One of my favourite tax thinkers, not least because of his love of Pavement and cats, Daniel Shaviro has set us a challenge. He was in discussion with Reuven Avi-Yonah about the benefits of changing the system of dividend taxation. Currently dividends are paid out of post-tax earnings but then frequently carry a tax credit which can be used by the receiving shareholder as a credit against their own personal income tax. Avi-Yonah had suggested that an alternative approach would be to scrap the tax credit altogether but to allow companies to deduct the dividend in determining their taxable profits.

And this sets Shaviro thinking (emphasis is mine):

Reuven argues that dividend deduction would be more effective than imputation in encouraging the managers to pay dividends, on the ground they often don't especially care about shareholder taxes but love to get company-level deductions. Thus, even if the two methods of dividend deduction and imputation are in fact economically equivalent, the former will in fact induce greater payouts.

One could certainly challenge this view on multiple grounds, but the one I emphasized, in particular because I thought it was more of a new point, reflects accepting the basic premise (at least arguendo) but then asking what the managers really care about. A common answer, with considerable real world empirical support, would be that they appear to care more about financial accounting income than about income tax liability. So the entity-level tax benefit of dividend deductibility won't affect their behavior as strongly as Reuven anticipates unless there is an accounting benefit. But would there be?

I am not an accountant, but I've played in or near their waters often enough to realize that this is a trickier question than it may initially seem from a lawyer or economist standpoint.

Presumably the financial accounting rules would NOT be revised to allow dividend deductions against financial accounting income, even if newly made deductible against taxable income. But wouldn't financial accounting income reflect the benefit of reducing federal income tax liability through dividend payouts?

Not necessarily. An initial point to keep in mind is that financial accounting often ignores the mere deferral of federal income tax liability. In principle, under dividend deduction, the ultimate corporate tax is zero as all earnings get paid out (or at least an amount equal to taxable income, which is often less than the tax measure of earnings for dividend purposes). So it would seem that the accounting rules in the dividend deduction scenario should either (a) ignore federal taxes on the ground that they're merely temporary, at least until they escape the possibility of being reversed through net operating losses created by dividend deductions, or at least (b) ignore the difference between paying out deductible dividends this year or next year. I'm not in fact sure how it would all end up playing out, but we should recognize that (a) there would be a tricky issue for the accountants to work out and (b) there wouldn't necessarily be a straight accounting benefit for the tax liability effect.

By analogy, consider the accounting rules for the foreign earnings of U.S. companies' foreign subsidiaries. These get the U.S. tax benefit of deferral - that is, they aren't subject to U.S. tax until they actually are repatriated for tax purposes. But companies get no accounting benefit from deferral - they are treated as if the U.S. repatriation taxes were being fully paid on a current basis - unless they solemnly declare to their accountants that the funds are being "permanently" reinvested abroad. Once this happens, the potential future U.S. repatriation taxes are discounted by 100% (i.e., to zero) rather than by zero percent.

Anyway, if the timing of repatriation is effectively ignored in financial accounting on the view that it doesn't matter exactly WHEN it happens (despite the potential effect on the present value of U.S. tax liability, then the same idea might apply, albeit in a somewhat different and (at least to me) unpredictable fashion, with regard to the effect of current versus future dividend payouts on entity-level, purely domestic U.S. income tax liability.

Any accountants out there, your thoughts on this admittedly esoteric issue (either in the comments page here or by e-mail to me) would be of potential interest.

Any takers?

My initial reaction is that the IASB would love to get this on their agenda. They did start to think about moving the income statement around but abandoned the project when convergence became more important. Convergence hasn't yet produced significant changes, but I'm sure the IASB would relish reopening the debate.

That said, the tax treatment of dividends should be irrelevant from a financial reporting point of view. Its position in the income statement reflects the discretion management has over whether to declare a dividend (or not). If it became tax deductible, the tax charge would drop, leading possibly to higher distributions. However, that's not to say that the IASB wouldn't be open to alternative methods of presentation that made company managers look better.

Does anyone have an alternative view? Please drop by Daniel's website and let him know.

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Filed under: Academic research, Taxation with tags corporation tax, daniel shaviro, dividends, reuven avi-yonah, us