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Impact of TCJA on the Dividends Received Deduction

A simple summary of DRD and the impact of this lesser-known TCJA change

In addition to the headline impacts of TCJA, a lesser known change affects dividends received deductions ("DRD").

Dividends received deduction basics

As we discuss in detail in our advanced accounting course, the dividends received deduction ("DRD") exists to prevent companies that are shareholders in other companies from paying a triple tax on dividends they receive from their investment in those companies.  In the absence of the DRD, when a company ("investor") is a shareholder in another company ("affiliate"), any dividends the affiliate issues to the investor would face a triple tax: First, on the affiliate level (affiliate pays tax on income), next on the investor's corporate level (investor pays tax on income at the corporate level), and lastly on the investor's shareholder level.   Here's an example:

  1. A company ("investor") owns 30% of another company ("affiliate").
  2. First level of tax: The affiliate generates $50 million in taxable income during the year and pays $15 million tax. The remaining $35 million in after tax income is distributed as a dividend to shareholders.
  3. Second level of tax: Since the investor is a shareholder that owns 30% of the affiliate, it recognizes affiliate income of $10.5 million (30% x $35 million) and pays a tax on this at the investor's corporate tax rate of 30%, amounting to $3.15 million ($10.5 million x 30%) and thus retaining $7.35 million.
  4. Third level of tax: Lastly, once the investor distributes the $7.35 million as a dividend to its own shareholders, those shareholders must pay a capital gains tax at 15%, leaving the investor's shareholders with $6.25 million ($7.35 million x  85%).

In other words, income generated by an affiliate of $50 million, which investor owns 30% ($15 million), gets triple-taxed all the way down to $6.25 by the time the investor shareholders can cash the check.  The DRD aims to lessen the blow of this triple tax by allowing the investor to deduct the majority of the dividends received at the corporate level.  Specifically, prior to TCJA, the DRD allowed the investor to deduct 80% of the dividend income.  Recalculating the example above with the DRD example would yield:

  1. A company ("investor") owns 30% of another company ("affiliate").
  2. First level of tax: The affiliate generates $50 million in taxable income, pays $15 million tax (we made the tax rate 30% for simplicity - its actually 21% post-TCJA and was 35% pre-TCJA), and the remaining $35 million in after tax income is distributed as a dividend to shareholders.
  3. Second level of tax: Since the investor is a shareholder that owns 30% of the affiliate, it recognizes affiliate income of $10.5 million (30% x $35 million). However, because of the DRD, 80% of this is deductible, the investor's corporate level tax on dividends received is only 7% or $0.63 million (20% x $10.5 million x 30%) and thus retaining $9.87 million.
  4. Third level of tax: Lastly, once the investor distributes the $9.87 million as a dividend to its own shareholders, those shareholders must pay a capital gains tax at 15%, leaving the investor's shareholders with $8.39 million ($9.87 million x  85%).

Keeping $8.39 million on $15 million is definitely better than keeping $6.25. So that's the goal of DRD.

Enter TCJA and the impact on DRD

The TCJA lowered corporate tax rates from 35% to 21% but did not intend on lowering the effective tax rate on received dividends.  To correct for this, the TCJA simply lowered the DRD from 80% to 65% when a C-corporation owns anywhere between 20%-80% of the affiliate, such that:

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  • Prior to TCJA: The DRD led to a tax on affiliate dividends of 35% x (1-80%) = 7.0%.
  • After TCJA: The now lower DRD creates a tax on affiliate dividends of 21% x (1-65%) = 7.35%.

Noticed that there is not a material difference on the overall tax on dividends received (7.0% vs 7.35%).

Additional DRD changes

  • When a C-corp owns less than 20% of an affiliate, TCJA lowered the DRD from 70% to 50%
  • When a C-corp owns more than 80% of an affiliate, TCJA kept the DRD at 100%
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