 percent of existing preferred stock is eligible for tax-exempt dividend payments. But Mr. Scapell said that some companies might choose to redeem existing hybrid securities and issue new preferred shares that would qualify for tax-exempt dividend payments.
One area in which the Bush proposal is not balanced is in its treatment of companies with past profits or losses. Past undistributed profits do not affect a company's ability to pay out tax-exempt dividends on current income. But past losses, which show up as tax-loss carry-forwards, will prevent companies from paying tax-exempt dividends from current income, so long as the use of those carry-forwards allows the company to avoid paying taxes. |
