Unveiling the Dividends Received Deduction
The Dividends Received Deduction (DRD) is a provision of the U.S. tax code designed to mitigate the impact of multiple rounds of taxation on corporate profits. The DRD allows a corporation to deduct a specified portion of the dividends it receives from another corporation, thereby reducing the total amount of tax due. This provision is designed to curb what could be perceived as an undue burden on corporate earnings, which can potentially be taxed three times over. The impetus behind the DRD is to prevent this triple taxation from becoming a reality, instead, ensuring a fair taxation process for the corporations involved.
The Taxation Tangle – The Need for DRD
The structure of corporate earnings and distributions can often become a complex maze of taxation. An initial layer of taxation occurs at the corporate level when a corporation earns a profit. When these earnings are then distributed as dividends, the shareholders who receive these dividends are again subjected to taxation at the individual level.
However, in scenarios where a corporation owns shares in another corporation, the dividends received by the shareholder corporation may be subject to a third round of taxation. This is where the DRD steps in, reducing the tax burden and making the process more equitable. By deducting a percentage of these dividends from the shareholder corporation's taxable income, the DRD prevents the dividends from being triple-taxed.
Different Strokes for Different Ownership
The DRD percentage varies according to the degree of ownership the receiving corporation holds in the paying corporation. There are distinct tiers within the DRD system, linked to the extent of ownership that the recipient corporation has in the corporation paying out dividends.
For corporations that own less than 20% of the dividend-paying corporation, a 70% deduction is applicable. This provision essentially means that these corporations can deduct 70% of the dividends they receive from their taxable income.
The deduction percentage increases for corporations that have a more substantial stake. If the shareholder corporation owns more than 20% but less than 80% of the dividend-paying corporation, it can deduct 80% of the received dividends.
The highest level of deduction is reserved for scenarios where the recipient corporation owns over 80% of the dividend-paying corporation. In such cases, because they file consolidated returns and are considered one entity for tax purposes, these corporations are allowed to deduct 100% of the received dividends.
The Fine Print of DRD
There are several critical rules to the DRD. Certain exceptions and specific criteria define whether a corporation qualifies for this deduction or not. Notably, corporations cannot claim a DRD for dividends received from a Real Estate Investment Trust (REIT) or capital gain dividends received from a Regulated Investment Company. Furthermore, the DRD's rules differ when it comes to dividends received from domestic corporations versus those received from foreign corporations.
The Dividends Received Deduction, while a complex provision of the U.S. tax code, provides a critical buffer against the possible triple taxation of corporate dividends. Through its tiered system of deductions, it supports corporations across the spectrum, encouraging investment, and fostering corporate growth.
Summary:
A Dividends Received Deduction (DRD) is a tax deduction available to corporations when they are paid dividends from another corporation.
This is a provision to reduce the number of times an amount of earnings can be taxed: company A, which is paying the dividend, will have already been taxed on it, and the shareholders of company B will be taxed as well, so the Dividends Received Deduction alleviates taxes at the intermediary stage when Company B receives it.
The Dividends Received Deduction reduces the amount of taxes due on dividends which have been paid to a corporation from another corporation, in situations where the payee owns dividend-eligible stock of the payor.
Corporate earnings are infamously double-taxed as it is: an owner of a corporation, for instance, will have to allow the earnings to be taxed at a corporate level and then again at a personal level when they are distributed in various ways, with few exceptions.
It is not uncommon for companies to own interest in another company, and the dividends from the shares owned are in danger of being triple-taxed without this deduction. If a company owns less than 20% of the company paying the dividends, it can deduct 70% of the amount of dividends received from its own taxes.
In situations were a company owns over 80% of the dividend paying company, as its subsidiary, 100% of the dividends can be deducted; this is because they will file consolidated returns and will be considered one entity for tax purposes.
If a company owns less than 80% but more than 20%, 80% of the dividend paid by the affiliated company will be deductible per the dividends received deduction.