[15579]
January 23, 2003
TO: TRANSFER AGENT ADVISORY COMMITTEE No. 8-03
RE: TREASURY EXPLANATION OF EXCLUDABLE DIVIDEND PROPOSAL
The Treasury Department has released the attached detailed explanation of the
President’s dividend exclusion proposal. This explanation differs in some respects from earlier
Treasury descriptions of the proposal. Set forth below is a general overview of several
provisions of particular interest to regulated investment companies (“RICs”) and their
shareholders.
Excludable Dividends
Under the proposal, certain distributions made by a corporation to its shareholders
would be excluded from the shareholders’ taxable income (“excludable dividends”). If a
corporation distributed as dividend income more than the excludable amount, a proportionate
amount of each dividend would be treated as excludable. A RIC generally would be permitted
to flow through to its taxable shareholders the excludable dividends it receives on equities held
in its portfolio.
Excludable Dividend Amount (“EDA”)
The amount that a corporation could pay as an excludable dividend generally would be
limited to the corporation’s excludable dividend amount (“EDA”). A corporation’s EDA
essentially reflects corporate income that has been fully taxed in the US (including US income
taxes, on foreign source income, that would have been paid but for offsetting foreign tax
credits). For example, if a corporation has $100 of taxable income on which it pays $35 of US
income tax, the EDA will be $65.1 EDA would be increased or decreased by various
adjustments discussed in detail in the Treasury explanation.
A corporation’s EDA for a calendar year would be based on the tax shown on the tax
return filed in the preceding calendar year. Thus, for example, if a corporation with a fiscal year
1 The formula for determining EDA is: (US corporate income tax divided by .35) minus US corporate income tax. In
the example above, the corporation’s $35 of tax divided by .35 equals $100; this $100 less tax paid of $35 equals $65.
If a corporation instead had taxable income of $100, but paid only $20 of US tax (because of, for example, R&D tax
credits), the EDA would be $37.14, calculated as follows: $20/.35 (or $57.14) minus $20.
2
ending on December 31, 2001 filed its tax return on September 15, 2002 (the due date plus
extensions), the tax shown on that return would determine its EDA for calendar year 2003.
Retained Earnings Basis Adjustments (“REBAs”)
A corporation that did not distribute as excludable dividends the full amount of its EDA
for a calendar year could provide its common shareholders with increases in the cost basis of
their shares equal to the undistributed amount. A RIC would be permitted to flow through
these retained earnings basis adjustments (“REBAs”) as basis adjustments to its shareholders.
REBAs could be made by the corporation at any point during the calendar year. For
example, if a corporation’s EDA for the calendar year were $65 and the corporation distributed
only $50 of excludable dividends (thereby reducing its EDA to $15), the remaining $15 of EDA
could be treated as a REBA and increase proportionately the cost basis of the common
shareholders’ shares.
Cumulative Retained Earnings Basis Adjustments (“CREBAs”)
In addition, the cumulative amount of REBAs for all years -- an amount referred to as
the cumulative retained earnings basis adjustment (“CREBA”) -- could be used by a corporation
to pay excludable dividends in a year for which the EDA is insufficient to ensure excludable
dividend treatment for the full amount of the distributions.2 A RIC would be permitted to flow
through a distribution out of CREBA to its shareholders.
Distributions out of CREBA would reduce each shareholder’s cost basis in his or her
shares. Any distributions out of CREBA in excess of any shareholder’s cost basis would be
treated as capital gain.
Ordering Rule for Distributions
The Treasury explanation provides the following ordering rules where a corporation’s
distributions for a calendar year exceed its EDA (and only a proportionate amount of each
distribution, as noted above, is treated as an excludable dividend). Specifically, a distribution in
excess of EDA is treated as (1) a return of basis, and then capital gain, to the extent of CREBA
(as noted above); (2) a taxable dividend to the extent of the corporation’s earnings and profits;
(3) a return of capital to the extent of a shareholder’s remaining basis; and (4) capital gain.
2 For example, assume a corporation that has a $15 REBA in Year One and a $10 REBA in Year Two; if the
corporation has no EDA in Year Three, it nevertheless could pay excludable dividends of $25 out of CREBA. A $25
distribution in this example would reduce the corporation’s CREBA to zero.
3
RIC Distribution Requirements
A RIC would not be allowed a dividends paid deduction for distributions that are
excludable or from CREBA. For purposes of the RIC distribution requirements, excludable
dividends would be treated in the same manner as tax-exempt interest (i.e., subject to a 90
percent distribution requirement).
Shareholder-Level Requirements
Shareholders generally would exclude their excludable dividends from gross income.
IRS Forms 1099 would be modified to provide the amount of any excludable dividend, any
REBA and any CREBA.
A shareholder would not be eligible for excludable dividend or REBA treatment unless
the stock were held for more than 45 days during the 90-day period beginning 45 days before
the ex-dividend date (with a more-than-90-day holding period requirement applicable to
preferred stock). The rules of section 1059 -- which require a basis reduction for certain
dividends eligible for the dividends received deduction3 -- would be extended to apply with
respect to excludable dividends. Rules similar to the rules under section 854(b)(2) -- which
disallow losses on RIC shares held for 6 months or less to the extent of exempt-interest
dividends received during the holding period -- would apply to a RIC shareholder receiving an
excludable dividend or a REBA.
Foreign Shareholders
US withholding tax would continue to apply to dividends paid to nonresident alien
(foreign) investors -- whether those dividends were excludable or not -- and to distributions
from CREBA. US withholding tax would not apply, however, to REBAs (as foreign investors
are not subject to withholding tax on capital gains).
Treatment of Pension Plans, 401(k) Plans and Individual Retirement Accounts
The proposal would not change the tax treatment of retirement plans. The Treasury
document provides an explanation of why investment income from retirement plans already is
effectively free from tax and why, consequently, investments in retirement plans would remain
tax advantaged relative to investments in taxable accounts.
Other Rules
Certain types of redemptions would reduce EDA. The proposal also would repeal the
personal holding company rules.
3 The proposal also would repeal the corporate dividends received deduction for portfolio investments, subject to
transition rules.
4
Effective Date
The proposal would apply to dividends (and REBAs) received beginning in 2003.
Keith Lawson
Senior Counsel
Attachments
Attachment no. 1 (in .pdf format)