A Corporate Tax Primer

Business Credit, April 1995 | Go to article overview

A Corporate Tax Primer


Here are some frequently asked questions concerning corporate taxes. Business Credit asked tax specialists at Davis Polk and Wardell for some answers.

BC: Why is there a movement to reform the U.S. corporate tax system?

P&W: U.S. businesses today labor under a federal income tax system which has grown so arbitrary and complex, many believe, that controversies, ambiguities, and the costs of compliance have become a serious drain on productivity.

The most recent effort to reform the Code came on June 7, 1994, when Senators John Danforth and David Boren introduced S. 2160 (the Comprehensive Tax Restructuring and Simplification Act of 1994). The Danforth-Boren proposal would replace the corporate income tax with a business activities tax and, the authors claim, be revenue neutral, treat debt and equity equally, tax labor and capital the same, and be border adjustable, so that it can be levied on imported goods and removed from U.S. exports in a manner similar to the value added taxes of many of our trading partners. It would not penalize business savings or investment as the current system does. It would rely on the records that a corporation keeps in the ordinary course of business, significantly simplifying the current tax compliance system. These changes, according to the senators, would be important steps toward correcting the three main problems the current U.S. system presents for business: the system's payroll orientation which results in increased labor costs, its extraordinary complexity which leads to uncertainty and added record-keeping costs, and the system's undue intrusion into the business decision-making process.

It is expected that further impetus will be given to the tax reform movement when the Bipartisan Commission on Entitlements and Tax Reform issues its report on tax reform some time this year.

BC: How are corporations currently taxed?

P&W: Corporations are subject to a 35 percent tax on net income or, if greater, a 20 percent tax on "alternative minimum taxable income" (net income increased to offset the effects of certain deductions and favorable accounting methods).

BC: Does this bear on why corporations seem to prefer the issuance of debt to equity?

P&W: In computing net income, corporations are generally entitled to deductions for interest paid or accrued on their outstanding debt, but not for dividends paid on their outstanding stock. Thus, the corporate level tax, coupled with the shareholder level tax, generally results in the "double taxation" of corporate income distributed as dividends. Therefore, all other things being equal, the after-tax cost of issuing debt is cheaper than that of issuing stock.

In addition, interest paid to foreign investors is generally free from withholding tax, while dividends paid to them are almost invariably subject to a significant withholding tax.

BC: How is debt distinguished from equity?

P&W: In form, debt is generally evidenced by an agreement promising payment whereas equity is an ownership interest in a business venture. Securities evidencing ownership include preferred and common stock, and debt includes debentures, bonds, notes, bills, and mortgages.

Many contemporary financial products blend aspects of debt with equity, raising questions about how they should be classified for tax purposes. Debt status generally requires economic circumstances indicating a substantial likelihood of repayment as well as a legal obligation to repay a fixed amount on a certain date.

BC: Is there any relief from the double taxation of corporate dividend income?

P&W: As a general rule, corporations are not taxed on dividends received from wholly owned domestic subsidiaries. In addition, corporations generally pay tax on only 30 percent of dividends received from other domestic corporations.

Numerous proposals have been made by bar associations, legal scholars, and practitioners to provide more complete relief from double taxation--for example, by allowing shareholders a tax credit for taxes paid at the corporate level. …

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