[Senate Hearing 114-656]
[From the U.S. Government Publishing Office]




                                                        S. Hrg. 114-656

                     DEBT VERSUS EQUITY: CORPORATE 
                       INTEGRATION CONSIDERATIONS

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                                HEARING

                               before the

                          COMMITTEE ON FINANCE
                          UNITED STATES SENATE

                    ONE HUNDRED FOURTEENTH CONGRESS

                             SECOND SESSION

                               __________

                              MAY 24, 2016

                               __________

                                     
          
          
          
          
          
          
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            Printed for the use of the Committee on Finance
                             ______

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                          COMMITTEE ON FINANCE

                     ORRIN G. HATCH, Utah, Chairman

CHUCK GRASSLEY, Iowa                 RON WYDEN, Oregon
MIKE CRAPO, Idaho                    CHARLES E. SCHUMER, New York
PAT ROBERTS, Kansas                  DEBBIE STABENOW, Michigan
MICHAEL B. ENZI, Wyoming             MARIA CANTWELL, Washington
JOHN CORNYN, Texas                   BILL NELSON, Florida
JOHN THUNE, South Dakota             ROBERT MENENDEZ, New Jersey
RICHARD BURR, North Carolina         THOMAS R. CARPER, Delaware
JOHNNY ISAKSON, Georgia              BENJAMIN L. CARDIN, Maryland
ROB PORTMAN, Ohio                    SHERROD BROWN, Ohio
PATRICK J. TOOMEY, Pennsylvania      MICHAEL F. BENNET, Colorado
DANIEL COATS, Indiana                ROBERT P. CASEY, Jr., Pennsylvania
DEAN HELLER, Nevada                  MARK R. WARNER, Virginia
TIM SCOTT, South Carolina

                     Chris Campbell, Staff Director

              Joshua Sheinkman, Democratic Staff Director

                                  (ii)













                            C O N T E N T S

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                           OPENING STATEMENTS

                                                                   Page
Hatch, Hon. Orrin G., a U.S. Senator from Utah, chairman, 
  Committee on Finance...........................................     1
Wyden, Hon. Ron, a U.S. Senator from Oregon......................     3

                               WITNESSES

Warren, Alvin C., Jr., Ropes and Gray professor of law, Harvard 
  Law School, Harvard University, Cambridge, MA..................     6
Lurie, Jody K., CFA, vice president and corporate bond research 
  analyst, Janney Montgomery Scott LLC, Philadelphia, PA.........     7
Buckley, John L., former Chief Tax Counsel, Committee on Ways and 
  Means, House of Representatives, Washington, DC................     9
McDonald, John D., partner, Baker and McKenzie LLP, Chicago, IL..    10

               ALPHABETICAL LISTING AND APPENDIX MATERIAL

Buckley, John L.:
    Testimony....................................................     9
    Prepared statement...........................................    39
Hatch, Hon. Orrin G.:
    Opening statement............................................     1
    Prepared statement with attachment...........................    43
Lurie, Jody K., CFA:
    Testimony....................................................     7
    Prepared statement...........................................    47
McDonald, John D.:
    Testimony....................................................    10
    Prepared statement...........................................    52
Warren, Alvin C., Jr.:
    Testimony....................................................     6
    Prepared statement...........................................    62
Wyden, Hon. Ron:
    Opening statement............................................     3
    Prepared statement...........................................    66

                             Communication

The Center for Fiscal Equity.....................................    69

                                 (iii)

 
        DEBT VERSUS EQUITY: CORPORATE INTEGRATION CONSIDERATIONS

                              ----------                              


                         TUESDAY, MAY 24, 2016

                                       U.S. Senate,
                                      Committee on Finance,
                                                    Washington, DC.
    The hearing was convened, pursuant to notice, at 10:10 
a.m., in room SD-215, Dirksen Senate Office Building, Hon. 
Orrin G. Hatch (chairman of the committee) presiding.
    Present: Senators Grassley, Crapo, Heller, Wyden, Stabenow, 
Cantwell, Carper, Cardin, Bennet, Casey, and Warner.
    Also present: Republican Staff: Mark Prater, Deputy Staff 
Director and Chief Tax Counsel; Tony Coughlan, Tax Counsel; 
Chris Hanna, Senior Tax Policy Advisor; Jim Lyons, Tax Counsel; 
and Eric Oman, Senior Policy Advisor for Tax and Accounting. 
Democratic Staff: Joshua Sheinkman, Staff Director; Ryan 
Abraham, Senior Tax Counsel; Michael Evans, General Counsel; 
and Tiffany Smith, Senior Tax Counsel.

 OPENING STATEMENT OF HON. ORRIN G. HATCH, A U.S. SENATOR FROM 
              UTAH, CHAIRMAN, COMMITTEE ON FINANCE

    The Chairman. The committee will now come to order.
    Welcome, everyone, to this morning's hearing, which is our 
second hearing on the topic of corporate tax integration. Last 
week we had a hearing to examine the potential benefits of a 
dividends paid deduction. Today, we will focus on the differing 
tax treatment of debt and equity under the current system and 
the distortions that are created as a result.
    As a number of studies have shown, U.S. businesses pay an 
effective tax rate of about 37 percent on equity financing, 
while the effective tax rate on debt financing is negative. 
That is right: negative. The tax code actually gives a subsidy 
to corporations for debt financing. Experts and policymakers 
across the ideological spectrum have acknowledged that this is 
a problem.
    For example, President Obama's updated framework for 
business tax reform, which he released last month, makes this 
observation: ``The current corporate tax code encourages 
corporations to finance themselves with debt rather than with 
equity. Specifically, under the current tax code, corporate 
dividends are not deductible in computing corporate taxable 
income, but interest payments are. This disparity creates a 
sizable wedge in the effective tax rates applied to returns 
from investments financed with equity versus debt.''
    Now, the Congressional Budget Office and the Joint 
Committee on Taxation, along with the Treasury Departments of 
past administrations, agree. The George W. Bush 
administration's Mack-Breaux tax reform panel and the Obama 
administration's Volcker tax reform panel came to the same 
conclusion: our tax code's bias in favor of debt financing 
causes significant distortions in the economy.
    We will talk about a number of these distortions today, but 
I want to mention just a few here at the outset.
    Most obviously, the bias in favor of debt under our tax 
system incentivizes businesses to base financing decisions, not 
necessarily on market conditions or their specific situations, 
but on relative tax consequences. In addition, while debt is 
not inherently an inferior option, businesses and economic 
sectors that are over-leveraged are, broadly speaking, more 
vulnerable to losses in the event of an economic downturn.
    This puts consumers at greater risk for things like higher 
interest rates due to bankruptcies, taxpayer bailouts, and the 
like. Our system, which puts a premium on debt in the form of a 
tax preference, adds to these risks.
    Finally, the favored tax status of debt incentivizes the 
use of complicated and often wasteful tax-planning strategies 
that redirect resources away from projects and ventures that 
will lead to growth. This includes, for example, the use of 
financing instruments that will be regarded as debt by the IRS, 
even though they resemble equity in a lot of ways.
    This was apparently the focus of the administration's newly 
proposed section 385 regulations, which were ostensibly 
promulgated to prevent inversions, but, as we are finding out, 
have a much broader scope. These proposed regulations are, to 
say the least, quite complicated and will surely continue to 
generate a lot of discussion. One thing is clear, however: this 
mess demonstrates how distortive our current system really is.
    Now, before I conclude my opening statement, I want to 
address some misunderstandings that came up during our last 
hearing on corporate integration and the dividends paid 
deduction. During that hearing, some arguments and concerns 
were expressed in a manner that I believe mischaracterized the 
approach to corporate integration that I have been discussing 
for several months.
    I did not dwell on these points last week because I did not 
want to disrupt the witnesses' statements or deny them a chance 
to answer members' questions, and I did not want the hearing to 
get bogged down by a protracted debate over a policy proposal 
that is not yet final. But I do want to briefly set the record 
straight on a few points.
    One assertion we heard was that corporate integration 
favors big business at the expense of small businesses. That 
claim just is not accurate.
    True enough, corporate tax integration would directly 
benefit businesses organized as C corporations. According to 
the most recent JCT data, while there are about 1.6 million C 
corporations in the U.S., only about 5,000--less than one half 
of 1 percent--are publicly traded. The vast majority of the 
remaining 99 percent of C corporations are closely held small 
businesses.
    Like large corporations, these small businesses are subject 
to double taxation on earnings paid out to shareholders, but 
there are limitations on what they can do. So a dividends paid 
deduction would ensure a fairer and more efficient tax system 
for small businesses as well as large businesses.
    You do not have to take my word for it. A large coalition 
of small business associations, including the National 
Federation of Independent Businesses and the S Corporation 
Association, recently sent a letter to the leaders of the 
Finance Committee and the House Ways and Means Committee 
stating, ``Congress should eliminate the double tax on 
corporate income. The double corporate tax results in less 
investment, fewer jobs, and lower wages than if all American 
businesses were subject to a single layer of tax. A key goal of 
tax reform should be to continue to reduce or eliminate the 
incidence of the double tax and move towards taxing all 
business income once.''
    Without objection, a copy of that letter will be included 
in the record.
    [The letter appears in the appendix on p. 45.]
    The Chairman. On top of this pretty persuasive assessment 
from the small business community, our committee's Business Tax 
Reform Working Group also made clear in their report that 
dysfunctional tax policies affecting larger publicly traded 
businesses can and do have ripple effects on smaller 
businesses, including suppliers, service providers, and 
community organizations.
    Another assertion we heard last week was that corporate 
integration would impose a double tax on retirement plans. 
Truth be told, I am not entirely sure what the basis is for 
that particular claim. However, I do want to do my best to 
assuage any lingering concerns that people might have about 
this idea.
    Put simply, while we are still seeking input and crafting 
the specifics of our integration plan, I am not aware of any 
serious proposals out there that would result in two layers of 
tax on retirement plans, whether they are talking about income 
the plans receive from interest or from dividends.
    Now, I do not want to spend too long discussing all of the 
issues raised in our last hearing. Clearly, we will have to 
continue this discussion in the coming weeks and months.
    I look forward to a robust public discussion about these 
issues going forward, including here today with our 
distinguished panel of witnesses.
    So with that, I will turn to Senator Wyden for his opening 
statement.
    [The prepared statement of Chairman Hatch appears in the 
appendix.]

             OPENING STATEMENT OF HON. RON WYDEN, 
                   A U.S. SENATOR FROM OREGON

    Senator Wyden. Thank you very much, Mr. Chairman. Once 
again, we are dealing with a very important issue. I commend 
you for bringing up this whole question of debt versus equity. 
As we joked last week, these are not exactly the kinds of 
issues that come up at summer picnics, but they are 
exceptionally important, because one of the biggest challenges 
in tax reform is figuring out the right ways to slash the 
thicket of tax rules that today have too much influence over 
our economy.
    Democrats and Republicans, in my view, share the goal of 
getting the tax code out of the business of picking economic 
winners and losers. Towards that end, I have offered three 
proposals recently.
    The first is a set of technology-neutral energy tax 
proposals that cut energy subsidies in half; second, a simpler 
set of depreciation rules that end the expensing headache for 
small businesses; and third, a proposal that closes the 
loopholes on financial tricksters who want to rip off the 
system at the expense of middle-class taxpayers.
    Another major question that we deal with today is how tax 
reform should unwind the tax code's bias in favor of taking on 
debt. For business, this issue is all about how you are going 
to finance investment, growth, and hiring in the private 
sector.
    Maybe you have designed a new product line and you need to 
build a facility to produce it. Maybe you need to put up cell 
towers with the latest technology, or maybe your firm is ready 
to launch a west coast branch and hire a new team, and you have 
made exactly the right decision--you have decided to locate in 
Oregon.
    The question is whether you are going to finance those 
plans with debt by selling bonds, or with equity by selling 
stock. Today the tax code pushes business towards debt with a 
tax write-off for interest payments on the bonds they sell.
    Without any question, that has a big influence over our 
economy. On one hand, it makes bonds an attractive investment 
tool. But on the other hand, there probably are a lot of 
businesses with debt that they would not have taken on if the 
tax code did not encourage it.
    In my view, in America, to create more jobs in the private 
sector and make us as competitive as possible in a tough global 
economy, we want business decisions made for business reasons, 
not for tax reasons. And I believe reducing the tax code's 
economic distortions is a bipartisan proposition when it comes 
to tax reform.
    So today the committee is going to continue its examination 
of a proposal known as corporate integration, which is one 
strategy that has been put forward as a way to help limit the 
preference for debt. It would accomplish that by offering 
companies a write-off for dividend payments they make to their 
shareholders.
    And certainly as we have this discussion--we touched on it 
last week--I think Americans are going to have questions about 
how you would finance that tax cut, other than by withholding 
some amount from dividend and bond interest payments. So we are 
talking about a very complicated area of tax policy where 
changes could have enormous ripple effects on our economy.
    So I think Chairman Hatch is absolutely right in bringing 
up the issue of debt versus equity today for our committee to 
discuss. We all know that comprehensive tax reform is going to 
have to be bipartisan.
    Mr. Chairman, as we talked about last week, I am very much 
committed to working with you and our colleagues towards that 
end.
    The Chairman. Well, thank you, Senator.
    [The prepared statement of Senator Wyden appears in the 
appendix.]
    The Chairman. Now I would like to introduce our 
distinguished panel of witnesses.
    First, we have with us today Alvin. C. Warren, a Ropes and 
Gray professor of law at Harvard Law School. Professor Warren 
has taught tax law and policy at Harvard since 1979. He has 
been a member of the ABA's Counsel of the Section of Taxation 
and chair of its Committee on Basic Tax Structure and 
Simplification.
    He is the author of a major study on corporate tax 
integration published by the American Law Institute. Professor 
Warren has a bachelor's degree from Yale University and a J.D. 
from the University of Chicago Law School. So we welcome you, 
Professor, here today and are glad you could take time to be 
with us.
    Our second witness is Jody K. Lurie, who is a vice 
president and corporate credit analyst at Janney Montgomery 
Scott financial services firm. Ms. Lurie has wide-ranging 
experience focusing on corporate debt structures and portfolio 
reviews for companies across several industries.
    She has published numerous pieces on industry trends and is 
frequently quoted by a wide range of publications as an expert 
in her field. Before pioneering the firm's corporate credit 
research efforts, Ms. Lurie worked as an investment banker in 
Janney's consumer and retail group, participating on a number 
of transactions, including IPOs, mergers and acquisitions, and 
private placements.
    She is a graduate of Bryn Mawr College in Philadelphia with 
bachelor's degrees in mathematics and economics. Ms. Lurie is 
joined by her husband today, Michael Lurie, who is a tax 
attorney at Reed Smith in Philadelphia. Welcome to both of you.
    Our third witness is Mr. John Buckley, a distinguished tax 
lawyer with nearly 3 decades of experience here on Capitol 
Hill, participating in the development of Federal tax 
legislation.
    Starting in 1973, Mr. Buckley spent 20 years in the House 
Office of Legislative Counsel. After that, he spent 2 years 
serving as Chief of Staff for the Joint Committee on Taxation, 
which preceded his service of roughly 15 years as Chief Tax 
Counsel for the Democrats, both in the majority and the 
minority on the House Ways and Means Committee.
    For much of that time, roughly 17 years, he was an adjunct 
tax professor at the Georgetown University Law Center. Mr. 
Buckley has a J.D. from the University of Wisconsin School of 
Law. So we welcome you, Mr. Buckley to the committee again. 
This is a place you understand very well. I want to thank you 
for being here.
    Now, our final witness is John D. McDonald, who is 
currently a partner and leading tax lawyer at Baker and 
McKenzie in Chicago. Mr. McDonald is, by all accounts, well-
versed in tax matters, with a focus on domestic and 
international acquisitions and reorganizations, foreign 
currency matters and subpart F, and foreign tax credit 
provisions.
    He has been named one of Chambers USA's top tax advisors in 
multiple editions and has been listed as a recommended 
international tax lawyer in The Legal 500. Mr. McDonald has a 
bachelor's degree from Marquette University and a J.D. from 
Northwestern University School of Law. So we welcome you, Mr. 
McDonald, to the committee. I want to thank you for joining us 
here today.
    We will now move forward with our witnesses' opening 
remarks, as is customary. We hope all of you will try to limit 
your statements to 5 minutes with an understanding that your 
full written statements will be included in the record.
    So I will begin with you, Professor Warren, and go from 
there.

STATEMENT OF ALVIN C. WARREN, JR., ROPES AND GRAY PROFESSOR OF 
   LAW, HARVARD LAW SCHOOL, HARVARD UNIVERSITY, CAMBRIDGE, MA

    Professor Warren. Chairman Hatch, Ranking Member Wyden, and 
members of the committee, thank you for inviting me today to 
testify on corporate tax integration, particularly with respect 
to the tax treatment of corporate debt and equity.
    I would like to emphasize three points. First, the 
longstanding separate taxation of corporate entities and 
shareholders is in dire need of reform, because it produces 
deleterious financial and economic distortions.
    In particular, the deductibility of interest payments, 
coupled with the nondeductibility of dividend payments, creates 
a tax incentive for corporations to issue debt rather than 
equity. As indicated by the chairman in his opening statement 
and in the pamphlet prepared for today's hearing by the staff 
of the Joint Committee on Taxation,* the result can even be a 
negative corporate income tax rate for investments that benefit 
from other preferences such as accelerated depreciation.
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    * For more information, see also, ``Overview of the Tax Treatment 
of Corporate Dept and Equity,'' Joint Committee on Taxation staff 
report, May 20, 2016 (JCX-45-16), https://www.jct.gov/
publications.html?func=startdown&id=4914.
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    My second point is that these longstanding distortions can 
be eliminated or significantly reduced by moving from separate 
taxation of corporations and shareholders to an integrated tax 
on corporate and shareholder income. One approach would be to 
turn the corporate tax into a withholding tax that would be 
creditable against the shareholder tax due on dividends. The 
resulting integration of the two taxes would advance the goal 
of ultimately taxing income, from whatever source derived, at 
an individual's graduated tax rate.
    A second approach, which the staff has been developing for 
the chairman, would couple a dividend deduction with 
withholding on corporate dividend and interest payments. In my 
view, the chairman's innovative approach could provide the 
basis for significant reform of our outdated distortionary and 
wasteful system for taxing corporations and investors.
    My third and final point is that integration would involve 
numerous design issues, many of which are interrelated. I just 
want to mention two which are related to today's primary 
subject, the corporate tax preference for debt.
    The first is the treatment of tax-exempt investors, 
including pension plans. Under current law, dividends received 
by exempt entities will usually have borne a tax at the 
corporate level, whereas interest payments will not. There is 
thus a discontinuity today between debt and equity, not only at 
the company level, but also for exempt investors, including 
pension plans.
    We cannot eliminate the first discontinuity without taking 
into account the effects on the second. Depending on how it was 
implemented, integration could increase, decrease, or leave 
unchanged the total burden on corporate income received by tax-
exempt entities.
    A second important issue relating to corporate debt and 
equity is the effect of integration on decisions of corporate 
managers regarding how much of corporate earnings to distribute 
as dividends and how much to keep and invest at the corporate 
level. These are very complex decisions that depend on 
corporate and shareholder investment opportunities as well as 
on the relationship of four tax rates: the corporate rate, the 
shareholder rate on dividends, the shareholder rate on 
investment income generally, and the shareholder rate on 
capital gains.
    Some analysts have argued for tax provisions that would 
favor either distributions or retentions. My own view is that 
the tax system should strive for neutrality in these decisions, 
which I think are best made in the private sector without 
pressure one way or the other from the tax code.
    These examples indicate that corporate tax integration 
would have far-reaching consequences that would have to be 
considered carefully by the committee. Much work has already 
been done on these questions, and it is my firm belief that 
desirable, workable solutions can be found to all of these 
design issues, taking into account legislative goals on various 
dimensions.
    Thank you again, Mr. Chairman, for inviting me to testify 
today. I look forward to responding to any questions the 
committee might have.
    The Chairman. Thank you, Professor Warren.
    [The prepared statement of Professor Warren appears in the 
appendix.]
    The Chairman. Ms. Lurie?

 STATEMENT OF JODY K. LURIE, CFA, VICE PRESIDENT AND CORPORATE 
      BOND RESEARCH ANALYST, JANNEY MONTGOMERY SCOTT LLC, 
                        PHILADELPHIA, PA

    Ms. Lurie. Chairman Hatch, Ranking Member Wyden, and 
members of the committee, thank you for allowing me to present 
today. Please note that my comments represent my views and not 
necessarily the views of Janney Montgomery Scott.
    The current tax system promotes debt financing over equity 
financing due to the one layer of tax on interest payments 
versus the two on dividends. While corporate integration in 
theory could equalize treatment of debt and equity, it may 
cause unintended consequences and should be examined with 
caution.
    Tax theorists have argued that there is no inherent 
difference between debt and equity, therefore, the two should 
be treated the same under the tax code. Still, the capital 
markets extend beyond tax implications.
    Shareholders purchase equity securities for their unlimited 
growth potential, while most lenders buy bonds for their steady 
income returns, in exchange for limited up-side potential 
versus equity securities. Corporate management aligns with the 
goals of equity investors, and if it does not, activist 
investors may put pressure on management to increase 
shareholder returns.
    For the debt side, increasing dividends or share buybacks 
are both negative events. Cash is not going towards debt 
repayment or long-term growth initiatives. The current tax 
system shifts the balances so that companies do not tend only 
to shareholders.
    We can look at master limited partnerships, MLPs, a type of 
pass-through entity, as a key study for adverse effects in 
corporate integration. Most MLPs pay their equity unit holders 
all income not needed for core operations via cash 
distributions. MLPs are incentivized to have high CapEx--
capital expenditures--because with high CapEx comes deductions 
that are passed on to the individual unit holder.
    Before the collapse of energy prices, MLPs, like REITs, 
became a preferred investment for individual investors hunting 
for yield in the low-rate environment. Since the fall of 2014, 
however, most MLPs have come under pressure due to the fall in 
energy prices. While there have only been a handful of MLP 
bankruptcies, the outsized credit risk in the industry is 
notable, as seen by the concentration of MLPs with high-yield 
credit ratings.
    Industry cyclicality is, perhaps, inevitable, but what is 
not is a tax policy that favors companies paying out most of 
their cash so that they do not have the cushion necessary to 
weather a down market. Even before energy prices fell, MLPs 
operated with minimal cash balances and provided sizeable 
returns to unit holders via distributions.
    A pass-through structure does not necessarily decrease a 
company's appetite for an over-leveraged credit profile, but 
rather encourages a company to spend available earnings on 
short-term shareholder returns. While an equalization of debt 
and equity from a tax standpoint could lead to additional 
equity offerings over debt issuance, the dilution effect of 
companies would remain a deterrent, as it was for MLPs during 
the expansion era.
    In general, corporate integration is unlikely to cause 
companies to view equity and debt financing equivalently. After 
all, as security falls further down the capital structure, 
investors demand an extra premium for the extra risk.
    It is likely, however, that the difference between the cost 
of debt capital and the cost of equity capital will decrease. 
But benefits in debt over equity financing will remain. 
Further, despite record cash balances, some companies have 
utilized debt in recent years to finance shareholder giveback 
plans, as debt financing costs are below the 35-percent 
repatriation tax rate. Until there is parity in debt and other 
financing methods, companies will continue to use the debt 
markets to finance short-term equity returns.
    That said, corporate integration will likely lead to a rise 
in the equity capital market valuations, because it would 
encourage dividend payments. Equity indices broke record highs 
in recent years thanks, in part, to economic stimulus and 
improving credit profiles at large corporations.
    It is likely that the equity markets would respond 
positively to corporate integration. The additional cash being 
spent on shareholders, in theory, could reenter the economy.
    Although a proposed tax change may alter certain corporate 
behaviors, we see a lack of long-term CapEx and domestic 
capital investments contribute to economic and job growth. 
While companies have robust cash balances currently, CapEx has 
lagged since the recession.
    Rather than invest in new projects that may take years 
before realizing a return, companies are looking at share 
buybacks, dividends, M&As, and tax minimization to bolster 
shareholder returns. Corporate integration may put even more 
pressure on companies to pay outsized dividends to 
shareholders, which could lead to even less long-term capital 
investments. I see the discussion as timely but also see 
several potential unintended consequences that would stem from 
corporate integration.
    With that, I would be happy to take any questions.
    The Chairman. Thank you.
    [The prepared statement of Ms. Lurie appears in the 
appendix.]
    The Chairman. Mr. Buckley?

        STATEMENT OF JOHN L. BUCKLEY, FORMER CHIEF TAX 
COUNSEL, COMMITTEE ON WAYS AND MEANS, HOUSE OF REPRESENTATIVES, 
                         WASHINGTON, DC

    Mr. Buckley. Thank you, Mr. Chairman, for the opportunity 
to speak before this committee today.
    Ultimately, the question faced by this committee will not 
be whether there are issues under current law, but whether 
proposed legislation would be an improvement over current law.
    In this case, the proposal involves a dividends paid 
deduction coupled with withholding taxes on payments of 
corporate interests and dividends. Clearly, current law imposes 
some distortions. There is a preference for debt financing. 
That is in addition to the fact that that financing is already 
the cheapest source of outside capital available to 
corporations because it comes with lower risk and the 
bondholder is willing to accept a lower rate of return. 
However, the evidence as to whether that has actually created 
over-leveraging at the corporate level is, at best, ambiguous.
    Clearly, it also creates a bias in favor of retained 
earnings. Now, to be very frank, that is a bias that I think is 
not bad, because that bias, coupled with investment incentives 
like the research credit and accelerated depreciation, creates 
a strong incentive for capital investment in the United States, 
which I think is favorable for our economy.
    There are aspects of the proposal that I think should cause 
this committee to approach the topic with some caution and 
skepticism.
    First, the proposal clearly would eliminate the bias for 
retained earnings. Instead, it would substitute a bias for 
distribution of those earnings. It would dramatically reduce 
the benefit of, and in many cases, effectively repeal 
incentives like accelerated depreciation and the research 
credit.
    The proposal could dramatically increase the cost of 
borrowing by U.S. corporations. The overwhelming bulk of 
investors holding corporate debt obligations are tax-
indifferent investors. And by the term ``tax-indifferent 
investors,'' I mean investors whose interest income is not 
otherwise subject to tax.
    For those investors, the new withholding tax is a direct 
reduction in their interest rate of return on those 
investments. Unless those investors, which really are required 
for the efficient operation of our debt markets in this 
country, are willing to accept rates of return 35-percent lower 
than the rates that they currently receive, there will be 
upward pressure on interest rates.
    I see no reason why tax-indifferent investors will now be 
willing to accept lower rates of return. In particular, foreign 
investors have ample opportunities to invest overseas.
    Finally, the proposal is, at best, inconsistent with, if 
not in direct violation of our tax treaties. That is more than 
just a technical issue here. We benefit greatly as a country 
because foreign investors are willing to purchase our stocks 
and our bonds. Approximately 26 percent of all corporate debt 
instruments are held by foreign investors. The proposed 
withholding tax could cause many of those investors to leave.
    It also would invite retaliation by other countries against 
our companies or our citizens that invest there. It clearly 
could result in retaliatory action.
    Again, Mr. Chairman, I thank you for the opportunity to 
testify today, and I would be happy to answer any questions you 
may have.
    The Chairman. Thank you, sir.
    [The prepared statement of Mr. Buckley appears in the 
appendix.]
    The Chairman. Mr. McDonald?

            STATEMENT OF JOHN D. McDONALD, PARTNER, 
              BAKER AND McKENZIE LLP, CHICAGO, IL

    Mr. McDonald. Thank you, Mr. Chairman, Ranking Member 
Wyden, and members of this committee, for allowing me to 
testify on business tax reform.
    As an international tax practitioner who represents 
primarily U.S.-based manufacturing companies in the Midwest, I 
have all too often seen how our present system of corporate 
taxation incentivizes companies to invert, be acquired by a 
foreign multinational, or produce products and services 
offshore instead of in the United States. Changing this 
incentive structure while ensuring that U.S. businesses remain 
competitive in the global marketplace is, admittedly, a 
significant challenge.
    Our current corporate tax system has evolved over more than 
a century, and it is difficult to make sweeping changes 
overnight. Nevertheless, I applaud this committee's effort to 
think of creative solutions such as corporate integration to 
change the current dynamic. Integration approaches have 
actually moved the burden of the corporate income tax away from 
highly mobile corporations onto far less mobile U.S. 
individuals and tax-exempt entities and accounts. It is likely 
the only way the U.S. will be able to avoid simply copying the 
tax systems of other countries in an attempt to preserve the 
U.S. corporate tax base.
    The dividends paid deduction currently being considered by 
this committee is one such approach. Another key advantage of 
the dividend paid deduction is that it should reduce the 
current preference that exists for corporations that have debt 
financing.
    The tax law did not always favor debt over equity as much 
as it does today. Instead, the advantage of debt financing 
waxed and waned in the first decades of the 20th century based 
on interest deductibility limitations and corporate and 
individual tax rates.
    It was really only when Congress chose to impose two levels 
of corporate tax in 1936 and the only limit on the shear amount 
of debt that a corporation could issue was established by 
common law, that the real tax preference for debt was firmly 
established.
    Today, the code creates a disconnect, whereby a significant 
amount of debt-financed business profits do not bear any U.S. 
income tax, while a significant amount of equity-financed 
business profits bear two levels of income tax, and in certain 
cases, even more. This distinction does not make any sense.
    A dividends paid deduction allows Congress the chance to 
revisit this issue in a holistic fashion and create more 
balance in the code between debt and equity financing. The 
precise extent to which debt and equity parity is achieved, 
however, depends on a number of correlative decisions that have 
to be made at both the holder and issuer levels. I expand on 
those correlative issues in my written testimony, and I look 
forward to discussing them further during today's hearing.
    The Chairman. Well, thank you.
    [The prepared statement of Mr. McDonald appears in the 
appendix.]
    The Chairman. This has been very interesting, as all of 
these hearings have been. Now this is a question that any of 
you can answer, but I am going to start with you, Professor 
Warren, and just go down the line if we can.
    Please consider the following statement. ``Outsized 
reliance on debt financing can increase the risk of financial 
distress and, thus, raise the likelihood of bankruptcy. Unlike 
equity financing, which can flexibly absorb losses, debt 
requires fixed payments of interest and principal and allows 
creditors to force a firm into bankruptcy.''
    Do you agree or disagree with that particular statement, 
and would you tell us what your feelings are about that?
    Professor Warren. Well, I agree. I think it is an accurate 
description of one of the problems with having an incentive for 
debt finance. That debt finance then creates a series of 
mandatory payments for the company, not discretionary payments 
as with respect to dividends. And therefore, when you come into 
a period of financial difficulty, a company that is over-
leveraged can get into even worse financial difficulty because 
it cannot make those mandatory payments.
    The Chairman. Ms. Lurie?
    Ms. Lurie. So the way I think about it is that debt 
financing is something that can be necessary for a company to 
build their business. Equity financing or equity distributions 
are not necessary; it is only if the company is doing well and 
wants to give back to its shareholders in such a way.
    While yes, of course, an outsized amount of debt financing 
would contribute to over-leveraging and would, therefore, 
contribute to financial distress, a lot of the companies that 
you see making the largest debt issuance this year are the 
companies that have an outsized amount of cash on hand. So I 
think more the question is, how do you get these companies to 
utilize the cash that they have on hand, versus issuing $20-
billion debt offerings to make an acquisition?
    The Chairman. Okay. Mr. Buckley, do you agree or disagree 
with that statement?
    Mr. Buckley. I agree that the current law has an incentive 
for debt financing, a tax benefit for debt financing. That is 
in addition to, really, the natural bias to debt financing that 
a businessman would have. He does not want to give up a share 
of his company in order to acquire capital. Issuing stock means 
you, essentially, have to give up part of your company to 
another party.
    The other thing I would say is, the evidence, in my mind, 
has shown that companies outside of the financial sector--and 
let us just set the financial sector aside--have been fairly 
conservative in their use of debt financing in this country. So 
they understand the risks that you talk about, and they have 
been fairly cautious in their use of debt financing.
    The Chairman. Okay.
    Mr. McDonald?
    Mr. McDonald. In my opinion, the objective of any tax 
reform proposal should not be to incentivize equity financing 
or debt financing. The objective should be to ensure that we 
get at least one level of tax on U.S. source business profits.
    As I said in my opening statement, if you are a foreign 
investor that is lending money to a U.S. company and you take 
advantage of the portfolio interest exemption, you are getting 
a deduction in the United States. You get an inclusion 
offshore. You do not even have to be in a treaty jurisdiction, 
and there is no U.S. tax imposed, and no withholding tax 
imposed on that investment. Whereas, a U.S. individual has two 
levels of tax imposed on them.
    The Chairman. The reason I quoted that is, that quote is 
from President Obama's updated framework for business tax 
reform. I think it is interesting. I think he is right on what 
he said. I just thought I would bring that up in that way.
    Now, in December 2014, my staff issued a 340-page report on 
comprehensive tax reform with 100 pages devoted to corporate 
integration. Shortly after issuance of the report, we began to 
hear from private-sector academics, practitioners, and 
economists. There was near unanimous agreement that corporate 
integration should be achieved.
    The uncertainty arose in what method should be adopted in 
achieving corporate integration. Many of these groups and 
individuals pointed out exactly what Mr. Buckley stated, that 
there is a graveyard near the White House full of prior 
integration proposals.
    However, as we know, there are a lot of important issues 
today of bipartisan concern, such as base erosion, earnings 
stripping, lock-out, a large disparity between the marginal and 
effective tax rate on equity financing and debt financing, and 
the inefficient high corporate tax rate--all issues that 
corporate integration could help us to address.
    So circumstances today are dramatically different than in 
prior periods when corporate integration was seriously 
considered. Now to me, the important question is not whether 
corporate integration should be implemented--of course it 
should, in my eyes--but rather what method of corporate 
integration should be utilized.
    Mr. Warren, and, Mr. McDonald, it is obvious that both of 
you have spent an enormous amount of time focusing on corporate 
integration. Now, Mr. Warren, you published a 250-page report 
on corporate integration for the American Law Institute. Mr. 
McDonald, you recently published a 100-plus page article on 
corporate integration that you presented at the University of 
Chicago Tax Conference.
    Now, Mr. Warren, what method of corporate integration 
should be adopted, and how did you decide upon that particular 
method?
    Professor Warren. Mr. Chairman, I think there are various 
possibilities. In the report that you alluded to for the 
American Law Institute, our mission was to try to work out what 
we thought would be a framework that had the greatest 
possibility for solving all of the technical issues.
    That is a very different question than the one that is 
before the committee, which is what is a workable framework 
that could be enacted. The framework that the ALI came up with 
was turning the corporate tax into a withholding tax that would 
be credited against the shareholders' progressive tax rate. I 
continue to think that would be an important way to go.
    Alternatively, the approach that you have been developing 
of having a dividend deduction with withholding, I think, is 
another approach that would be appropriate.
    The Chairman. Mr. McDonald, the same question to you.
    Mr. McDonald. Yes, I firmly believe that if you are going 
to do integration, it is important that you move the income tax 
off of the corporate P&L and onto the shareholder. There are a 
couple of ways to do that, and one of them is the dividends 
paid deduction. The other approach is a shareholder mark-to-
market regime.
    The problem with a shareholder mark-to-market regime is, it 
is not entirely clear that it is administrable in all cases. 
The dividends paid deduction is far more administrable than the 
shareholder mark-to-market regime. So, therefore, I think a 
dividends paid deduction is clearly superior over, for example, 
a shareholder imputation credit.
    The Chairman. Okay. I have gone over.
    Senator Wyden?
    Senator Wyden. Thank you very much, Mr. Chairman. I think 
this has been an excellent panel. Let me see if I can pose 
several questions as part of this discussion.
    Now, Ms. Lurie, in your testimony you describe today's 
business environment where corporations are making short-term 
decisions to, ``keep shareholders happy. Rather than expanding 
a new product line or building a new plant that may take years 
before realizing a return, companies look at share buybacks and 
dividend payments.''
    It seems to me that you and Mr. Buckley are both saying, in 
some fashion, that for businesses to grow, it is important to 
retain earnings for long-term planning and investment. What in 
your view--and we can pose this to you, Ms. Lurie, and to you, 
Mr. Buckley--what happens to these companies under a corporate 
integration proposal?
    Ms. Lurie. Thank you, Senator. I think the question is a 
little hard to determine because there are only so many 
examples that we have of some form of corporate integration. We 
have REITs. We have MLPs. We have a few other examples that we 
can, sort of, look at.
    The reason why I spoke to MLPs is because that was an 
example of an industry that does not have a steady flow of 
income. Unlike REITs, you cannot really count on that rental 
income. So, if you look at these companies that are devoting a 
lot of the money that they do raise--either through equity or 
debt financing--to CapEx, you can see the erosion that could 
occur if you allow companies or incentivize companies to give 
back their retained earnings to shareholders.
    So I think, at the end of the day, it is a fine balance 
between letting companies do what they need to do to run their 
businesses, and getting out of the way--as the chairman 
mentioned--but also making sure that companies do not have too 
much of a leash to do whatever it is they want to do in the 
event that, over the long term, the economy goes bad or there 
is some sort of down market that causes these companies to be 
over-leveraged.
    Senator Wyden. Mr. Buckley, do you want to add to that?
    Mr. Buckley. I think retained earnings for many 
corporations are necessary to finance future growth. And it is 
particularly true among the new companies and growing 
industries. They do not have really good access to the credit 
markets. They do not want to issue more stock and dilute their 
interests in the business that they created. So it is retained 
earnings that they need to finance future growth.
    In a very bizarre way, a dividends paid deduction would 
result in those corporations paying a much higher level of 
corporate tax than anybody else, because a mature----
    Senator Wyden. Let the record show that Ms. Lurie nodded 
her head in the affirmative.
    Mr. Buckley. Yes. A mature company can afford to increase 
dividends and, therefore, eliminate corporate tax liability. A 
growing company needs to retain those earnings to fund future 
growth, and thus, it would be one of the few companies that 
would actually have significant corporate tax liability. I 
think it is just kind of a bizarre set of incentives that you 
are creating here.
    Senator Wyden. Now, the tax code provides a number of 
important incentives for companies to invest: in research and 
development for example, infrastructure, hard-to-employ 
workers, a variety of priorities that, on a bipartisan basis, 
have been designated as important.
    Some of the corporate integration proposals would allow 
corporations to reduce corporate tax by the amount of earnings 
paid to shareholders. Now obviously, under today's system, a 
number of corporations pay significantly below the 35-percent 
statutory rate.
    Is there reason to be concerned that providing corporations 
the ability to fully wipe out their corporate tax liability by 
paying all of their earnings as dividends could diminish the 
positive effects on some of these important tax incentives 
where there has been bipartisan support? We can have any of you 
take it on. In fact, why don't we--just for the heck of it, we 
will start with you, Mr. McDonald, and go right down the row.
    Mr. McDonald. Well, the answer is, I do not think so. I 
mean, those growth companies that Mr. Buckley and Ms. Lurie are 
referring to can still take advantage of those incentives. I 
think another thing to keep in mind is the ability of the net 
operating loss deduction. That can be carried back or carried 
forward so that, if a company is in a particular position 
whereby in some years they are going to be in a position to pay 
dividends and in some years they cannot, then that deduction 
can be carried backwards or carried forwards.
    The answer is, I think that companies will still take 
advantage of those incentives.
    Senator Wyden. I think the kind of concern I would have is, 
if a company has already eliminated its tax liability, what 
incentive would it have to hire disadvantaged workers or invest 
in low-
income communities? Why don't we just keep going with you, Mr. 
Buckley and Ms. Lurie, and get all of you on this point, 
because this is, as we have indicated, complicated stuff. That 
is why I think we want to take the time to get everybody's 
opinion on the record.
    Mr. Buckley?
    Mr. Buckley. The answer is that it would effectively repeal 
most of those incentives for the large bulk of corporations, 
because they could just simply convert stock buyback programs 
into increased dividends and, therefore, eliminate all 
corporate income tax.
    I believe that our tax laws should be neutral, but I 
believe that our tax laws should be neutral only so long as 
that neutrality tilts in favor of investment in the United 
States. Incentives like the R&D credit and accelerated 
depreciation tilt the playing field in favor of investment in 
the United States, and I think you should be very cautious 
about the impact of a shareholder dividend deduction on those 
incentives.
    Senator Wyden. Ms. Lurie, Mr. Warren?
    Ms. Lurie. Thank you, Senator. Just to build on what Mr. 
Buckley said, I was thinking of the bonus depreciation that 
some companies received a few years ago and the benefits that 
they received because of that and the amount of money that was 
going towards infrastructure in the country through water 
utilities and what have you. I think that is a more effective 
use of cash than allowing companies to give back to 
shareholders and effectively eliminate their tax liabilities 
through that method.
    Finding a way to eliminate their tax liabilities through 
long-term CapEx plans, I think, makes a little bit more sense. 
Thank you.
    Senator Wyden. Mr. Warren?
    Professor Warren. Senator Wyden, the question you raise is 
a very important and central one. If Congress went to this kind 
of integration and it was worried about elimination of certain 
corporate tax preferences, there are ways in which the proposal 
could be adjusted for that. I think it is an extremely 
important question.
    Senator Wyden. Mr. Chairman, I again want to commend you 
for taking on this debt and equity issue. This is 
extraordinarily important, and I just pass on that when our 
former colleague, Senator Gregg, and I worked on our bipartisan 
tax reform bill and sat on a sofa every week for 2 years, this 
was one of the issues--debt and equity--that was front and 
center in trying to come up with a bipartisan proposal. Senator 
Gregg, to his credit, had a very good idea, where he just took 
a little nip from the debt, in effect, the sort of escalator, 
the automatic escalator, in an effort to strike a balance. So I 
think you are absolutely right to take on this issue, and I 
look forward to working closely with you on it.
    The Chairman. Well, thank you, sir.
    Senator Heller?
    Senator Heller. Mr. Chairman, thank you, and I want to 
thank our witnesses for being here today. I apologize that I 
missed your opening statements. I had two other committees. 
Three committees going on at the same time, Mr. Chairman, so I 
am glad I was able to make it back, and I am certainly pleased 
that you and the ranking member are holding this hearing today, 
as important as it is.
    I want to, kind of, take this from the 30,000-foot level to 
make sure we are all doing this for all of the right reasons. 
There was a Wall Street Journal poll that came out today that 
said that the President's approval rating is at 51 percent. 
Now, I am trying to figure out how a President's approval 
rating of 51 percent can be attained when we only had \1/2\ of 
1 percent growth in the first quarter. I mean, any other 
president at any other time, you would probably see approval 
ratings be much less.
    So what I am assuming is that the administration has done a 
great job talking about this being the new normal. This is 
where we are, and people are tired of it. After 8 to 10 years 
seeing no growth, perhaps this is where we are in America 
today.
    We can talk about global competitiveness. We can talk about 
inversions. We can talk about integration. We can talk about 
all of these issues, but if the American people believe that 
\1/2\ of 1 percent is the new normal, how do we push back?
    So I guess my question to the panel here today--I know, 
maybe, it is a little off topic, but I would certainly like to 
get your input. One, is this a new normal; and two, if you do 
not believe it is, what can we do? What can we do to expand our 
global competitiveness?
    We will start with you, Mr. Warren.
    Professor Warren. I certainly hope it is not the new 
normal. It is a little off the subject, but nonetheless, I 
would say a couple of things. I think one of the things we have 
to think about is rates, particularly rates for U.S. companies 
as compared to companies abroad. I think we have to think about 
the comparison of rates between individuals and companies. 
Finally, I think we have to think about the tax base and 
whether or not we need some additional revenue source.
    Senator Heller. Ms. Lurie?
    Ms. Lurie. Thank you very much, Senator. I am, sort of, 
looking at this from more of an economic standpoint and 
thinking about the fact that we have been operating in a low 
interest rate environment for so long.
    Now, the short end of the curve--we saw a bump in December 
with the Fed raising rates--but yet the long end still remains 
depressed. The real question is, why is that?
    My colleagues and I have written--particularly, one 
colleague of mine has written many articles on that, describing 
that, while the short-term rate is rising through measures that 
the Fed is using, at the end of the day, there is no long-term 
growth that we see in the economy. We do not see any sort of 
dot-com growth or any sort of tech bubble that is occurring or 
real estate bubble that is occurring. So as a result, we are 
not seeing this amount of growth that we need to see to 
jumpstart the economy.
    Thank you.
    Mr. Buckley. I will join the other witnesses in hoping that 
this is not the new normal. I think what I would suggest is 
comprehensive business tax reform with a reduction in the 
corporate rate, financed by elimination of what people might 
consider to be distortive tax incentives, and a revision of our 
international rules to make our companies more competitive 
overseas and in the United States.
    One reason why inversions occur is because foreign-based 
multinationals have substantial competitive advantages in the 
United States, compared to U.S. multinationals. Now, having 
said that, I think you have to be fairly realistic in your 
expectations. I am not certain that is going to bump up 
economic growth dramatically.
    The experience of the 1986 act was that it improved things 
by getting rid of some distortions, but it was very difficult 
to see an impact on long-term growth. I think investments in 
the United States and education infrastructure, et cetera, are 
necessary to increase growth rates.
    Mr. McDonald. Our U.S.-based multinationals have 
significant money offshore. As Ms. Lurie noted in her written 
testimony, a lot of U.S. companies right now--because of our 
current tax system--are borrowing in the United States to pay 
dividends to their shareholders while keeping that cash 
offshore.
    One of the major advantages of a dividends paid deduction 
and the integration approach, but particularly a dividends paid 
deduction, is that hopefully it will have a positive effect on 
this so-called ``lock-out'' problem. Companies can bring back 
dividends from their low-tax offshore subsidiaries and then pay 
them out to their shareholders in the form of a deductible 
dividend that wipes out the repatriation tax that Ms. Lurie was 
referring to, thereby obviating the need to borrow simply to 
pay cash dividends.
    I think that is one thing that could enhance growth.
    Senator Heller. Thank you. Mr. Buckley, I do have a follow-
up question. Your effort on the Ways and Means Committee--
integration is not a new topic. I think previous 
administrations have discussed this particular issue. Why, in 
the past, has it failed?
    Mr. Buckley. I think it has failed--and I am speaking of 40 
years of discussing this issue; indeed, it goes further back 
than that. My law school professor was quite passionate on the 
issue when I went to law school.
    It is largely because of opposition from the corporate 
community, or indifference, that they do not want to have an 
incentive to distribute earnings. They would prefer to grow 
their business and retain earnings. Also, it has been because 
there are other alternatives that have been far more attractive 
to the business community, otherwise known as a corporate rate 
reduction.
    In 1986, the United States Senate rejected a dividends paid 
deduction that was included in the House-passed version of the 
1986 reform and substituted a slightly larger reduction in the 
corporate rate. That was greeted with a great deal of joy from 
the corporate community.
    Senator Heller. Thank you. If you will indulge me just one 
minute, Mr. Chairman----
    The Chairman. Let me just interrupt. Mr. Warren, would you 
give your impression on that same question?
    Professor Warren. The last time this was seriously 
considered was in the 1990s. I think the corporate community 
was not enthusiastic about it, but I think we are in a very 
different world now, with competition from abroad. So I 
actually think that the fact that integration failed to get the 
political momentum behind it in the past is not a reason not to 
take it very seriously now, given that we are in a very 
different world.
    Senator Heller. Mr. Chairman, thanks for the follow-up. I 
just want to ask one more follow-up to Mr. Buckley, and that 
is, do you believe that the Treasury Department's new rules 
will fix these international competitiveness problems that we 
have?
    Mr. Buckley. Are you talking about the regulatory----
    Senator Heller. Section 385.
    Mr. Buckley. I think it slightly reduces the opportunity 
for income stripping out of the United States, but only 
slightly. I think this committee has to look at a much broader 
solution to the question of collecting a full corporate income 
tax on income that is actually earned here and not diverted 
through interest payments or royalty payments to low-tax 
jurisdictions overseas.
    Senator Heller. Mr. Buckley, thank you. Mr. Chairman, thank 
you, and thanks for the follow-up questions.
    The Chairman. Thank you. Let the record show, however, that 
there was partial integration achieved in 2003. I think that is 
correct, is it not, Professor Warren?
    Professor Warren. By the reduced rates for dividends----
    The Chairman. Right.
    Professor Warren. Yes.
    The Chairman. Okay.
    Let us see--let me double-check my list. Senator Cardin?
    Senator Cardin. Thank you, Mr. Chairman. Thank you for 
convening this hearing, and I thank the panelists. Senator 
Thune and I cochaired the Business Tax Working Group, and 
corporate integration was one of the issues that we thought 
deserved the attention of the United States Senate and our 
committee. You should not be steered towards a particular 
structure as you make your decision how to organize.
    There is a great deal of interest in how we can deal with 
the inequities of a double taxation system. The concern is that 
if you try to do it in the current tax structure, within the 
walls of our current tax code, there are going to be 
consequences to that that may not be what you desire.
    I know there has been a great deal of discussion on the 
fact that most businesses in America do not use the C rate, so 
therefore, relative tax burdens are going to be changed, which 
will have an impact on pass-throughs. I am concerned about the 
impact it is going to have on tax credits for economic growth.
    I represent an urban State, where the New Market Tax 
Credits are particularly important to economic growth, where 
historic tax credits are important. I would be interested, if 
we just did the proposal in regards to the corporate 
integration, what impact could that have on a city like 
Baltimore that utilizes these tax credits for economic growth, 
or other areas that depend upon the incentives that are 
currently in the tax code, if all we do is deal with this one 
issue?
    Mr. Buckley, any thoughts?
    Mr. Buckley. All of those provisions require corporate tax 
liability to be effective. A dividends paid deduction for many 
companies--typically, for the companies that would be in the 
position of, essentially, buying those credits, the result 
would be elimination of all corporate tax liability. So I 
think, as Professor Warren said, you would have to develop a 
different mechanism of delivering those subsidies.
    Senator Cardin. The concern you have in today's political 
environment is, we are going to have a hard enough time making 
this proposal revenue-neutral, and with the budget caps, where 
do you get the resources to invest in economic growth for 
challenged communities?
    Mr. Buckley. What I was going to say is, the only realistic 
alternative--one alternative that I think this committee would 
not like--is a refundable credit. If there is not corporate 
liability, the only other alternative would be a direct 
spending program. And given the current environment, I do not 
think there is a realistic prospect of that either.
    Senator Cardin. Professor Warren?
    Professor Warren. I think the issue raised is extremely 
important and should be carefully considered in any integration 
program, but I believe it is a design issue. And if the kind of 
credits that you talk about are credits that the committee and 
the Congress decided should not be eliminated by the 
integration program, I think that could be accomplished.
    But I think you are exactly right to say that if you are 
going to take this seriously, you have to think through all of 
these far-reaching consequences. I just believe that these are 
problems that are soluble.
    Senator Cardin. I agree with you. You can design it to deal 
with the concerns. The problem is, in the current political 
environment, working solely within the C corporate integration 
issue, you have limited options on trying to design a way to 
deal with the multitude of policies that are affected by this 
proposal.
    I know my colleagues on the committee would be disappointed 
if I did not raise the obvious issue, and that is, why are we 
having this debate in America where we, among the industrial 
nations, rely less on government? Why do we not have a 
competitive advantage in our tax code as far as marginal rates 
go? Of course, the reason is that we restrict to basically 
income taxes, whereas the rest of the industrial world uses 
consumption taxes along with income taxes.
    If we were to harmonize with the international community, 
we could have lower tax rates. If the C rate was somewhere 
around 17 percent, I do not think we would be having this 
debate today. I do not think that would be an issue.
    So I hope, by design--and I agree, Professor Warren, we can 
design this. I hope, by design, we recognize the need to 
harmonize with the international community and design a code 
that is, I hope, more progressive than our current code in 
helping the low-income families, is revenue-neutral so we are 
not using it to grow government, but also friendlier towards 
the area where America historically has not been in this tax 
code, and that is savings--friendlier towards savings and 
investment, friendlier towards the problems that we have tried 
to deal with through the tax code but have not been successful 
in doing.
    The Chairman. Okay.
    Senator Casey?
    Senator Casey. Mr. Chairman, thank you very much, and thank 
you for allocating this time to this issue. It is critical that 
we dedicate this kind of time on consequential and complicated 
issues that involve tax reform. We appreciate the scholarship 
and the contribution of the panel that is here today.
    Ms. Lurie, I am going to start with you for a number of 
reasons, but principally because of your Pennsylvania roots and 
your distinguished record, not only in business but as a Bryn 
Mawr graduate. Your husband is here? Can he put his hand up 
there? Right there? Oh, okay. I want to make sure--and he is a 
Reed Smith lawyer?
    Well, this is really impressive that a Reed Smith lawyer is 
staffing you today. I appreciate you doing that. The chairman 
knows from his early days as a lawyer how significant that is, 
because he was a Pittsburg lawyer in days gone by. But we are 
grateful you are here.
    I want to start with you on kind of a broad question. When 
I talk to businesses in Pennsylvania and I bring up the issue 
of tax reform, they become very animated, for a good reason. 
They hope we will confront it and deal with it and come to a 
conclusion. But they also usually list a number of aspirations, 
but also a number of cautionary flags. They want us to tackle 
tax reform for all of the reasons that are obvious, but they 
also caution us to not change the code in a way that would 
adversely impact innovation or would adversely impact 
investment.
    So I want to start with you and Mr. Buckley on a question 
that I think is not only central to firms in Pennsylvania, 
manufacturing firms especially, but a whole range of folks 
across the business sector. One is the potentially adverse 
impact that this proposal could have on both accelerated 
depreciation and the R&D tax credit or similar provisions that 
are in place now. What is your sense of that?
    Ms. Lurie. Thank you, Senator. I think what we have to look 
at when we are tackling this idea is how it is going to affect 
different businesses and different industries, because I think 
different businesses and different industries are going to have 
incentives to do one plan over another, and they are either 
going to benefit from a dividends paid deduction or not. There 
are companies that do depend on the R&D credit, that do depend 
on having that, and then having that structure where they are 
incentivized to give more dividends out would certainly offset 
that a little bit.
    So I think there are a lot of hurdles that we will have to 
cross in order to figure out what industries are going to get 
negatively affected versus those that might be positively 
affected by some sort of change in the tax code.
    Senator Casey. Mr. Buckley, especially on accelerated 
depreciation, what is the point you are making on that?
    Mr. Buckley. Well, under current law, a corporate manager 
is actually neutral as to whether he distributes earnings or 
retains earnings. That decision does not impact his corporate 
tax liability.
    If he distributes, there is the potential of a shareholder 
tax, but for him making a decision, it is neutral if he is 
focused at the corporate level.
    In that context, accelerated depreciation is a robust 
incentive to keep the money, invest the money, grow the 
company. In the future, it may no longer be a neutral choice at 
the corporate level. If he distributes the earnings, he gets an 
immediate reduction in tax, far more robust than what he would 
get if he invested those earnings and used accelerated 
depreciation.
    I think it dramatically reduces the incentive effect, and 
that, I think, should be of concern to this committee. I admit 
accelerated depreciation is not neutral, but in my opinion it 
is not neutral in favor of investment in the United States, and 
that is the type of non-neutrality that I am more than happy to 
support.
    Senator Casey. I know we do not have a lot of time. Maybe I 
will submit this for the record, but other issues where there 
may be potentially adverse impact--I mentioned investment. I 
also mentioned having the tools to respond to a recession, but 
in the interest of time----
    So thank you very much. I appreciate your time.
    The Chairman. Senator Warner, we will turn to you.
    Senator Warner. Well, thank you, Mr. Chairman. I get, I 
hope, an extra minute for waiting for the last.
    Let me start, because I have a number of things--I would 
like to make a couple of comments and take it in a slightly 
different direction.
    One, I really appreciate the fact that you are digging into 
this. This is not easy. I think regardless of where we sit--
which side of the aisle--I think most of us would, at least, 
privately acknowledge you could not create a more complicated, 
messy tax code than we have in America.
    Yet, with this complexity also comes the problem that, out 
of the 34 OECD nations, we are 31st in terms of total revenue. 
So we have complexity, and yet vis-a-vis our competitors, we 
are at an extraordinarily low revenue rate.
    So the fact that you are willing to take this on--I commend 
you. The absurdity of the, kind of, double taxation that has to 
be addressed, and the lock-out of the $2.4 trillion of earnings 
caught abroad that need to be repatriated, are important 
questions.
    I, personally, am someone who has spent a bunch of time 
fighting for the Simpson-Bowles-type approach that is based, 
Mr. Buckley, on the old idea of, let us lower the rate and get 
rid of some of the exclusions. So I intellectually believe 
that, but I find some caution on that.
    One, when we used to think that we could lower the rate 
from 35 to say 28 or 25 percent when the rest of the world has 
moved now with patent boxes and other tools to rates that are 
even substantially lower, I am not sure we are going to be able 
to chase that rate down low enough to stay competitive, when 
just taking into account--and I voted for this at the end of 
last year--that we just added another $680 billion of unpaid 
tax exclusions that we made permanent. So if anything, we are 
going the opposite direction.
    I give Professor Warren credit for acknowledging the fact 
that it may be time for us to look at new revenue sources so we 
can bring down the rate to a level that will keep us 
competitive. I also think that some of my colleagues have 
raised this issue. There are preferences about a pro-American 
investment around R&D and accelerated depreciation.
    Senator Heller's comments about what the new normal is--I 
worry that we also have a tax code that, even with all of its 
components, frankly, so favors investment in plant and 
equipment over human capital that we have this combination of 
globalization, technology, and activist investors that makes it 
so the first thing that businesses eliminate, particularly for 
short-term returns, is any kind of investment in human capital.
    The terminology--we think, if you invest in plant and 
equipment, that is an asset. If you invest in training a human 
being, that is a cost.
    So, I guess where I would like to go in my question--since 
I have used up 3 minutes of my time already--I want to hear 
from everyone. Ms. Lurie, you touched on this in your 
testimony. Even with all of these distortions, we have seen, I 
think, a reluctance among American businesses to make long-term 
capital investments, whether it is in human capital or plant 
and equipment. I fundamentally believe we have a problem in 
modern American capitalism around ``short-termism'' versus 
long-term value creation. I fear that as a 20-year capitalist 
and someone who has spent more time on the business side than 
on the political side, that short-termism will destroy long-
term value creation and really undermine our country.
    I would actually like to hear from all of you. Even if we 
can try to make sure that we try to keep some of the incentives 
right in this modified system that we have moved to, is this 
problem of short-termism real, number one? And number two, in 
even a well-designed corporate integration system, will that 
not accelerate distribution of profits rather than the kind of 
long-term capital investment, both in plant and equipment and 
in human capital, that would move us past these \1/2\-percent 
growth rates that we have seen?
    Considering the fact that I went last, can I get an extra 
30 or 40 seconds to have all of the witnesses respond, Mr. 
Chairman?
    The Chairman. Sure.
    Professor Warren. My own view is a little different from 
some other members of the panel about an incentive to 
distribute earnings under an integrated system. I think the 
missing element is the relationship between the rates. That is 
to say, a lot of the discussion has been on the assumption that 
retained earnings were great in a period in which individual 
rates were very high, 70 percent at one point. Corporate rates 
were 30 percent.
    Of course under those circumstances, there is definitely an 
incentive to retain earnings, but it is primarily due to the 
difference in those tax rates. You want your money compounding 
in an after-tax rate of 35 percent, rather than an after-tax 
rate of 70 percent.
    An important element of all of this--and responding to your 
question--I think, is that the committee has to think about not 
just the structure, whether we have separate taxes or 
integrated taxes, but also the rate relationships. You could 
imagine rate relationships where there would be an incentive to 
distribute earnings: a very low shareholder tax rate and a very 
high corporate tax rate.
    But you can adjust those rates. Obviously, there are all 
sorts of other constraints, but those rates would have enormous 
impact on whether or not there is going to be a distribution, 
and whether or not we stay with a separate tax system or go to 
an integrated system.
    Senator Warner. Thank you.
    Ms. Lurie?
    Ms. Lurie. Thank you, Senator. So I think shareholders are 
inherently impatient, whereas bondholders--not to favor the 
bondholder side--are a little bit long-term driven, just 
because they know that there is a life of a bond and it matures 
over that life of the bond, and they get their principal back.
    I think with that concept of being impatient, if you allow 
companies to be able to more readily push money out the door to 
the shareholders, then I think you will have more short-
termism, as you described, and less of that long-term 
viewpoint.
    Now, one question I did want to bring up--and this speaks 
to the chairman's write-up in 2014--is the discussion about how 
many companies are actually corporations versus alternative 
structures, and to compound on that, how many companies that 
have that C corp structure have shareholders that are actually 
being affected by a change in the double taxation to a single 
structure, versus how many debtholders would be affected, and 
if that would then negate any benefit you are seeing on the 
shareholder side from putting back money into the economy.
    Senator Warner. Thanks.
    Mr. Buckley. You know, Senator, I share your concern about 
short-term thinking among corporate management. In part, it may 
be due to the rise of activist investors and other factors. 
Their focus, increasingly, is on increasing earnings per share 
in the short run. That is the reason why you see these big 
stock buybacks. It is the easiest way to increase earnings per 
share to report to shareholders, rather than investing the 
income for the long-term.
    You know, I do not see the dividends paid deduction 
changing that, other than changing the form in which they 
return the income to shareholders. Increasing the dividend will 
have a much more dramatic impact on current earnings per share 
than a stock buyback. For every dollar per share you increase a 
dividend, with a dividends paid deduction, you would increase 
earnings per share by 35 cents for disinvesting your corporate 
assets.
    I think you raise a tremendously important point. On human 
capital, the only slight quibble I would have is, it is very 
difficult for corporations to robustly invest in human capital, 
because human capital is mobile; therefore, I think the 
response to that has to be greater involvement with government 
education programs, job training programs, et cetera.
    Mr. McDonald. I think the reason that the companies are 
chasing earnings per share is because there is not another 
reliable metric. I think if companies were more inclined to 
distribute their dividends and shareholders were, therefore, 
able to invest in companies based on long-term dividend 
streams, you would have more long-term thinking.
    I think the other thing that we should take a step back on 
and ask ourselves is, what are these companies growing for? 
They are growing for the shareholders. They are the owners of 
the company. So rather than penalizing companies that pay 
dividends to shareholders--it is, after all, their company--I 
think we should be, at best, neutral between debt and equity 
financing and just not penalize companies for distributing 
dividends out to those who are the owners of the company.
    Senator Warner. Mr. Chairman, I just would like to, again, 
say thanks for being willing to take this on. I do think if we 
want to move beyond whatever this new normal is, the idea of 
how we simplify our system but incent long-term value creation 
has to be part of this ongoing discussion. I think there is a 
lot of bipartisan agreement on that. Thank you, Mr. Chairman, 
for the extra time.
    The Chairman. Well, thank you. I appreciate you being here.
    Let me just say, there has been some talk about corporate 
integration and tax preferences during this hearing. I want to 
clarify that the dividends paid deduction is not mandatory. In 
other words, companies will not be forced to pay out their 
taxable income in the form of dividends. Some companies, I 
think, would decide to retain some or all of their taxable 
income. Those companies can use these tax preferences to reduce 
or eliminate their tax liability. I expect that companies that 
already have these tax preferences will use them to reduce or 
eliminate their tax liability rather than let them go to waste.
    Let me just ask a question for both Professor Warren and 
Mr. McDonald. I would like you both to answer this. Let us 
start with you, Professor Warren. Should the tax system 
encourage corporations to retain earnings? As I view it, Ms. 
Lurie and Mr. McDonald have both said ``yes.''
    Professor Warren. So my view is different. My view is that 
this is a dimension on which the tax system should be neutral.
    The Chairman. All right. Let me ask you, do you feel the 
same way, Mr. McDonald?
    Mr. McDonald. I also think the tax law should be neutral. I 
agree. It should be neutral. We should not incentivize 
companies to hoard cash.
    The Chairman. Well, let me just say this: corporations like 
Apple have lots of cash, exceeding $100 billion as I understand 
it. Yet, Ms. Lurie points out they are issuing a large amount 
of debt. Why is that?
    Ms. Lurie. Thank you, Mr. Chairman. I think, at the end of 
the day, companies are not going to pay that repatriation tax 
unless they really feel like they have to. If the cost of debt 
is significantly below the repatriation tax, they are going to 
borrow, because they do have the cash there, it is just not 
necessarily accessible.
    So I think companies are sitting on the cash in hopes that 
there is going to be a repeal of the repatriation tax sometime 
down the road.
    The Chairman. Mr. McDonald, would you take a crack at that?
    Mr. McDonald. Well, that is one of the advantages, as I 
mentioned before, of a dividends paid deduction, that currently 
the company that you mentioned is penalized if they bring that 
cash back to pay out a dividend to their shareholders. Whereas, 
if we were to enact a dividends paid deduction, that cash could 
come back. There would be a tentative tax computed, but then 
the dividends could be paid out to the shareholders and 
eradicate the tax. So that is one of the big advantages of a 
dividends paid deduction.
    The Chairman. Again for Professor Warren and Mr. McDonald, 
if shareholders receive more dividends as a result of the 
dividends paid deduction, is that bad?
    Professor Warren. In my view, no.
    Just to back up a moment. These are the kinds of decisions 
that should be made in the private sector based on market 
conditions without pressure one way or the other from the tax 
system.
    The Chairman. Does this mean less investment in the 
economy?
    Professor Warren. I know of no reason to think it would 
mean less investment in the economy.
    The Chairman. Well, shareholders tend to put such money 
towards its highest and best use, which might be current 
consumption, or it might be reinvesting in the corporation that 
paid the dividend, or it might be putting the money into 
another investment. Is the money somehow wasted because it is 
paid as a dividend?
    Professor Warren. Not in my view.
    The Chairman. Mr. McDonald?
    Mr. McDonald. I totally agree.
    The Chairman. See, where I am having some difficulty is, I 
cannot see why anybody would be against what we are trying to 
do here. I can see where you would want to mold it and make 
sure you get it the very best you can.
    Ms. Lurie, in Mr. Buckley's written testimony, he wrote, 
``In my opinion, tax reform should be designed with the goal of 
increasing economic growth, expanding employment in the United 
States. Our tax system should be based on principles of 
economic neutrality as long as that neutrality tilts the 
playing field in favor of investment and job growth in the 
U.S.'' Do you agree with Mr. Buckley's statement?
    Ms. Lurie. I do.
    The Chairman. All right. A well-respected economist, Martin 
Sullivan, recently published a cover story for Tax Notes 
magazine in which he concluded that corporate integration would 
tilt investment to the United States. This is what he came up 
with. I am sure you are familiar with that.
    Dr. Sullivan wrote that, ``Integration of the corporate and 
individual tax would eliminate the disparity between debt and 
equity and between pass-through entities and C corporations.'' 
He then provides a number of examples that show that, ``In 
addition to reducing distortions in the domestic economy, 
integration disproportionately benefits domestic investment.''
    Do you have any problems with that?
    Mr. Buckley. Mr. Chairman, the only thing I would ask is 
whether he contemplates withholding taxes on dividends and 
interest payments made by U.S. corporations. I think that will 
be a bar to foreign investment in the United States, 
particularly an investment in debt securities, because you are 
reducing the yield that a foreign investor will get when he 
purchases a debt obligation of the United States corporation.
    That foreign investor will not face a similar reduction in 
yield if he simply keeps his money overseas and invests in 
high-quality bonds issued by foreign corporations.
    So I think there is potential here for decreasing foreign 
investment in the United States, particularly in our debt 
market.
    The Chairman. Mr. McDonald, do you agree with that?
    Mr. McDonald. Well, I would revisit the opening question I 
started with, which is, is it right that certain portions of 
debt-
financed U.S.-sourced business profits bear no U.S. income tax? 
It is one thing if the lender happens to be in a treaty 
jurisdiction where at least there is an assumption that the 
lender is bearing a full rate of tax in their host country, but 
that does not apply to portfolio interest exemption. The 
individual is not paying any tax in the United States. They may 
not be paying any tax in the foreign jurisdiction. So no tax is 
applied.
    The Chairman. Professor Warren, do you have a comment?
    Professor Warren. This is--as with respect to almost 
everything we have talked about today--a complicated issue. In 
this case, it would depend on how the markets would react, 
whether or not there would be other sources of interest that 
would not be subject to withholding, and whether American 
issuers would gross up the interest paid to lenders. If so, 
that would put a burden at the corporate level rather than at 
the lender level. So I think this is a very complicated 
question.
    I do not think it undermines the basic analysis in the 
Sullivan article that you talked about.
    The Chairman. Look. What I am concerned about is that we 
have a lousy tax system in this country. We are losing 
internationally. Our companies are inverting, many of them. The 
administration's approach is to penalize the companies rather 
than incentivize them.
    We are causing our country all kinds of problems here 
because we want to do the whole tax code. I would love to do 
that, but we are not going to do it this year in this time 
frame. I see this as a way of stopping some of the inversions 
and also putting incentives where they ought to be. No matter 
what you do, somebody is going to find fault with it, but the 
fact of the matter is, our current system is broken and not 
working. And our country is in dire jeopardy if we do not start 
doing some things that might work. We cannot keep spending and 
running up national debt. So it is important that we get this 
tax system right. To be honest with you, I am very, very 
concerned about it.
    Let me just ask one more question. I have stipulated that 
the corporate integration discussion draft will be revenue-
neutral. Right now--from what I have been told--it is revenue-
positive, but we want it to be revenue-neutral and maintain the 
progressivity of the tax system.
    Those two stipulations which irritate some on my side, by 
the way, have seemed to have been ignored by the other side. 
Suppose, in addition to meeting those goals, the discussion 
draft has 
revenue-neutral options to resolve the lion's share of the 
objections, for instance, that Mr. Buckley has raised.
    If the discussion draft cleared those hurdles, Mr. Buckley, 
would there be a policy reason remaining to maintain the double 
taxation of dividends? Then let me ask Professor Warren and Mr. 
McDonald to feel free to comment as well.
    Mr. Buckley. If the discussion draft is successful in 
addressing a whole range of issues, I see no policy objection. 
Now, if it creates a set of new distortions and new 
dislocations, then I think there is reason for caution.
    The Chairman. Well then, we should never do anything, 
because we are going to have some new distortions and new 
dislocations, perhaps. I do not know. I do not particularly 
think that is what is going to happen here.
    Professor Warren and then Mr. McDonald.
    Professor Warren. I would just say here--pretty much on the 
same comparison, I think, that Mr. Buckley just made--that at 
the end of the day, one has to compare the final version of the 
proposal with current law. My view is that the path that the 
committee is on in developing a proposal is a very positive 
path, but we have to wait and see the final version.
    The Chairman. That is great.
    Mr. McDonald?
    Mr. McDonald. Aside from a dividends paid deduction, there 
is only one other door to walk through, which is to basically 
copy the system of our trading partners. There are a lot of 
features of that system that people on the other side of the 
aisle are not going to like either, like a territorial system. 
A dividends paid deduction gives people more optionality as to 
what they are going to do with international tax reform.
    The Chairman. Let me ask you this, Professor Warren: 
regarding debt and equity, our tax system has a bias against 
financing a C corporation with equity. Should we get rid of 
that bias against equity and instead create a level playing 
field?
    Professor Warren. Yes, I believe we should. I think one of 
the really telling points is the demonstration in the pamphlet 
prepared by the Joint Committee on Taxation for this hearing, 
that you can end up with--and we have today in many companies--
an effective negative corporate tax rate on tax-preferred 
investments that are financed by debt. I do not know of any 
policy reason why we would want to have a negative corporate 
tax rate.
    The Chairman. Well, in other words, should we let the 
business decide how it should raise the money it needs to 
operate without the tax code influencing that choice?
    Professor Warren. That would be my position.
    The Chairman. Does anybody disagree with that position?
    [No response.]
    The Chairman. Now is your chance.
    [No response.]
    The Chairman. Well, let me ask Mr. Buckley this question. 
Professor Warren and Mr. McDonald have shown the link between 
corporate integration and the responses to many of the problems 
with the U.S. business tax system, including inversion 
transactions. Now, I appreciate the cautionary counsel that you 
are providing us as members today: pursuing integration means 
dealing with political barriers that will not be easy to clear. 
If we take your advice and discard the dividends paid deduction 
and any efforts to balance debt and equity, what do we do to 
counter the problems of the business tax system that Professor 
Warren and Mr. McDonald are trying to remedy?
    Mr. Buckley. Again, Mr. Chairman, I will answer it like I 
did to Senator Heller. I think the best approach going forward 
is broad-based reform with corporate rate reductions.
    The Chairman. We all agree with that, but have you noticed 
how inept the Congress is in approaching that? We do not have 
the time this year to do that, and even if we did, we could not 
get it through because of the political year.
    I guarantee you that if we can get through this year, and 
we are still in the majority----
    Mr. Buckley. But you have to be very----
    The Chairman. Let me finish.
    Mr. Buckley. Okay.
    The Chairman. If we are still in the majority, we are going 
to do it in the next couple of years. We will do that full tax 
reform, and I do not care who puts up a roadblock, we are going 
to roll right over it, because we have to have it. We have to 
be competitive in this world. Right now, just throwing that up 
as a block does not mean anything.
    Now, what I am trying to do is get us somewhere with 
corporate integration, and I would like to have your genius, 
and you two as well. Help us to know how to write this if that 
is the problem. Help us to know what to do. Let us talk in 
terms of positiveness, because I think you can see that this is 
an idea that has some merit. The question is, how do we write 
it? How do we make it work?
    I am challenging both Mr. McDonald and Professor Warren to 
help us too.
    Mr. Buckley. Mr. Chairman, I think one of the aspects of 
this proposal that has to be addressed is its impact on 
corporate bond rates. I mean, Professor Warren essentially 
alluded to the fact that U.S. companies may have to gross up 
their interest payments to reflect the new withholding tax.
    Let me say I disagree with Mr. McDonald. That burden of 
that withholding tax will not be borne by the foreign investor. 
It will be borne by U.S. companies who, for legitimate business 
reasons, are debt financing their business expansion. They will 
be facing a cost increase that their foreign competitors 
overseas will not.
    So my suggestion--if you are going ahead--is, you have to 
figure out some way of making sure you do not negatively impact 
the economy by increasing the interest rates that corporations 
have to pay to finance----
    The Chairman. I have the same concern.
    Mr. McDonald?
    Mr. McDonald. Yes. So that foreign lender is, presumably, 
in competition with U.S. lenders who are going to be subject to 
tax. Now, I have not seen the proposal and I do not exactly 
know how this withholding tax is going to work, but presumably 
this withholding tax is not designed to create a double tax. It 
is presumed to be creditable against that U.S. lender's tax 
liability.
    If that is the case, then you have foreign lenders and you 
have U.S. lenders competing to lend money to those 
corporations. I do not exactly accept the notion that the 
corporation is automatically going to bear the burden of that 
higher interest rate.
    Mr. Buckley. Let me, again, slightly differ. Most--it is 
almost all--U.S. investors in corporate debt securities are 
tax-indifferent investors; they face no U.S. tax on their 
interest income. So they are in the same position that the 
foreign investor is, that that withholding tax is a reduction 
in their interest yield.
    The question this committee has to ask is, are they willing 
to accept a lower interest yield and continue to make the same 
level of investments? I see no reason why they would do that.
    The Chairman. Professor Warren, it is up to you to resolve 
this conflict. [Laughter.]
    Professor Warren. The facts here are very interesting. I am 
looking at the pamphlet issued by the Joint Committee on 
Taxation for today's hearing. I was actually surprised to learn 
the very high percentage of U.S. corporate bonds that are held 
today by regulated investment companies and by insurance 
companies, which is an additional dimension on this debate.
    If the regulated insurance companies are passing their 
attributes through to the investors, then those investors may 
well be taxable, depending on their position. As we all know, 
insurance companies are taxed under an incredibly complicated 
scheme. So I have not even started to think about how you would 
think about integration with the withholding on debt where the 
interest goes to insurance companies.
    So my view is that this is an important issue that needs to 
be worked on and considered, but I do not regard it as being 
something that would so clearly be detrimental to U.S. interest 
that we should not try to figure it out.
    The Chairman. Well, I agree with that statement. You know, 
the interest withholding proposal is designed to deal with the 
bias toward debt, in general, and earnings stripping of the 
U.S. tax base in particular. The withholding proposal attacks 
the biggest form of earnings stripping, and that is excessive 
interest deductions.
    What is more, many tax reform proposals fully or partially 
deny this deductibility of interest. Now, denying the deduction 
is the economic equivalent, in my opinion, of the interest 
withholding proposal with respect to tax-exempts and, of 
course, foreigners.
    Am I wrong in making that statement?
    Professor Warren. No. I do not think so. What I would say 
is that the interest withholding proposal has an advantage over 
the denial of deduction proposals in that there would be a 
possibility of portfolio shifts so that taxable shareholders 
might purchase bonds on which interest had been withheld to use 
the credit. Therefore, if there had to be any gross up, it 
would be less.
    The Chairman. All right. Ms. Lurie, I think one of your 
main points is this, that many firms are over-leveraged; that 
is, they have too much debt. Now your concern is that if there 
were not incentives to retain earnings, then firms with high 
debt would not have adequate cash reserves on hand to pay their 
regular debt payment should there be a downturn in the firm's 
business fortunes.
    So my question is, if you think that firms are over-
leveraged, then would not at least one partial solution to that 
problem be to stop giving debt such favorable tax treatment as 
compared with equity?
    Ms. Lurie. I think you have to look at a couple of 
different pieces that we have in real life, where we have seen 
it proved out where companies do not have as favorable a 
treatment towards debt as they do have to equity. In those 
scenarios, we did see that companies still did, in fact, over-
leverage, and, in fact, they will continue to do so if the cost 
of debt is cheaper than the cost of equity. So if there is 
always going to be that margin, then they are going to lever up 
with debt and give away equity, and they do not want to dilute 
their equity shares.
    The Chairman. Mr. McDonald, let me have your views on that. 
It seems to me--maybe you could give us the benefit of your 
feelings.
    Mr. McDonald. Yes, well, Ms. Lurie references MLPs. Except 
with a very narrow class of publicly traded partnerships, they 
are subject to two levels of tax, because what they are 
invested in is C corps. The fact that you enact a dividends 
paid deduction is not automatically going to cause people to 
issue a bunch of common equity in order to pay down their debt. 
It is going to have a dilutive effect. I agree with that.
    But I do think--and it is a guess--that if you had a 
dividends paid deduction that equalized the playing field a 
little bit, you would see greater reliance on nonparticipating 
preferred stock as a greater option by issuers than you see 
today, instead of debt.
    The Chairman. Now, Mr. McDonald, you wrote--sorry to keep 
you so long, but this is extremely interesting to me, as you 
can imagine. This has been a particularly good panel, I 
believe.
    You wrote, ``The committee should consider how far it wants 
to tip the scales in favor of equity financing.'' Would the 
dividends paid deduction proposal tip the scales in equity's 
favor or merely make the tax code neutral as to whether a 
corporation finances with equity or debt?
    Mr. McDonald. Yes. It entirely depends--this is what I was 
trying to stress in my written testimony. It entirely depends 
on a series of second- and third-order decisions you are going 
to have to make. Interest is not always up-side to a 
corporation. It has a deleterious effect on their foreign tax 
credit limit, for example, that is probably the biggest 
negative impact, and there are a whole host of others.
    So you are going to have to decide, as a committee, which 
one of those provisions that have negative connotations to a 
corporation are equally going to apply to a dividends paid 
deduction, and that is a policy decision.
    The Chairman. Professor Warren, would you give us your 
thoughts on this?
    Professor Warren. Well, again, my view is that we should 
look for a structure where the tax law is as neutral as it can 
be between retaining earnings and making distributions. I think 
that should be the basic policy decision with respect to that 
issue.
    The Chairman. Does this approach help us that way?
    Professor Warren. Again, depending on some other decisions 
that you make, I think this approach is on a pathway to do 
that.
    The Chairman. Well, let me ask this question of Mr. 
McDonald. The Treasury and IRS promulgated some proposed 
regulations under section 385 just last month. Now those 
regulations tend to draw a line between what instruments should 
be regarded as debt and what instruments should be regarded as 
equity.
    So my question is, are you hearing from your clients about 
these proposed regulations, and if we assume that the dividends 
paid deductions were generally coupled with a withholding tax 
on dividends and interest, what might the implications of that 
be for the section 385 proposed regulations and the ongoing 
controversy over whether a given instrument is debt or equity?
    Mr. McDonald. Yes. With respect to your first question, we 
are hearing from all of our clients. These regulations were 
billed as an anti-inversion tool, but they are far, far 
broader. They apply to companies that are not inverted but 
foreign-based, and they apply to U.S.-based multinationals that 
have never even thought of inverting. And they are going to 
have a lot of second- and third-order deleterious effects on 
legitimate business activity, which is probably the subject of 
a whole separate hearing.
    But with respect to your second point, I think the 
dividends paid deduction, if coupled with the withholding tax 
so that we seek to get at least one level of tax, not two, not 
zero, but one across the board on all U.S.-sourced business 
profits, it does more or less obviate the need for these 
regulations, because you are not trying to prevent people from 
getting impermissible debt. It does not matter as much whether 
you are funding with debt or equity.
    The Chairman. Your feelings, Professor Warren?
    Professor Warren. My reaction is similar. That is to say, 
we have a big difference today between debt and equity. There 
are different ways you can approach it. The integration 
proposal approaches it by making the treatment the same. The 
proposed 385 regulations approach the discrepancy by moving the 
line between what is debt and what is equity, so that fewer 
things would be considered debt.
    Where that line is located and the pressure on the line 
would be less of a problem if we had less differential taxation 
of debt and equity.
    The Chairman. My personal view is, it is a stupid approach 
towards trying to solve this problem.
    This question is for you, Mr. McDonald. You have worked 
extensively in the field of international tax law. Can you 
briefly tell us the interrelationship between earnings 
stripping and the phenomenon of inversions, and can you please 
tell us how this proposal, a dividends paid deduction coupled 
with a withholding tax on dividends and interest, might address 
that issue?
    Mr. McDonald. Yes. Well, earnings stripping--there are a 
couple of different ways that you can do earnings stripping, 
but earnings stripping through a debt issuance is one of the 
ways that companies that are inverted can get an immediate 
reduction in their effective tax rate over a very short period 
of time. So the favorable treatment that the code currently 
gives debt over equity actually incentivizes that short-term 
benefit from inversions. I think, again, the dividends paid 
deduction, not in isolation, but coupled with a withholding tax 
so that we ensure all business profits are subject to one level 
of tax, would, in fact, reduce the incentive to invert.
    The Chairman. Thank you.
    Professor Warren?
    Professor Warren. I basically agree with that.
    The Chairman. Okay. Well, this question is for Ms. Lurie, 
and I invite Mr. McDonald to share his thoughts also.
    Now you have expressed concern that the new policy could 
encourage ``lumpy'' dividends as the corporation's profits 
fluctuate. Do you think this concern would be alleviated by 
allowing a dividends paid deduction to generate an NOL that can 
be carried back or carried forward to reduce taxable income in 
other years?
    Ms. Lurie. Thank you, Mr. Chairman. I think it would really 
depend on how the actual structure would work. I think really 
more than anything, figuring out what the withholding tax and 
the dividends paid deduction, versus an interest withholding, 
would look like, I think, will really sort of dictate whether 
or not a company sees themselves as benefitting from giving to 
shareholders in 1 quarter, 1 year, an outsized amount or not.
    I think companies already utilize NOLs to their full 
potential if they can when they have them, either through 
acquisitions or through looking at years to take advantage of 
them. So I think that would just further that issue, but it 
would really sort of beg the question of looking at this 
situation further.
    The Chairman. Okay. This question is for Mr. Buckley, but 
if Professor Warren or Mr. McDonald has any thoughts on this 
matter to share, I would welcome those.
    Almost a decade ago, then Ways and Means chairman and a 
friend of mine, Charlie Rangel, had a tax reform proposal that, 
among other things, would have allocated certain interest 
expense deductions to foreign income enjoying tax deferral. 
Would the effect of that have been to significantly delay or 
even sometimes effectively disallow such interest deductions?
    Mr. Buckley. Well, it obviously would have delayed the 
interest deductions until the related foreign income was 
repatriated. Now, that is obvious, its impact.
    The Chairman. All right. Mr. McDonald, do you have any 
comments?
    Mr. McDonald. No, other than it is kind of the other side 
of the coin. Instead of taxing the tax-exempt shareholder who 
is receiving the interest income, we are simply deferring, 
potentially indefinitely, the interest deduction to the 
corporation.
    The Chairman. Professor Warren?
    Professor Warren. I agree with Mr. Buckley.
    The Chairman. You are getting off easy, Professor Warren. 
Let me ask this of Mr. Buckley.
    In your written testimony, you favorably cite Mr. 
Talisman's article a couple of times, which focused on keeping 
corporate interest fully deductible. It appears the article was 
written--at least in part--in response to Senator Wyden's tax 
plan, which would disallow the interest deduction related to 
the inflation component.
    I want to focus on part of Mr. Talisman's conclusion. He 
writes, ``Also, as proponents for a limitation readily admit, 
the real culprit for any debt bias is a double-level tax on C 
corporations, leading to the conclusion that it would be far 
better to eliminate double taxation than to expand it to an 
elimination of interest deductions.''
    Do you agree with Mr. Talisman's conclusion that (1) the 
real culprit for the debt is the double-level tax on C 
corporations and (2) that it would be far better to eliminate 
double taxation than to expand it to an elimination of interest 
deductions?
    Mr. Buckley. I think I agree with Mr. Talisman's article. 
The only thing I would say is, it never occurred to me that a 
corporate integration proposal would couple a dividends paid 
deduction with essentially a withholding tax that, as you point 
out, is equivalent to denial of the business deduction for 
interest. I just think the two of them are a little bit too 
much to respond to what, let me concede, is a problem. But 
again, this is where I keep disagreeing with Mr. McDonald. That 
withholding tax will not be paid by the investor. It will be 
paid by the company, and it will have an impact on the company 
equivalent to what you would get from a disallowance of the 
interest deduction. I just find it surprising to see the two of 
those items combined in a corporate integration proposal.
    The Chairman. Mr. McDonald?
    Mr. McDonald. I keep coming back to the fact that there was 
never in our Internal Revenue Code, as far as I am aware, a 
conscious decision to have a certain slice of business profits 
that were simply subject to no tax at all. So I get that moving 
to a situation where we have one level of tax on interest held 
by tax-exempts is a change. The question is, whether it is a 
change for the better or a change for the worse.
    The Chairman. All right. Mr. Buckley, you list in your 
written testimony several non-tax reasons for a corporation to 
finance itself with debt rather than with equity. But do any of 
those reasons mean the tax law should create a bias in favor of 
debt over equity? In fact, if the reasons for debt financing 
are sufficiently strong, might this not suggest that debt 
financing would be less elastic in response to tax and thus, if 
anything, might be a more suitable object for heavier taxation 
than equity financing? I would invite Professor Warren and Mr. 
McDonald to comment as well.
    Mr. Buckley. I believe that, even with a fairly robust 
increase in the corporate interest rate that could occur due to 
the withholding tax, for many companies, debt financing will 
still be very, very attractive. It is a lower cost, because the 
bondholder has less risk and, therefore, demands a lower rate 
of return. It also does not involve diluting the stock 
ownership in the company.
    However, what you are doing then is increasing the after-
tax cost of a financing mechanism that is chosen by 
corporations for good and valid business reasons. That can only 
lead to less business investment in the United States or--let 
me leave it at that. It can only lead to companies reducing 
their investment plans, because you have increased the cost of 
external capital to the company through external withholding 
tax.
    The Chairman. Professor Warren?
    Professor Warren. I disagree somewhat. That is to say, I 
disagree with the premise of Mr. Buckley's statement that the 
debt financing is necessarily for good business reasons. People 
debt finance today to get the advantage of a negative tax rate. 
I do not regard that as an appropriate use of the tax system.
    So I think you have to think about the interaction of the 
interest deduction with the other tax preferences that are in 
the code.
    The Chairman. Mr. McDonald?
    Mr. McDonald. I agree.
    The Chairman. All right. Professor Warren, in your 
testimony--are you getting too tired? Are you okay?
    It is very seldom I get to ask a lot of questions. I can 
take my 5 minutes, and then we have 20 others who do it. So 
this is a field day for me, and it has been a wonderful panel, 
as far as I am concerned.
    Professor Warren, in your written testimony, you note that, 
with respect to tax-exempt shareholders and debtholders, ``One 
approach would be to determine the corporate taxes paid on 
dividends to exempt entities and then to enact an explicit tax 
on their income from corporate investments, against which 
corporate taxes or withholding would be creditable and 
refundable. The level of the new tax could be set to maintain, 
decrease, or increase the current tax burden on corporate 
income received by exempt entities. In 1992, the Treasury 
estimated that such a tax in the range of 6 to 8 percent would 
approximate the then-current corporate tax on dividends paid to 
exempt entities. This general approach, which was recommended 
in the 1993 American Law Institute study, has the advantage of 
minimizing tax differentials. Some would say it has the 
disadvantage of recognizing explicitly the rate of tax at which 
tax-exempts are taxed on their investment income.''
    Now some have suggested, under a corporate integration 
proposal, tax-exempts would bear the same tax burden on 
corporate earnings as taxable shareholders and bondholders. 
Would a modest tax on the investment income of tax-exempts 
alleviate such concerns?
    Professor Warren. Well, I think it depends on how you 
actually structure it. So if you take the example of a dividend 
deduction with withholding where the dividend is paid out of 
corporate taxable income, say at 35 percent--which is the 
example given in the committee's materials--if that were 
nonrefundable, the exempt investor would end up having a burden 
on that kind of dividend that is exactly the same as is levied 
today under the corporate tax. It would not be called a 
corporate tax. It would be called a withholding tax.
    Individual taxable investors would be subject to the same 
rate if the credit were nonrefundable, except for people whose 
marginal rate was greater than 35 percent. So one way to think 
about a nonrefundable withholding tax is that it sets a flat 
rate for that kind of income, and then is subject to an 
additional tax for higher-rate taxable investors.
    Again, everything is in the details, but I do not think it 
is generally true that tax-exempt organizations would pay taxes 
at a higher rate than taxable investors.
    The Chairman. In your written testimony, you note that, 
with respect to retirement plans, ``The fact that an 
integration structure could reduce taxes for investments 
outside qualified accounts, while holding constant the absolute 
tax burden inside retirement accounts, should not be considered 
a defect. The policy of encouraging retirement saving through 
tax-preferred accounts should not require opposition to 
reducing taxes on other forms of saving.''
    Could you please elaborate a little bit on that statement?
    Professor Warren. The basic benefit of either of our two 
forms of tax-preferred retirement vehicle is the same. In 
either a Roth IRA or qualified accounts such as a traditional 
IRA, the basic benefit is being able to compound the income at 
a zero rate of tax.
    If you are outside a qualified account and your marginal 
tax rate is, say, 30 percent, the advantage of saving for 
retirement is reducing your tax rate from 30 percent to zero.
    If we kept the absolute tax burden on exempts the same, 
there would be no reduction in the benefit from retirement 
savings as compared to current law. On the other hand, if we 
also reduced the marginal rate of tax on investment outside of 
qualified accounts--say that went from 30 percent to 20 
percent--then the relative advantage of saving through a 
qualified account or Roth IRA would necessarily go down.
    In my view, it is important to think about what we want to 
do about the absolute burden on savings outside qualified 
accounts and Roth IRAs. We may want to keep it the same. We may 
want to raise it or lower it. I think that is all totally 
appropriate.
    Being in favor of a strong policy to encourage people to 
save for retirement--which I am--should not entail opposition 
to reduction of other tax rates for investments that are held 
in other forms of savings.
    The Chairman. Well, Professor Warren, you have been 
involved with corporate integration for many years, having 
authored a 1993--I think it was--ALI study on this subject. 
Now, there has been very little disagreement as to whether 
corporate integration is the right policy. But could corporate 
integration help with some of the problems we are seeing today, 
such as base erosion, inversions, the lock-out effect, the high 
corporate tax rate, and earnings stripping? Would you care to 
comment?
    Mr. McDonald, if you would care to comment after Professor 
Warren, I would appreciate it.
    Professor Warren. I think the article by Dr. Sullivan in 
Tax Notes that you referred to earlier goes through the 
arguments, and I basically agree with his analysis. I think it 
could be a big plus in our current environment, which was not 
the environment in the 1990s when we last talked about this 
kind of integration.
    Mr. McDonald. I would agree. I would just add that interest 
is not the only way to base-erode. But as it relates to 
interest, I think that the proposal that is currently being 
considered would go a long way towards minimizing the impact of 
base erosion, in the United States at least.
    The Chairman. All right. I am going to ask just one more 
question, but for you, Professor Warren, you, Ms. Lurie, and 
you, Mr. McDonald.
    One of the justifications for utilizing either the 
shareholder credit method or dividends paid deduction method of 
corporate integration is the idea that corporations are mobile 
today, as evidenced by inversions, and of course, the income of 
corporations is extremely mobile, as evidenced by BEPS and 
stateless income. Shareholders, however, are much less mobile. 
So maybe it makes more sense to tax the corporate earnings at 
the shareholder level rather than at the corporate level.
    I would really appreciate it if you would comment.
    Professor Warren. I agree with that. The world has changed 
significantly in that regard since the 1990s. I do think it 
shows that the Congress made a mistake in the 2003 legislation 
which reduced taxes at the shareholder level and kept them high 
at the corporate level. I think it puts our companies in a 
disadvantageous competitive position.
    The Chairman. Ms. Lurie?
    Ms. Lurie. I think that while I am no expert in State tax, 
I think it does bring up that question of interstate commerce 
and how it would affect what each State is receiving from the 
companies that are incorporated there, versus what they are 
receiving from shareholders in each of those States.
    The Chairman. Mr. McDonald?
    Mr. McDonald. Yes. I think we can all look towards our 
personal experiences. When we had extraordinarily high marginal 
rates, people did not suddenly expatriate out of the United 
States just to avoid taxes. There are a lot of things that keep 
us rooted where we are as individuals. Those factors just do 
not play into corporate business decisions, nor can they. So I 
am absolutely in favor of moving the burden of the tax squarely 
onto the shoulders of the shareholder.
    The Chairman. Well, let me just make this statement. The 
allegation of a treaty override--in substance, any withholding 
on dividends would not be a treaty override. In fact, in the 
lion's share of cases, those claiming treaty benefits would be 
better off as to dividends.
    As to interest, there is broad agreement that interest 
payments are facilitating earnings stripping. We need to attack 
earnings stripping if we want to stop inversions.
    Now, this is an entirely new system. The treaties were 
negotiated under the assumption that we would continue our 
double taxation system. The withholding at issue here is 
arguably a new type of tax to which the treaties do not apply.
    I just wanted to make those comments to set the record 
straight.
    I want to personally thank all of you witnesses here today. 
I have kept you here longer than I, perhaps, should have.
    Professor Warren and Mr. McDonald, you laid out the case 
for dealing with the primary distortion in our business tax 
system. Favoring debt over equity does matter.
    Ms. Lurie and Mr. Buckley, we also very much appreciated 
your comments on the issue of debt versus equity.
    I would ask everybody--members, staff, policymakers, tax 
professionals, and our friends in the media--to step back for a 
moment and reflect on what we have heard today in the context 
of the big picture. The American business tax system is 
migrating offshore, whether by foreign takeovers, American 
management's defensive tactic of inversions, or the formation 
of businesses overseas. New business that, but for our out-of-
date tax system, would be formed here are now being formed 
offshore.
    The European Union and other trading partners are 
aggressively luring U.S. businesses through tax incentives like 
patent boxes. At the same time, foreign companies are harassing 
the leading edge of U.S. firms through changes in their tax and 
administration. Foreign companies are favored in debt-based 
acquisitions under our tax policy.
    We can respond with targeted, complex regimes like the 
section 385 regulations, or we can tinker around the edges with 
anti-
earnings stripping proposals. But why not end the gamesmanship? 
Why not use simple mechanisms instead of complex rules? Why not 
respond by leading in a different direction, like this 
committee did in 1986? Why not have the U.S. lead the world in 
a new direction? Why not have our trading partners respond to 
the U.S. system, instead of the other way around? While we are 
at it, why not tilt the U.S. tax system towards retaining U.S. 
investment and luring more from overseas?
    Now, that is where I am trying to go with the dividends 
paid deduction and parity between debt and equity. My vision is 
a simpler system: balance between debt and equity financing, 
which cuts out incentives to shift income overseas, rewards 
investors for businesses in the United States, and attracts 
foreign investment.
    So I want to thank my friends on both sides of the aisle 
for their participation in this process. I look forward to 
exploring the discussion draft with all of you when it is 
completed.
    In concluding, all of this reminds me of a story told by 
the late Martin Ginsburg who taught tax law at Georgetown for 
many years, the husband of our Supreme Court Justice. After 
giving a lengthy lecture about the difficulties in 
distinguishing interest from dividends, a student raised his 
hand and said, ``Professor Ginsburg, aren't you making this a 
lot more difficult than it needs to be. It is easy to 
distinguish interest payments from dividends. If it is 
deductible, then it must be interest. If it isn't, then it must 
be a dividend.''
    Of course, it is not really that simple, but it could be. 
That is what we are trying to get to with our corporate tax 
integration proposal.
    I appreciate all of you for adding to our understanding and 
knowledge here today. This is an important hearing, and I take 
it very seriously. I am trying to solve some problems without 
the politics involved. I would like to bring both sides 
together as we did last year with 37 bipartisan bills that this 
committee passed out--already this year, with a number of 
bipartisan bills. This could be a bipartisan approach to help 
deter the inversions and at the same time put us into a better 
tax system than we currently have today, at least with regard 
to these issues that we are trying to resolve with this 
corporate inversion approach.
    I would appreciate each of you thinking about that and 
sending us your best ideas on how we might accomplish this 
without a lot of difficulties and problems that could arise 
otherwise. We are very grateful for you being here. We are very 
grateful for you being willing to stay this extra time.
    With that, we will recess until further notice.
    [Whereupon, at 12:20 p.m., the hearing was concluded.]

                            A P P E N D I X

              Additional Material Submitted for the Record

                              ----------                              


   Prepared Statement of John L. Buckley, Former Chief Tax Counsel, 
         Committee on Ways and Means, House of Representatives
                              introduction
    Chairman Hatch, Ranking Member Wyden, I want to thank you and the 
other members of the committee for the opportunity to appear before you 
today.

    Mr. Chairman, I believe that you should be commended for the way in 
which this committee has approached the issue of tax reform. Bipartisan 
working groups foster understanding across party lines, a necessary 
component of a successful tax reform effort. The hearings that you are 
conducting reflect a commitment to a careful examination of the issues. 
As you continue the process of developing tax reform legislation, you 
may want to take into account comments once made by a former chairman 
of this committee, Senator Moynihan. ``The idea of a new set of simple 
rules is always appealing. However, any time a change of this magnitude 
is under consideration with huge potential risks to the economy and 
shifts of fortune in the balance, we must approach proponents' claims 
with caution and healthy skepticism.''

    The subject of today's hearing, the double taxation of corporate 
income, has been the subject of debate for an extremely long time. 
Based on my experience, interest in the topic has been much greater 
within the academic community than the corporate community. 
Indifference or outright opposition from the corporate community played 
a large role in the defeat of the corporate integration proposals made 
by the Reagan, George H.W. Bush and George W. Bush administrations. 
During my career as a congressional staffer, the only lobbying that I 
experienced on this issue occurred when individuals representing 
several large corporations came in to express opposition to the George 
W. Bush administration proposal.

    I have to acknowledge that details matter and that the opposition 
to the Bush administration proposal was based on opposition to its 
method of delivering the relief, a shareholder exemption for dividends 
paid out of fully taxed earnings. Press reports indicate that a quite 
different proposal is now being considered. That proposal would provide 
a deduction for corporate dividend payments similar to the current 
deduction for corporate interest payments. The cost of the new 
dividends-paid deduction would be offset by the imposition of a 35%, 
nonrefundable, withholding tax on the payment of corporate dividends 
and interest. The proposal could effectively repeal the corporate 
income tax for most corporations, as they shift funds allocated for 
stock buybacks to increased dividend distributions. It is likely the 
only corporations that would continue to have significant liability 
would be corporations which need to retain earnings to fund future 
growth or which for regulatory purposes are required to increase their 
equity capital (banks and other financial institutions are an example). 
The proposal promises far greater benefits to corporations than 
previous ones and it is possible that it may receive a different 
reaction from the corporate community. But, details matter and I 
believe that the new withholding taxes will be problematic for many 
corporations and their shareholders.

    I believe that politics will, and more importantly should, play a 
large role in the development of tax reform legislation. I mean to 
include both the politics necessary to assemble the congressional 
majorities required for enactment and the more difficult task of 
assessing the potential for negative public response after enactment. 
Tax proposals enacted without regard to politics can have a fairly 
short life span. For example, in 1982 the Congress enacted a 
withholding tax on dividends and interest. It was a small withholding 
tax with a 10% rate. It was fully refundable and only applied to 
payments made to individuals, exempting payments to corporations, 
individual retirement funds, pension funds, other tax-exempt 
organizations, and foreign investors. It was repealed before it took 
effect as a result of the public outcry.

    The proposal being discussed today includes a far greater and more 
expansive withholding tax of 35% on all corporate dividend and interest 
payments, without regard to whether the recipient is tax-exempt. It 
would be nonrefundable. As a result, individuals would face at least a 
35% rate on dividend and interest income, even if they were in a lower 
marginal tax rate bracket. Tax-exempt entities, including pension funds 
and individual retirement plans, would effectively pay tax 
notwithstanding their exempt status.

    If the proposal were enacted, individuals with individual 
retirement or 401(k) plans would receive statements showing a reduction 
in their investment income due to the withholding tax, but no 
corresponding benefit, as is the case with other withholding taxes. In 
the case of dividend income, you could argue that the proposal merely 
substitutes direct tax liability for the indirect burden of the 
corporate tax. No such argument would be available in the case of 
interest payments due to the current deduction for interest at the 
corporate level. The merits of the argument probably would not matter; 
I doubt that you will be successful in convincing angry constituents. I 
believe that the holders of Roth IRAs will be particularly incensed 
since they essentially waived an immediate tax reduction for 
contributions to the account in return for the promise of no taxation 
of the account's earnings in the future.

    Essentially, the proposal would impose taxes directly on your 
constituents and a long list of tax-exempt entities in lieu of the 
indirect burdens of the current corporate tax. Before legislating, you 
should consider whether that approach would be able to withstand the 
attacks that may follow enactment.

    Finally, the potential disruptions and distortions that could 
result from the proposal could dwarf the problems caused by the current 
double taxation of corporate earnings. For example, corporations may 
use costly and less efficient leasing transactions involving a non-
corporate lessor to avoid the withholding tax on corporate interest 
payments. The fact that dividends received by tax-exempt entities would 
be subject to tax at a 35% rate, but capital gains would remain exempt, 
could create a new set of distortions in the case of the growing number 
of corporations with dividend distributions in excess of their fully 
taxed income. For you, the question is not whether there are issues 
under current law. The more important question is whether the cure is 
worse than the disease.
                   critiques of current corporate tax
    In the past, proponents of corporate integration have focused on 
two economic distortions arguably caused by the double taxation of 
corporate income: the incentive to operate in pass-through form rather 
than as a taxable corporation and the bias for debt financing that 
could result in over-leveraging at the corporate level.
Incentive for Pass-Through Organizations
    I have to admit that I have always been puzzled by the focus on 
increased use of pass-through entities like partnerships, limited 
liability companies, and subchapter S corporations. If you think that 
the double taxation of corporate earnings is a serious problem, why 
would you object to the use of a business structure that avoids the 
double tax?

    I recognize that there has been a steady increase in the use of 
pass-through entities over the past 30 years. That increase has 
occurred even though there has been a large reduction in the level of 
double taxation due to large individual and corporate rate reductions 
in 1986 and the special dividend rates enacted in 2003 and the sharp 
decline in the portion of stock ownership representing taxable 
accounts. Clearly, factors other the double taxation of corporate 
income have played a role.

    Again, the question is whether the proposal being discussed would 
increase or decrease the use of pass-through entities. There are two 
aspects of the proposal that would substantially increase incentives to 
operate in a non-corporate form. First, small businesses, without 
access to the public equity markets, often rely on debt financing for 
their capital needs. As explained below, the proposal could increase 
the cost of debt financing for corporate borrowers, eliminating any 
temptation for a small business to use the corporate form even with an 
unlimited dividend-paid deduction. Second, a pass-through entity can 
make tax-free distributions of cash flow sheltered from tax by reason 
of accelerated depreciation or other tax benefits. Under the proposal, 
investors in a taxable corporation would face a 35% withholding tax on 
dividends funded with similar cash flows, even though the corporation 
received no benefit from the new dividend-paid deduction.
Bias for Debt Financing
    Many proponents of corporate integration argue that the current 
favorable tax treatment for corporate debt financing leads to excess 
use of debt at the corporate level and greater risk of bankruptcy or 
other financial distress among corporations. An article by Jonathan 
Talisman, former Treasury Assistant Secretary for Tax Policy, makes the 
important, but often ignored, point that there are substantial nontax 
reasons for using debt rather than equity to raise investment capital 
and thus they are not pure substitutes for each other. Debt does not 
dilute the interests of existing shareholders. Debt is a less risky 
investment than stock, which means that debt generally has a lower 
cost. Also, issuing stock can involve much larger underwriting fees 
than debt financing provided by a bank or other financial institution. 
In short, corporations will continue to have significant debt levels 
and it is very unlikely that they will issue additional stock to reduce 
current levels of debt.\1\
---------------------------------------------------------------------------
    \1\ Jonathan Talisman, ``Do No Harm: Keep Corporate Interest Fully 
Deductible,'' Tax Notes, 2013.

    The Talisman article also cites several well-respected academics to 
support the proposition that ``any tax-driven bias for debt may be 
exaggerated and, to the extent it exists, it does not contribute 
substantially to overleveraging or distress.'' I am not in the position 
to judge whether the experts cited in the Talisman article or other 
experts on the issue are correct. But, I am confident that a dividend-
paid deduction is the wrong approach if you are concerned about excess 
---------------------------------------------------------------------------
debt in the corporate sector.

    Retained earnings are one of the largest sources of capital 
available to corporations for purposes of investment and debt 
reduction. That is not surprising; there are no fees for retaining 
earnings and no tax at the shareholder level. The dividend-paid 
deduction will create enormous pressure to increase corporate dividend 
distributions and fund future investments with debt. That pressure 
could be irresistible since some academic studies indicate that 
corporations have been conservative in using debt and have the capacity 
to increase borrowing.

    Originally, I thought that the withholding tax on interest was 
without justification and a mere ``money grab.'' Now, I think that it 
may be a necessary component of the proposal designed to counteract the 
incentive to debt finance caused by the dividend-paid deduction. Also, 
a withholding tax on dividends, but not on interest, could create a new 
set of distortions. Hybrid debt securities that have both debt and 
equity features could be used to create deductible returns on equity 
without being subject to withholding tax liability.
Increased Cost of Corporate Borrowing
    Withholding taxes are often compliance tools forcing both reporting 
and prepayment of the tax. If the amount withheld exceeds the actual 
liability, the excess is refunded. The withholding tax in this proposal 
is quite different; it is nonrefundable and bears little relationship 
to the tax that would actually be imposed on the recipient.

    For individuals with marginal rates of 35% or higher and 
corporations that are not financial intermediaries, the proposed 
withholding tax on interest has the same effect as a traditional 
withholding tax and would not cause those investors to demand a higher 
interest rate. However, those investors are a very small part of the 
corporate bond market.

    The bulk of investors in the corporate bond market are tax-
indifferent investors, investors whose interest income is otherwise 
exempt from tax. Tax-indifferent investors include retirement plans; 
pension funds; religious, charitable, and other tax-
exempt organizations; life insurance companies using corporate bonds to 
fund life reserves; and foreign investors. Banks and other financial 
intermediaries also could be included in this group because a 35% 
withholding tax on their gross interest income normally would be 
dramatically larger than the tax on their net interest income, namely 
the spread between the interest income and their cost of funds. Tax-
indifferent investors are the group whose demand for corporate bonds is 
necessary to clear the market, that means having a willing buyer for 
all bonds being offered for sale in the market. The interest rate 
demanded by that group of investors will set the rate for the entire 
market. For those investors, the withholding tax is simply a reduction 
in their yield on the bonds. The withholding tax will increase 
corporate bond rates unless that group is willing to accept yields 35% 
lower than they currently receive.

    Currently, interest rates on corporate bonds reflect the sum of the 
risk-free interest rate (the rate on Treasury bonds) plus a risk 
premium. In the future, a new element will be added, the amount of the 
new withholding tax. There is no reason to believe that the withholding 
tax will cause tax-indifferent investors to accept a lower risk premium 
because they have alternatives to U.S. corporate bonds if they are 
seeking an interest rate return. They could simply invest in Treasury 
bonds, rather than receiving little additional income for accepting the 
higher risk of corporate bonds. The withholding tax would make the 
United States an ``outlier'' in world capital markets causing foreign 
investors simply to avoid the United States and domestic investors to 
invest in overseas markets. As a result, I believe market rates will 
increase to reflect the withholding tax in order to keep tax-
indifferent investors in the U.S. corporate bond market. With the 
current level of corporate debt issuance, that implies an increase of 
slightly more than 50%. An example using the simplifying assumption 
that the withholding tax has a rate of 33% is useful. Assume that the 
current interest rate on the bond is 4%, the rate would have to go up 
to 6% to make the tax-indifferent investor whole for the withholding 
tax (6 minus the withholding tax of 2).

    Clearly, there would be a market response to the prospect of 
increased interest rates. Corporations could reduce the issuance of 
bonds by reducing planned investments, using alternative financing 
arrangements like leases, or replacing debt with equity. The reduced 
supply would tend to reduce the otherwise large increase in rates. 
Offsetting the reduced supply, there could be reduced demand as tax-
indifferent investors unwilling to accept lower returns decide to make 
their interest-bearing investments in overseas markets or through 
structures like leasing. In summary, it seems clear that there will be 
an increase in rates due to the withholding tax; the amount of the 
increase could be as much as 50%, and there will be a period of 
volatility in the credit markets as market participants attempt to 
measure the respective sizes of changes in the supply of, and demand 
for, corporate bonds.

    Some economic models may assume that the corporate bond market will 
adjust, with no increase in interest rates as fully taxable investors 
replace tax-indifferent investors. I do not believe that there are 
enough taxable investors to replace tax-indifferent investors and 
believe that many market participants would agree.
Lessons from 2003
    In 2003, the George W. Bush administration proposed a version of 
corporate integration. Under that proposal, a corporation would 
establish an exempt dividend account to which the corporation would add 
its fully taxable income for each year. Dividends paid out of that 
account would be exempt from tax at the shareholder level. The proposal 
was greeted with opposition from the corporate community and was not 
enacted. The opposition came from a group of corporations whose 
dividends exceeded their fully taxed income. That group included 
capital-intensive companies whose income was sheltered from tax by 
accelerated depreciation and other benefits like the research credit, 
multinationals not repatriating the income from large operations 
overseas, and multinational energy companies repatriating income on 
which there was no U.S. tax because of foreign tax credits. If 
anything, the number of those corporations has grown as companies have 
expanded their operations overseas since 2003 and the Congress has 
provided larger depreciation and other benefits.

    Those companies had two concerns. First, they felt that the value 
of their shares in the market would suffer if their shareholders only 
received a partial exclusion while shareholders of other companies 
enjoyed a full exclusion. Second, they argued that the value of tax 
incentives was reduced due to the fact that the use of those incentives 
would result in increased tax at the shareholder level. The impact of 
the corporate integration proposal being discussed today on those 
companies and their shareholders would be far worse.

    That proposal would substantially increase taxes at the shareholder 
level, seemingly based on the assumption that all dividends are paid 
out of corporate earnings that would otherwise be taxed at the full 35% 
rate and the assumption that shareholders would not be harmed because 
corporations would pass on the value of the dividend-paid deduction by 
increasing dividends. Those assumptions are simply incorrect in many 
instances and where they are incorrect the total tax on dividends will 
be substantially greater than under current law. Corporations that 
currently distribute dividends in excess of their fully taxed income 
would do their shareholders a favor by reducing the dividend rate. Any 
attempt by those corporations to pass on the benefit of the dividend-
paid deduction through increased dividends would result in more over 
taxation at the shareholder level.

    Just like the Bush administration proposal, any distribution out of 
tax-favored income would result in a recapture of the tax benefit by 
increased tax at the shareholder level. For example, if the United 
States adopted a territorial system of international taxation, any 
distribution out of exempt foreign income would be recaptured by a 35% 
tax at the shareholder level.
                               conclusion
    In my opinion, tax reform should be designed with the goal of 
increasing economic growth and expanding employment in the United 
States. Our tax system should be based on principles of economic 
neutrality as long as that neutrality tilts the playing field in favor 
of investment and job growth in the United States.

    I am not an economist so I am not going to offer an opinion 
concerning the impact of double taxation on the economy, but there is 
no question that it, combined with incentives like accelerated 
depreciation and the research credit, create a bias for retention of 
corporate earnings and reinvestment in our domestic economy. I would 
note that unprecedented period of economic growth and expansion of the 
middle-class in the 1950s and 1960s occurred when the level of double 
taxation was dramatically greater than today due to corporate rates in 
excess of 50% and a maximum tax rate of 70% on dividends.

    However, you do not need to be an economist to conclude that the 
corporate integration proposal being discussed today could have large, 
negative implications for our economy.

        The proposal would eliminate the bias for retention of 
corporate earnings and substitute a bias for distribution of those 
earnings. It would dramatically reduce the benefit of, if not 
effectively repeal, incentives like accelerated depreciation and the 
research credit. Simply increasing dividend distributions would provide 
a larger tax reduction than accelerated depreciation would provide for 
an investment in plant and equipment. The research credit would be 
effectively repealed for many corporations that could simply eliminate 
all corporate tax liability by converting stock buybacks into dividend 
distributions.
        The proposal could dramatically increase the interest cost of 
corporate borrowing. You do not have to ``love'' debt to recognize that 
debt financing is the lowest-cost and most flexible source of external 
capital for corporate investment. U.S. companies, but not their foreign 
competitors, would face that cost increase.
        The proposal could result in complex and inefficient financial 
transactions designed to take advantage of the fact that the rate on 
non-corporate debt could be substantially lower than the rate on 
corporate debt and the fact that the capital gain income of tax-
indifferent investors would remain tax-exempt while dividends received 
by those investors would be subject to a 35% tax rate.
        The imposition of new withholding taxes on foreign investors 
is at best inconsistent with, if not in direct violation of, tax 
treaties, perhaps inviting retaliatory action affecting U.S. investment 
overseas.

    In short, the cure would be worse than the disease. Again, thank 
you for the opportunity to testify today. I would be happy to answer 
any questions you may have.

                                 ______
                                 
              Prepared Statement of Hon. Orrin G. Hatch, 
                        a U.S. Senator From Utah
WASHINGTON--Senate Finance Committee Chairman Orrin Hatch (R-Utah) 
today delivered the following opening statement at a hearing to explore 
how corporate integration could make the tax code neutral in regards to 
financing with debt or with equity:

    Welcome, everyone, to this morning's hearing, which is our second 
hearing on the topic of corporate tax integration. Last week we had a 
hearing to examine the potential benefits of a dividends paid 
deduction. Today, we will focus on the differing tax treatment of debt 
and equity under the current system and the distortions that are 
created as a result.

    As a number of studies have shown, U.S. businesses pay an effective 
tax rate of about 37 percent on equity financing, while the effective 
tax rate on debt financing is negative. That's right: negative. The tax 
code actually gives a subsidy to corporations for debt financing. 
Experts and policymakers across the ideological spectrum have 
acknowledged that this is a problem.

    For example, President Obama's Updated Framework for Business Tax 
Reform, which he released last month, makes this observation: ``[T]he 
current corporate tax code encourages corporations to finance 
themselves with debt rather than with equity. Specifically, under the 
current tax code, corporate dividends are not deductible in computing 
corporate taxable income, but interest payments are. This disparity 
creates a sizable wedge in the effective tax rates applied to returns 
from investments financed with equity versus debt.''

    The Congressional Budget Office and the Joint Committee on 
Taxation, along with Treasury Departments of past administrations, 
agree. The George W. Bush administration's Mack-Breaux tax reform panel 
and the Obama administration's Volcker tax reform panel came to the 
same conclusion: Our tax code's bias in favor of debt financing causes 
significant distortions in the economy.

    We'll talk about a number of these distortions today, but I want to 
mention just a few here at the outset.

    Most obviously, the bias in favor of debt under our tax system 
incentivizes businesses to base financing decisions, not necessarily on 
market conditions or their specific situations, but on relative tax 
consequences.

    In addition, while debt isn't inherently an inferior option, 
businesses and economic sectors that are over-leveraged are, broadly 
speaking, more vulnerable to losses in the event of an economic 
downturn. This puts consumers at greater risk for things like higher 
interest rates due to bankruptcies, taxpayer bailouts, and the like. 
Our system, which puts a premium on debt in the form of a tax 
preference, adds to these risks.

    Finally, the favored tax status of debt incentivizes the use of 
complicated and often wasteful tax-planning strategies that redirect 
resources away from projects and ventures that will lead to growth. 
This includes, for example, the use financing instruments that will be 
regarded as debt by the IRS, even though they resemble equity in a lot 
of ways. This was apparently the focus of the administration's newly 
proposed section 385 regulations, which were ostensibly promulgated to 
prevent inversions, but, as we're finding out, have a much broader 
scope. These proposed regulations are, to say the least, quite 
complicated and will surely continue to generate a lot of discussion. 
One thing is clear, however: This mess demonstrates how distortive our 
current system really is.

    Now, before I conclude my opening statement, I want to address some 
misunderstandings that came up during our last hearing on corporate 
integration and the dividends paid deduction. During that hearing, some 
arguments and concerns were expressed in a manner that I believe 
mischaracterized the approach to corporate integration that I've been 
discussing for several months.

    I didn't dwell on these points last week because I didn't want to 
disrupt the witnesses' statements or deny them a chance to answer 
members' questions, and I didn't want the hearing to get bogged down by 
a prolonged debate over a policy proposal that is not yet final. But I 
do want to briefly set the record straight on a few points.

    One assertion we heard was that corporate integration favors big 
business at the expense of small business. That claim just isn't 
accurate.

    True enough, corporate tax integration would directly benefit 
businesses organized as C corporations. According to the most recent 
JCT data, while there are about 1.6 million C corporations in the U.S., 
only about 5,000--less than \1/2\ of 1 percent--are publicly traded. 
The vast majority of the remaining 99.7 percent of C corporations are 
closely held small businesses.

    Like large corporations, these small businesses are subject to 
double taxation on earnings paid out to shareholders, but there are 
limitations on what they can do. So a dividends paid deduction would 
ensure a fairer and more efficient tax system for small businesses as 
well as large businesses.

    You don't have to take my word for it. A large coalition of small 
business associations, including the National Federation of Independent 
Businesses and the S Corporation Association, recently sent a letter to 
the leaders of the Finance Committee and the House Ways Means Committee 
stating:

    ``Congress should eliminate the double tax on corporate income. . . 
. The double corporate tax results in less investment, fewer jobs, and 
lower wages than if all American businesses were subject to a single 
layer of tax. A key goal of tax reform should be to continue to reduce 
or eliminate the incidence of the double tax and move towards taxing 
all business income once.''

    Without objection, a copy of that letter will be included in the 
record.

    On top of this pretty persuasive assessment from the small business 
community, our committee's Business Tax Reform Working Group also made 
clear in their report that dysfunctional tax policies affecting larger 
publicly traded businesses can and do have ripple effects on smaller 
businesses, including suppliers, service providers, and community 
organizations.

    Another assertion we heard last week was that corporate integration 
would impose a double tax on retirement plans. Truth be told, I'm not 
entirely sure what the basis is for this particular claim. However, I 
do want to do my best to assuage any lingering concerns that people 
might have about this idea.

    Put simply, while we're still seeking input and crafting the 
specifics of our integration plan, I am not aware of any serious 
proposals out there that would result in two layers of tax on 
retirement plans, whether we're talking about income the plans receive 
from interest or from dividends.

    Now, I don't want to spend too long discussing all of the issues 
raised in our last hearing.

    Clearly, we'll have to continue this discussion in the coming weeks 
and months. I look forward to a robust public discussion about these 
issues going forward, including here today with our distinguished panel 
of witnesses.

                                 ______
                                 
         Letter Submitted for the Record by Hon. Orrin G. Hatch

                    Parity for Main Street Employers

The Honorable Orrin G. Hatch        The Honorable Kevin Brady
Chairman                            Chairman
Committee on Finance                Committee on Ways and Means
U.S. Senate                         U.S. House of Representatives
219 Dirksen Senate Office Building  1102 Longworth House Office 
                                    Building
Washington, DC 20510                Washington, DC 20515

The Honorable Ron Wyden             The Honorable Sander Levin
Ranking Member                      Ranking Member
Committee on Finance                Committee on Ways and Means
U.S. Senate                         U.S. House of Representatives
219 Dirksen Senate Office Building  1102 Longworth House Office 
                                    Building
Washington, DC 20510                Washington, DC 20515

                             March 17, 2016

Dear Chairmen and Ranking Members:

As Congress debates tax reform to make American businesses more 
competitive, the undersigned organizations representing employers 
organized as S corporations, partnerships and sole proprietorships 
offer the following three principles to help guide your efforts.

First, tax reform needs to be comprehensive. Jobs in the United States 
are evenly divided between corporate and pass-through employers, with 
nearly 70 million 
private-sector workers employed at S corporations, partnerships and 
sole proprietorships. To ensure that we avoid harming these critical 
employers, tax reform needs to be comprehensive and improve the tax 
code for corporations and pass-through businesses alike.

Second, Congress needs to restore rate parity by reducing the tax rates 
paid by pass through businesses and corporations to similar, low 
levels. The 2012 fiscal cliff negotiations resulted in pass-through 
businesses paying, for the first time in a decade, a significantly 
higher top marginal tax rate than C corporations. Taxing business 
income at different rates penalizes pass-through businesses and 
encourages planning to circumvent the higher rates, ultimately 
resulting in wasted resources and lower growth. To ensure that tax 
reform results in a simpler, fairer and more competitive tax code, 
Congress needs to reduce the top tax rates to similar levels for all 
taxpayers.

Third, Congress should eliminate the double tax on corporate income by 
integrating the corporate and individual tax codes. A study by Ernst 
and Young made clear that the double corporate tax results in less 
investment, fewer jobs, and lower wages than if all American businesses 
were subject to a single layer of tax. A key goal of tax reform should 
be to continue to reduce or eliminate the incidence of the double tax 
and move towards taxing all business income once.

By embracing these broad concepts, Congress can move the taxation of 
business income in a direction that helps all employers, regardless of 
how they are organized, to invest and create jobs here in America.

We appreciate your consideration of these priorities.

Sincerely,

Aeronautical Repair Station Association; ACCA--The Indoor Environment 
and Energy Efficiency Association; Agricultural Retailers Association; 
American Architectural Manufacturers Association; American Beverage 
Licensees; American Business Conference; American Composites 
Manufacturers Association; American Council of Engineering Companies; 
American Feed Industry Association; American Foundry Society; American 
Horticulture Industry Association; American Hotel and Lodging 
Association; American Institute of Architects; American Rental 
Association; American Subcontractors Association; Inc.; American Supply 
Association; American Trucking Associations; AMT--The Association for 
Manufacturing Technology; Associated Builders and Contractors; 
Associated Builders and Contractors Florida East Coast Chapter; Inc.; 
Associated Equipment Distributors; Associated General Contractors of 
America; Association of Independent Manufacturers'/Representatives 
(AIM/R); Association of RV Parks and Campgrounds; Auto Care 
Association; Aviation Suppliers Association; Building Owners and 
Managers Association International; Construction Industry Round Table; 
Design Professionals Coalition; Direct Selling Association; Door and 
Hardware Institute; Electronics Representatives Association; Family 
Business Coalition; Financial Executives International; Financial 
Services Institute; Food Marketing Institute; Foodservice Equipment 
Distributors Association; Greater Tennessee Chapter, Associated 
Builders and Contractors, Inc.; Hearth, Patio and Barbecue Association; 
Heating, Air-Conditioning and Refrigeration Distributors International; 
Independent Community Bankers of America; Independent Electrical 
Contractors; Independent Insurance Agents and Brokers of America; 
Independent Lubricant Manufacturers Association; Industrial Minerals 
Association--North America; Industrial Supply Association; 
International Association of Plastics Distribution; International 
Foodservice Distributors Association; International Franchise 
Association; International Housewares Association; International 
Warehouse Logistics Association; ISSA, The Worldwide Cleaning Industry 
Association; Land Improvement Contractors of America; Metal Treating 
Institute; Metals Service Center Institute; Modification and 
Replacement Parts Association; Motor and Equipment Manufacturers 
Association; National Association of Chemical Distributors; National 
Association of Convenience Stores; National Association of Electrical 
Distributors; National Association of Landscape Professionals; National 
Association of Shell Marketers; National Association of the Remodeling 
Industry; National Association of Truck Stop Operators; National 
Association of Wholesaler-Distributors; National Automobile Dealers 
Association; National Beer Wholesalers Association; National Christmas 
Tree Association; National Club Association; National Electrical 
Contractors Association; National Federation of Independent Business; 
National Funeral Directors Association; National Grocers Association; 
National Industrial Sand Association; National Insulation Association; 
National Lumber and Building Material Dealers Association; National 
Marine Distributors Association; National Marine Manufacturers 
Association; National Newspaper Association; National Propane Gas 
Association; National Ready Mixed Concrete Association; National 
Restaurant Association; National Roofing Contractors Association; 
National Small Business Association; National Stone, Sand and Gravel 
Association; National Tooling and Machining Association; National 
Utility Contractors Association; NEMRA--National Electrical 
Manufacturers Representatives Association; Non-Ferrous Founders' 
Society; North American Association of Food Equipment Manufacturers; 
North American Equipment Dealers Association; NPES The Association for 
Suppliers of Printing, Publishing, and Converting Technologies; Outdoor 
Power Equipment and Engine Service Association; Pacific-West Fastener 
Association; Pet Industry Distributors Association; Petroleum Marketers 
Association of America; Precision Machined Products Association; 
Precision Metalforming Association; Printing Industries of America; 
Professional Beauty Association; S Corporation Association; Secondary 
Materials and Recycled Textiles Association; Service Station Dealers of 
America and Allied Trades; Small Business and Entrepreneurship Council; 
Small Business Legislative Council; Society of American Florists; 
Specialty Equipment Market Association; Tire Industry Association; Tree 
Care Industry Association; Truck Renting and Leasing Association; Water 
and Sewer Distributors of America; Western Equipment Dealers 
Association; Wichita Independent Business Association; Wine and Spirits 
Wholesalers of America; and Wisconsin Grocers Association.

                                 ______
                                 
    Prepared Statement of Jody K. Lurie, CFA,\1\ Vice President and 
      Corporate Bond Research Analyst, Janney Montgomery Scott LLC
---------------------------------------------------------------------------
    \1\ Please note that my written and oral comments today represent 
my views, and not necessarily the views of Janney Montgomery Scott LLC. 
I would like to acknowledge the help of my supervisors, colleagues, and 
friends.
---------------------------------------------------------------------------
    To Chairman Hatch, Ranking Member Wyden, and the other members of 
the committee, thank you for allowing me to present my thoughts on the 
potential effects to the capital markets with the implementation of 
corporate integration.

        Recent events have highlighted issues related to the double 
taxation of corporate income.
        At the same time, the current structure appropriately promotes 
debt repayment over dividend distribution.
        As a positive, corporate integration could result in a rally 
in the equity markets.
        Further review of some of the unintended consequences from 
corporate integration may be warranted.
                              introduction
    For decades, the American tax system has grappled with issues 
related to the double taxation of corporation income. While most of the 
witnesses today and in last Tuesday's hearing testified on retirement 
accounts, international tax law, and specific issues around stocks and 
dividends, the focus of my testimony is the effect of corporate 
integration on bonds and interest.

    Under the current tax system, corporations receive a deduction for 
interest payments on debt securities (such as bonds), resulting in only 
one layer of tax on the debt side. Since a corporation does not receive 
a deduction for dividend payments, the system promotes debt financing 
over equity financing, all else equal. While corporate integration in 
theory could equalize the treatment between equity and debt, it may 
also cause unintended consequences and should be examined with caution.

    I have identified seven outcomes that are likely to occur from 
corporate integration. First, the equalization of the tax treatment of 
debt and equity may create an increased incentive for companies to 
return cash to shareholders over alternatives, such as debt repayment. 
Second, equity market valuations may rise, though companies may alter 
their dividend policies. Third, corporate integration would have 
diverse effects on companies in different industries. Fourth, the 
potential reduction in the debt markets may lead to job cuts. Fifth, 
corporate integration would likely encourage corporations to create 
complex organizations and financing instruments. Sixth, corporate 
integration may be impractical for the current corporate bond trading 
system, and could impose substantial compliance costs from an execution 
standpoint. Seventh, corporate integration may not address the real 
issue at hand, which is whether comprehensive entity tax reform would 
help the economy.
                     debt and equity are different
    Many tax theorists have argued that there is no inherent difference 
between debt and equity; therefore, the two types of securities should 
be treated the same under the tax code. Even if this were true from a 
tax perspective, the capital markets extend beyond tax implications. 
The basic distinctions between debt and equity are widely known 
throughout the capital markets. In Finance 101, we learn that 
shareholders and lenders have different goals.

    A shareholder purchases an equity security with the potential of 
unlimited growth and returns on his investment at the cost of higher 
risk. In contrast, a lender who buys a straight bond has limited upside 
potential, but with lower risk versus an equity. While some lenders 
invest for capital appreciation (i.e., the price of the bond rising), 
many seek income returns equal to the market rate and their principal 
repaid in full at maturity.

    Corporate management typically aligns with the goals of the equity 
investors. Executive compensation is usually tied to equity performance 
via stock options and warrants, so management has a personal interest 
in increasing the equity value and, with that, paying dividends. 
Additionally, activist equity investors can seize control of a 
corporation's board of directors and institute policies that quickly 
bolster returns. Increasing dividends or share buybacks are both 
negative events for lenders, particularly when financed with debt.

    Since the cards are already stacked against lenders, I see it as 
reasonable for the tax system to incentivize companies to repay their 
lenders before making discretionary dividends to their shareholders. 
The current tax system, which favors interest payments over dividends, 
does this. Equalizing the tax treatment of debt and equity may 
incentivize corporations to pay large dividends rather than save cash 
for other purposes, like debt repayment or long-term capital 
investments.
                          shareholder returns
    Corporate integration has similarities in taxation of pass-through 
entities, which are not taxed at the corporate level, but at the 
shareholder level. Recent events related to pass-through entities can 
provide a case study for corporate integration in practice. In 
particular, these events suggest that a withholding tax and dividend 
paid deduction may encourage companies to distribute, rather than 
retain, earnings to their shareholders.
MLPs as an Example
    The formation of businesses as alternative structures (such as 
partnerships, RICs, REITs, S corporations, and LLCs) to avoid double 
taxation is well known, and speaks to inefficiencies of the current tax 
system. That being said, recent events suggest that a move towards 
corporate integration may result in adverse effects.

    Master limited partnerships (``MLPs''), as an example, are a type 
of publicly traded partnerships (``PTPs''). As background, MLPs are 
required to generate 90% of their income through a qualified source, 
such as natural resources-related activities, so the majority of MLPs 
are involved in the energy sector. Most MLPs pay out to equity 
unitholders all income not needed for core businesses via cash 
distributions (i.e., dividends). As pass-through entities, MLPs pay no 
taxes, but rather the individual partners pay taxes on the entity's 
income. As a result, MLPs are incentivized to have high capital 
expenditures because with high capital expenditures come deductions 
that are passed on to the individual unitholders.\2\
---------------------------------------------------------------------------
    \2\ Jody Lurie, Janney Fixed Income Weekly, ``Credit: Masters of 
Their Own Design (MLP Overview),'' http://www.janney.com/
File%20Library/Fixed%20Income%20Weekly/April-30-2012.pdf, (April 30, 
2012).

    As I will explain in more detail shortly, we can learn many lessons 
from recent events in the MLP space. Before the collapse in energy 
prices, MLPs, like REITs, became a preferred alternative for individual 
investors looking for income in the current low interest rate 
environment. Since fall 2014, however, most MLPs and their oil, gas, 
metals, and mining peers have come under pressure due to the fall in 
energy and commodity prices. While there have only been a handful of 
MLP bankruptcies--two prominent firms filed for Chapter 11 bankruptcy 
protection this month--the outsized credit risk in the industry is 
---------------------------------------------------------------------------
notable.

    Industry cyclicality is perhaps inevitable, but what is not is a 
tax policy that favors companies paying out a substantial portion of 
their cash so that they do not have the necessary cushion during a down 
market. Years of feast are often followed by years of famine, and tax 
policy should not encourage gorging during feast only to be followed by 
starvation during famine. During the years after the 2008-2009 
recession and before the 2014 erosion in energy prices, MLPs benefited 
from sector-wide expansion with technological advancements in the 
United States and heightened demand for domestic oil, natural gas, and 
liquids. Market participants utilized the debt and, to a lesser extent, 
equity markets to finance capital expenditures, while at the same time 
promising unitholders distributions with yields that were competitive 
with high-yield corporate bonds. Even before the drop in energy prices 
less than 2 years ago, these companies operated with minimal cash 
balances, providing sizable returns to their equity unitholders via 
distributions.

[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]


    When the energy market crashed, MLPs began to cut back on capital 
expenditures, but only reduced or eliminated their equity distributions 
as a last resort due to market perception related to dividend cuts. 
Several MLPs experienced credit ratings downgrades, and the current 
landscape of MLPs is skewed towards the lower end of the ratings 
spectrum. Of the 114 MLPs and energy-related publicly traded 
partnerships, about half are not rated, and over a third are high yield 
(i.e., double B or lower) rated by Moody's and/or S&P. Many MLPs 
operated before the fall in energy prices with minimal cash on hand and 
high levels of debt and leverage, so when the fall in prices occurred 
these MLPs had few financing options. Two prominent MLPs filed for 
Chapter 11 bankruptcy protection this month. It is likely the 
bankruptcy tally among MLPs will rise, as predicted by both Moody's and 
S&P.\4\
---------------------------------------------------------------------------
    \3\ Bloomberg (May 17, 2016); does not include non-rated companies; 
classification based off the lower of Moody's and S&P's ratings when 
available; triple C includes double C as well; some companies are PTPs 
and not MLPs, per Bloomberg classifications, but are viewed as such 
from a market perspective
    \4\ Moody's Investors Service, April Default Report (May 9, 2016), 
and Standard and Poor's Financial Services, Default, Transition, and 
Recovery: The Global Corporate Default Tally Climbs to 62 Issuers So 
Far in 2016, (May 12, 2016).

    A pass-through structure does not necessarily decrease a company's 
appetite for an overleveraged credit profile, but rather encourages a 
company to spend all available earnings on short-term shareholder 
returns as opposed to saving some cash to ensure the long-term 
viability of the entity. While an equalization of debt and equity 
taxation could lead to additional equity offerings over debt issuance, 
the dilution effect for the company would remain a deterrent, as it was 
for MLPs during their expansion era, so debt issuance would stay the 
preferred method coupled with a focus on shareholder returns. MLPs are 
an example of a publicly traded entity that is taxed only once--at the 
unitholder level--so the recent history of MLPs serves as a cautionary 
tale on corporate integration.
Favoring Shareholders, While Ignoring Long-Term Investments
    Since the 2008-2009 recession, corporate cash balances have reached 
record levels. At year-end 2015, non-financial corporate liquid assets 
totaled $1.95 trillion.\5\ The low rate environment has encouraged 
borrowing, though many companies have shifted their debt profiles away 
from less short-term debt like commercial paper and towards long-term 
debt like corporate bonds. I have published multiple articles on the 
corporate cash balance topic, noting that the largest companies in the 
United States represent an outsized portion of corporate cash, and that 
a notable amount is locked up overseas due to high repatriation costs. 
Companies have utilized the debt markets to finance robust shareholder 
remuneration plans, as debt financing costs are significantly below the 
35% tax rate on repatriating deferred foreign income. Unless the cost 
to issue debt equals the repatriation cost or until there is a way for 
companies to access the cash through a less costly method, companies 
will continue to use the debt markets to finance short-term equity 
returns.
---------------------------------------------------------------------------
    \5\ Board of Governors of the Federal Reserve System, ``Financial 
Accounts of the United States,'' http://www.federalreserve.gov/
releases/z1/current/z1.pdf (March 10, 2016).

    When reviewing corporate liquidity trends, another issue that 
arises is the reduced amount of capital expenditures relative to 
available cash. While non-financial corporate liquidity peaked at year-
end 2015, the trailing 12 month amount of capital expenditures has not 
kept pace. In fact, since the recession, capital expenditures have been 
tracking well below corporate cash levels. Companies are not investing 
in organic growth projects, but rather opting for short-term measures 
to keep shareholders happy. Part and parcel to this issue is the 
increase in mergers and acquisitions, through which some companies have 
pursued tax inversions. Rather than invest in a new project (such as 
expanding a product line or building a new plant) that may take years 
before realizing a return, companies are looking at share buybacks, 
dividends, mergers and acquisitions, and tax minimization to bolster 
---------------------------------------------------------------------------
shareholder returns.

    Although the proposed tax changes may alter certain corporate 
behavior, it is likely we will continue to see a lack of long-term 
capital investments, and domestic capital investments are significant 
contributors to economic and job growth. Corporate integration may put 
even more pressure on corporations to pay outsized dividends to 
shareholders, which could lead to even less long-term capital 
investment.

[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]



                    a rise in equity capital markets
---------------------------------------------------------------------------
    \6\ Board of Governors of the Federal Reserve System, ``Financial 
Accounts of the United States,'' http://www.federalreserve.gov/
releases/z1/current/z1.pdf (March 10, 2016); data pulled from 
Bloomberg.
---------------------------------------------------------------------------
    Corporate integration would likely lead to a rise in equity capital 
market valuations because it would encourage dividend payments. As I 
commented previously, equity indices broke record highs in recent 
years, thanks in part to economic stimulus and improving credit 
profiles at large corporations. It is likely that, with a decreased 
cost of equity capital through a change in the tax treatment of equity, 
the equity markets would respond positively. The more cash being spent 
on shareholders, in theory, could reenter the economy. Empirical 
studies have shown that companies with consistent and increasing 
dividend plans see greater total returns over the long run than 
companies that do not pay or that cut their dividends. Part of this 
trend is the result of perceived company stability by investors. That 
said, it is unclear as to whether the new policy would encourage 
consistent or lumpy dividends, as the return amount would ultimately be 
based on the optimal rate to benefit from a dividend paid deduction and 
could vary with income levels each quarter.
                            cost of capital
    An equalized treatment of equity and debt from a tax perspective is 
unlikely to cause companies to view equity and debt financing 
equivalently. After all, as a security falls further down the capital 
structure, investors demand an additional premium to take on the 
security's risk. It is likely, however, that the difference between 
cost of debt capital and cost of equity capital will decrease, 
companies will still see the benefit in debt- over equity-financing. 
What's more, certain industries may benefit more or less from the new 
regulation. Banks, for example, will likely benefit as lenders 
underlying the bank loans through the withholding tax and credit 
system. At the same time, it is unlikely banks would dramatically 
change their financing profile due to their desire to borrow cheaply 
and charge a spread on lending. Moreover, banks have regulatory 
requirements, and try to optimize the capital structure based on such 
guidelines. Regulated utilities, however, which operate with consistent 
cash flow streams, may look at the policy favoring dividends as a 
positive. Like REITs, they may see the dilution effect as less of a 
factor because they can increase their dividends with each equity 
issuance. At the same time, a higher cost of debt capital, though 
potentially marginal, could be the determinant between whether a 
capital project will meet the required return on investment or not.
                 shrinking fixed-income capital market
    The U.S. capital markets are the largest in the world, offering 
some of the most complex and diversified solutions for financing and 
investing. Debt capital markets, more affectionately known as ``fixed-
income'' capital markets, represent 60% of the $66.5 trillion total 
U.S. capital markets, while equity capital markets represent the 
remaining 40%, as of year-end 2015.\7\ Corporate debt, including bonds, 
bank loans, and commercial paper, represents 20% of the U.S. fixed-
income capital markets.\8\ The Federal Reserve's monetary policy since 
the recession resulted in a rise in both equity and debt market 
valuations. Stock indices set new highs, and the low interest rate 
environment led to a yield-grabbing mentality by investors. In terms of 
corporate debt, a handful of companies broke records in terms of 
issuance size with their bond offerings in recent years, and an 
increased number of issuers entered into the primary market to capture 
the low rates. Both domestic and international companies seized the 
opportunity, and we saw a record number of issues and issuance amount 
by international companies enter into the U.S. corporate bond market. A 
change in the tax policy could lessen the appeal of issuing debt in the 
U.S. markets, especially now that interest rates are lower overseas.
---------------------------------------------------------------------------
    \7\ Securities Industry and Financial Markets Association. Data 
sourced from Federal Reserve, Bloomberg, Federal Agencies, NYSE, and 
NASDAQ (May 19, 2016).
    \8\ Securities Industry and Financial Markets Association, ``U.S. 
Bond Market Issuance and Outstanding,'' http://www.sifma.org/research/
statistics.aspx (May 3, 2016).

    As experts suggest, it is possible that the debt markets could 
shrink due to the equalizing of debt and equity with the proposed tax 
system. Per the Bureau of Labor Statistics, over 900,000 people work in 
the securities industry, and the headcount has risen in the post-
recession era.\9\ Anecdotally, however, we have witnessed shrinking 
headcount in the equity markets with the advent of electronic trading 
platforms and regulatory changes. While technological advancements have 
also affected the fixed-income markets, the heterogeneity of debt 
securities has prevented the wholesale industry change that is 
occurring in the equity markets. What's more, the low rate and low 
growth environment in which we operate has led to further headcount 
reduction by industry participants looking to cut costs and bolster 
margins. A less profitable or less active fixed-income market could add 
further job losses to a challenged situation.
---------------------------------------------------------------------------
    \9\ Bureau of Labor Statistics, ``Securities, Commodity Contracts, 
and Other Financial Investments and Related Activities: NAICS523,'' 
http://www.bls.gov/iag/tgs/iag523.htm (May 19, 2016).
---------------------------------------------------------------------------
             creative engineering and further tax avoidance
    As history shows, companies always look for ways to minimize taxes. 
A corporate integration system, while improving certain issues facing C 
corporations and their constituents today, may not prevent companies 
from pursuing creative structures to limit tax liabilities. Companies 
may create complex structures, including commercial mortgages, sale 
leaseback transactions, or various other formats, to avoid paying 
withholding tax on debt and equity. These unintentional outcomes are 
inherently hard to predict.
                            costly execution
    My firm and other broker-dealers and financial institutions already 
face the hurdle of complex and costly trading platforms. Adding an 
equivalent to a shareholder credit or dividend paid deduction system on 
the debt side will likely translate to additional expenses and 
implementation challenges. The proposed tax changes are not as 
straight-forward and easy to administer as one might think.
                               conclusion
    Given recent events around corporate inversions, I view this 
discussion as timely and notable. Among the many challenges that may be 
created by the potential new tax regime are the incentives that would 
arise for companies to give back to shareholders over creditors or 
long-term capital investments, as the latter use of cash would have a 
better economic multiplier on job creation and long-term expansion. 
Identifying a way to encourage companies to invest longterm in domestic 
projects would likely better support the economy than would providing 
inroads into dividend distribution. Recent events related to MLPs 
provides a good case study when considering how companies may change 
their behavior through the equalized tax treatment of debt and equity. 
Further, relative to other fixed-income securities, corporate debt may 
provide more attractive yields for certain investors, so the 
combination of reduced attentiveness to balance sheets and higher 
yields could cause an imbalance in individual investors' portfolio 
allocation and could expose them to unforeseen credit risk.

                                 ______
                                 
           Prepared Statement of John D. McDonald, Partner, 
                         Baker and McKenzie LLP
                            i. introduction
    Mr. Chairman, Ranking Member Wyden, and members of this 
distinguished committee, it is an honor to participate in these 
hearings on business tax reform.\1\ I have been a tax practitioner 
specializing in international taxation for 20 years. I have authored or 
co-authored over 100 articles on domestic and international taxation, 
including one focusing on the merits of corporate integration.\2\ I 
have co-
authored one treatise focusing on U.S. corporations doing business 
abroad. I also had the privilege for a brief period during my career to 
assist the Islamic Republic of Afghanistan with various legal issues 
including tax regulation and sovereign debt restructuring in Kabul. I 
am here today in my own capacity and not on behalf of my firm. My views 
do not represent those of any client or other organization.
---------------------------------------------------------------------------
    \1\ Unless otherwise noted, all code, section, and Treas. Reg. 
Sec.  references are to the United States Internal Revenue Code of 
1986, as amended, or regulations issued pursuant thereto.
    \2\ The article on integration is A Taxing History: Why Corporate 
Tax Policy Needs to Come Full Circle and Once Again Reflect the Reality 
of the Individual as Taxpayer, 94 Taxes 3 (March 2016).
---------------------------------------------------------------------------
    ii. businesses are mobile and seek the lowest tax jurisdictions 
                 to produce their products and services
    Given that my practice tends to focus on U.S.-based publicly traded 
multinationals organized as corporations, my testimony focuses on 
businesses doing business in corporate form. As this committee is well 
aware, corporations, and the businesses they conduct, are highly 
mobile. Innovation will make them even more mobile. This committee has 
already witnessed the way the Internet has transformed the sale of 
software, music and videos. One can imagine that, in the decades to 
come, many companies we think of today as manufacturing ``tangible'' 
products will simply design the product (presumably in multiple 
locations), store the digital designs on servers owned by a 3rd party 
maintained in multiple locations, and sell the ``product'' via digital 
download over the Internet to a consumer anywhere in the world who 
happens to have a 3-D printer in their home or office who can then 
``print'' the product. In this environment, it simply does not matter 
whether you are a ``U.S.-based'' or ``non-U.S.-based'' multinational. 
Nor does it matter if the ``manufacturing'' and ``marketing'' staff are 
physically proximate to the customer.

    While these changes are happening, corporate managers are 
incentivized to reduce costs. U.S. Federal, State and foreign taxes are 
a cost. They are no different from raw material costs or labor costs. 
U.S. Federal corporate income taxes are, in fact, one of the most 
significant costs U.S. based multinationals have to reduce. To put it 
in perspective, a corporation's treasury function may spend significant 
time and energy to reduce a company's borrowing cost by 30 basis 
points. Yet, a multinational's decision to invert or produce products 
outside of the United States can save up to 3,500 basis points in U.S. 
Federal taxes alone on the profit derived from that activity.

    So long as tax costs are imposed on corporations and reflected on 
income statements that, in turn, impact the compensation of corporate 
managers, those managers will be under incredible pressure to reduce 
those costs. It is, after all, their job.
            iii. the perils of retaining our current system
    As this committee is well aware, our current tax structure 
incentivizes corporate managers to produce products or services 
offshore instead of the United States even though, on a pre-Federal tax 
basis, that may not be the most efficient place to produce. The U.S. 
tax system incentives corporate managers to migrate intangibles to 
offshore jurisdictions. It then incentivizes those corporations to use 
those offshore funds to acquire more assets offshore rather than 
repatriate them to the United States (the so-called ``lock-out 
effect''). The U.S. system also incentivizes corporations to invert. 
Although recent attempts have been made to curtail inversions, the U.S. 
Government cannot prevent corporations from simply being acquired by 
larger foreign corporations headquartered in countries with more 
favorable tax regimes.
                 iv. if you can't beat them, join them
    One approach would be to retain the current U.S. corporate tax 
structure but lower the corporate tax rate and develop an innovation 
box regime. These changes would make the United States more attractive 
relative to its peers.

    The difficulty with this approach is that it is unclear how much 
this will truly impact the incentives of corporate managers. The U.S. 
Federal corporate income tax will still show up on corporate income 
statements. Corporate managers will still be tasked with reducing that 
line item. Congress can make it harder to invert, but it cannot prevent 
companies from being acquired, and it cannot prevent tomorrow's 
breakthrough company from being formed offshore today.

    Thus, if the current corporate tax system is retained, the United 
States will be forced via tax competition to make other changes, like a 
territorial system, that put it on par with other countries. Yet, any 
territorial system that is designed to be appealing enough to make the 
United States competitive will likely enhance (rather than reduce) the 
incentive companies already have to own intangibles and produce their 
products and services offshore.

    Most importantly, however, other countries will not simply stand 
pat. Any reform that makes the U.S. look better to corporate managers 
making investment decisions will almost certainly be countered by other 
countries that will make their corporate regimes even more attractive 
vis-a-vis the United States than they currently are. The Organization 
for Economic Cooperation and Development's (``OECD's'') and G-20's base 
erosion and profit shifting (``BEPS'') initiative attempts to put some 
additional guardrails around the manner in which many countries and the 
United States compete with one other. Yet, not all countries are OECD 
or G-20 members. Not all issues are governed by the OECD guidelines. 
The member countries have broad discretion about how they interpret the 
OECD guidelines that do apply. Moreover, it is not clear how the OECD 
can ensure compliance by those G-20 countries that are not OECD 
members. Last, but not least, even the OECD guidelines do not prevent 
countries from simply lowering their tax rates across the board.

    The bottom line is that it is not easy to eliminate (or even 
reduce) tax competition. If it were easy to eliminate tax-competition, 
the members of the European Union would already have their consolidated 
corporate tax base, and the States within the United States would have 
done something similar long ago.
             v. integration provides a better path forward
    A far better approach is to revamp the current corporate tax system 
so that the corporate tax burden is shifted away from the corporation 
(which is highly mobile) to the shareholders (who are not).\3\ The goal 
should be to design a system that allows corporate managers of U.S.-
based multinationals to manage their business, as much as possible, on 
a pre-U.S. Federal tax basis.
---------------------------------------------------------------------------
    \3\ I use a defined term here, because obviously ``shareholders'' 
could, in turn, be U.S. or foreign corporations or non-resident aliens, 
etc. . . . By shareholders I mean to include U.S. individuals, tax-
deferred accounts of those individuals, and U.S. tax-exempt entities. 
Foreign individuals and entities will have to be addressed through a 
withholding tax mechanism, with due consideration of any treaty 
concerns.

    Starting in 1936, the U.S. tax system has explicitly sought two (2) 
levels of tax on corporate profits--one at the corporate level and 
again at the shareholder level. Since then, there have been multiple 
attempts to eliminate this ``double-taxation'' of corporate profits 
through various ``integration'' approaches that have been studied and 
analyzed over the years. I discuss the merits of these systems briefly 
below in reference to their impact on corporate manager incentives.
A. The Limits of An Imputation Credit Approach
    One integration approach is to enact a shareholder imputation 
credit similar to that used in Australia and New Zealand. In this 
approach, corporations continue to pay tax, but domestic shareholders 
are allowed to credit those taxes against their own tax liability that 
they would otherwise have on the dividend. This has the effect of 
reducing or eliminating the second level of tax on corporate profits.

    Some have argued that a shareholder imputation credit would reduce 
the incentive corporate managers have to migrate intangibles abroad and 
produce products and services abroad. The argument is that since the 
shareholder credit is only available with respect to distributions of 
profits that have been subjected to home-
country taxation, corporate managers will have less incentive to avoid 
paying those home-country taxes.

    There are a number of responses to this argument.

    First, the extent to which the imputation credit is even helpful or 
relevant depends on the corporation's shareholder base. Australia, for 
example, allows dividends sourced from foreign (i.e., non-Australian) 
profits to be paid to non-Australian shareholders without withholding 
tax, regardless whether the income has been subjected to Australian tax 
and regardless whether a treaty applies. Moreover, non-Australians do 
not receive any imputation credit. Thus, if the shareholder base is 
largely non-Australian, a corporate manager has no desire to pay 
Australian corporate tax in order to pass along a shareholder 
imputation credit. There is no upside for them. One could argue that 
the United States does not necessarily have to have the same system as 
Australia and could, for example, impose a withholding tax on 
distributions of foreign untaxed earnings to non-domestic shareholders. 
The U.S.'s flexibility is constrained by tax-competition, however. This 
leads to my next point below.

    Second, the corporate tax is still reflected on the income 
statements of the multinational. Thus, corporate managers will still be 
incentivized (all other things being equal) to locate in jurisdictions 
that have other attractive features beyond simply a shareholder 
imputation credit. The United States will be compelled by tax 
competition to have similar features or lose investment. Perhaps the 
most significant example is a taxpayer favorable territorial system.\4\ 
In this regard, it is important to point out that Australia effectively 
has a territorial system. Moreover, as noted above, Australia allows 
those repatriated profits from CFCs that have not been subjected to 
Australian tax to be distributed to non-Australians without any 
withholding tax. Thus, this committee should not assume that moving to 
a shareholder imputation credit approach will somehow reduce the 
pressure on Congress to enact other features, such as a territorial 
system, that further incentivize intangibles migration and offshore 
production. The United States will still have to engage in tax-
competition with other countries, even if it enacts a shareholder 
imputation credit.
---------------------------------------------------------------------------
    \4\ As the committee is aware, there are a wide variety of 
``territorial'' systems. Some systems exempt virtually all types of 
profits from the entire home country corporate tax, whereas others only 
exempt certain types of profits from most (but not all) home country 
corporate tax.

    Third, corporate managers would only be incentivized to pay home-
country tax during those periods when the company is paying dividends. 
Even then, they would only be incentivized to pay that amount of home-
---------------------------------------------------------------------------
country taxes that are sufficient to support the dividends paid.

    Fourth, it does not reduce the incentive corporate managers 
currently have to finance their business operations with debt.
B. Other Integration Approaches Would Change Incentives for the Better 
        but Possess Serious Administrative Issues
    Other integration approaches would completely shift the burden of 
the corporate tax on to the shareholder. These approaches would have 
the advantage of allowing corporate managers to plan entirely on a pre-
tax basis. They would also focus the imposition of the business tax on 
individuals or U.S. tax exempt entities that are far less mobile than 
multinational corporations.

    For example, one approach, which is only applicable for publicly 
traded corporations, involves eliminating the corporate income tax 
entirely and forcing shareholders of publicly traded companies to mark 
their shares to market (an ``MTM'' approach). Another approach involves 
treating all corporations like partnerships (a ``pass-through'' 
approach).

    Both approaches involve significant administrative issues, however. 
For example, it is not at all clear how an MTM approach would be 
collected on a MTM basis (or even a realization basis) from non-
resident aliens and foreign corporations if the U.S. issuer's stock is 
traded between two foreign persons on a foreign exchange. Similarly, 
the difficulty of allocating income of publicly traded entities on a 
pass-through basis has been addressed in a number of studies on 
integration.
C. The DPD Represents a More Administrable Integration Approach that 
        Also Favorably Impacts Corporate Manager Incentives
    An administrable integration approach that would also have a more 
positive impact on corporate manager incentives than the shareholder 
imputation credit is the so-called ``dividends paid deduction'' or 
``DPD'' being considered by this committee. The DPD has been considered 
by Congress over the years (starting at least as early as 1946) as a 
method for eliminating the double-taxation of corporate profits.

    Unlike the shareholder imputation credit, however, the DPD does 
more than mitigate double-taxation. It should reduce (albeit not 
eliminate) the incentive that corporate managers have to make 
investments on a post-U.S. Federal income tax basis. This, then, 
reduces the need for the U.S. Federal Government to engage in tax 
competition with other countries to have the best suite of tax features 
for multinationals.

    First, the DPD ought to reduce (albeit not eliminate) the tax 
incentive that U.S.-based multinationals have to produce products or 
services offshore. I say ``reduce'' because it is still possible that a 
corporation would have taxable income in excess of ``free'' cash flow 
(the cash flow existing after reinvestment in the business) that cannot 
be eliminated on a present basis through a DPD.\5\
---------------------------------------------------------------------------
    \5\ Most businesses (and investments made by those businesses) move 
through different stages during which they have different income and 
cash flow profiles. See e.g., Donald L. Lester, John A. Parnell, and 
Shawn Carraher, ``Organizational Life Cycle: A Five-Stage Empirical 
Scale,'' 11 International Journal of Organizational Analysis 339 
(2003).

        EXAMPLE: USCO, a publicly traded U.S. multinational, needs to 
        decide whether to build a plant in the U.S. or offshore. The 
        pre-tax projections of cash flow and taxable income are as 
        follows:
---------------------------------------------------------------------------
    \6\ I am assuming the negative free cash flow is funded either by 
issuing equity or debt.


------------------------------------------------------------------------
                               2017     2018     2019     2020     2021
------------------------------------------------------------------------
Revenue                           $0      $30     $100     $105     $111
------------------------------------------------------------------------
    COGS                          $0    ($18)    ($30)    ($30)    ($30)
------------------------------------------------------------------------
    Operating Expenses            $0    ($10)    ($10)    ($10)    ($10)
------------------------------------------------------------------------
    Depreciation               ($10)    ($12)    ($16)    ($20)    ($24)
------------------------------------------------------------------------
Taxable Income                 ($10)    ($10)      $44      $45      $47
========================================================================
Cash Flow From Operations         $0       $2      $60      $65      $71
------------------------------------------------------------------------
CAPEX                         ($100)    ($20)    ($40)    ($40)    ($40)
------------------------------------------------------------------------
``Free Cash Flow'' \6\        ($100)    ($18)      $20      $25      $31
------------------------------------------------------------------------

    Beginning in 2019, the net operating loss carryforwards will have 
been used, and taxable income will be generated, but there will not be 
enough ``free'' cash flow to pay a sufficiently large dividend to wipe 
out the entire corporate tax through a DPD. Depending on the U.S. 
corporate rate, the foreign tax rate and the length of time taxable 
income is expected to exceed free cash flow, USCO may still conceivably 
have an incentive to engage in deferral. Nevertheless, the differential 
between the U.S. and foreign tax rate would have to be significant, and 
the time frame during which taxable income exceeds cash flow would also 
have to be lengthy for the prospect of deferral to motivate offshore 
production.

    Second, the DPD should substantially reduce the so-called ``lock-
out'' effect that currently plagues many U.S.-based multinationals, 
without necessitating a switch to a territorial regime.\7\ Presently, 
if earnings are retained offshore, and not repatriated, no U.S. tax is 
paid and no tax is accrued on the U.S. financial statements.\8\ This 
creates a tremendous incentive to keep cash in non-productive passive 
investments, reinvest cash offshore, and borrow in the United States to 
fund dividends and stock buy-backs. With a DPD, to the extent that the 
repatriated cash will be used to pay dividends,\9\ there is no Federal 
tax reason for the multinational to keep cash offshore.\10\
---------------------------------------------------------------------------
    \7\ To be clear, enactment of a DPD does not preclude the enactment 
of some form of territorial regime.
    \8\ The financial statement presentation is driven by Accounting 
Principles Board Standard 23 which has since been codified as ASC 740-
10-25-3.
    \9\ I address stock buy-backs below.
    \10\ The corporate taxpayer would still be incentivized to keep 
cash offshore if the cash is being brought back to repay principal on 
debt (which would not be deductible) or invest in assets with long 
class lives that will depreciate slowly.

    Third, the DPD would either substantially reduce (or possibly even 
eliminate) the preference that currently exists in the U.S. tax system 
for debt financing corporate operations. The precise extent to which 
parity is achieved, however, depends on a number of specific policy 
choices that Congress will have to make if it proceeds with a DPD. I 
address this issue specifically in the remainder of my written 
testimony.
             vi. the impact of a dpd on debt-equity parity
    The committee is keenly interested in the extent to which allowing 
corporations a DPD would eliminate the preference for debt financing in 
the United States. The tax law did not always favor debt over equity 
financing as much as it does today. In fact, there is little to suggest 
that the current preference for debt financing was ever fully 
considered as an affirmative policy choice by Congress. Instead, the 
advantage of using debt financing instead of equity financing waxed and 
waned in the first decades of the 20th century based on interest 
deductibility limitations and corporate and individual rates. It was 
only when Congress chose to impose two levels of tax on corporate 
profits in 1936 and the only limit on the sheer amount of debt a 
corporation could issue was established by common law that the tax 
preference for debt was firmly established. Again, this does not appear 
to be a considered policy decision taken by Congress, but instead is a 
state of affairs that evolved over time based on other changes in the 
code.

    The importance of the distinction is illustrated in stark relief 
with the issuance of the proposed section 385 regulations. As this 
committee will likely hear from others over the coming months, the new 
proposed section 385 regulations will have a profoundly negative impact 
on ordinary non-tax motivated transactions and investment in this 
country. Thus, it would be good for the government and the taxpayer 
community if the tax treatment of debt and equity were brought into 
greater balance, thereby obviating the need for punitive rules, like 
the proposed section 385 regulations, that hinder legitimate economic 
activity such as cash-pooling, acquisitions of foreign companies that 
will not be compliant with section 385 and post-
closing integration.

    Clearly, allowing a DPD will eliminate the biggest tax difference 
between debt and equity financing. Yet, there are a lot of second- and 
third-order effects that this committee should consider in connection 
with granting a DPD. The committee should consider how far it wants to 
tip the scales in favor of equity financing.

    One threshold issue, for example, is the ``base'' out of which the 
DPD may be claimed. A ``dividend'' represents property distributed out 
of a corporation's earnings and profits (``E&P'') which will not 
necessarily be the same as a corporation's ``taxable income.'' A basic 
example would be interest on a tax-exempt bond, which would be included 
in E&P but not included in taxable income. Interest expense reduces a 
corporation's earnings and profits (``E&P'') but may only be deducted 
against taxable income. Thus, a decision will need to be made as to 
whether a distribution of property creates a DPD if it is made out of 
E&P \11\ or whether it will be limited to distributions made out of 
``taxable income.'' This will then have certain cascading effects which 
I refer to below.
---------------------------------------------------------------------------
    \11\ To the extent the DPD exceeds taxable income, it would then 
presumably create a net operating loss that could be carried backwards 
or forwards.

    There are also more bespoke issues that are unique to specific 
holders and specific issuers. In the interest of simplification, 
Congress should also reconsider a number of anti-abuse provisions the 
code contains that will cease to have a rationale once a DPD is 
enacted. The DPD could also impact many common reorganization 
transactions. I try to highlight some of those effects the committee 
should consider below.
A. Issues From a Holder's Perspective
    Different holders will have different concerns with respect to the 
DPD proposal depending on their status and how the rule is crafted.
            1. U.S. Shareholder Perspective
    U.S. individuals, domestic corporations and tax-exempt entities 
will have different concerns with respect to the DPD proposal than 
foreign investors. We address domestic taxpayers below.
              a. Individual Holders

    It is useful to think in terms of tax base, rate, and timing.

                                Tax Base

    The DPD should not impact or create a ``base'' difference between 
debt and equity. In terms of the tax base, under current law, the rules 
governing debt (including but not limited to contingent debt) and the 
rules governing equity both allow for the tax-free return of invested 
capital/principal and the inclusion in gross income of return on that 
capital/principal. Thus, it is really the rate at which that income is 
taxed and the time when it is taxed that have to be considered in 
determining how far a DPD would tilt the scales in favor of equity 
financing.

                                Tax Rate

    Normally, interest deducted by a corporation is included in the 
taxable income of individuals at ordinary income rates. Yet, 
individuals currently enjoy a favorable tax rate on dividends paid by 
domestic corporations under section 1(h)(11) if they hold the shares of 
the issuer for a sufficient period of time. If the DPD is enacted and 
there is no change to the foregoing preference, there will be an 
incentive (all other things being equal) for holders to own debt-like 
equity as opposed to equity-like debt.\12\
---------------------------------------------------------------------------
    \12\ Congress has historically been concerned abut equity-like 
debt, rather than debt-like equity. See e.g., Sec. Sec. 163(l) and 279.

    One additional issue the committee will need to address is the tax 
treatment of redemptions taxed under section 302(a). If the committee 
wants the DPD to mitigate the current ``lock-out'' effect for CFC 
earnings, the committee will have to consider whether the DPD applies 
to share repurchases governed by section 302(a) as well as property 
distributions governed by section 301. This is because many companies 
use their free cash flow to buy back stock, not just pay dividends. 
Stock buy-backs from public shareholders are often governed by section 
302(a) of the code (governing sale-type redemptions), not section 
302(d) and section 301 (governing dividend-equivalent redemptions). If 
the redemption is governed by section 302(a), section 312(n)(7) 
currently limits the amount of the E&P reduction to those earnings 
attributable to the shares that were redeemed. Yet, despite the E&P 
reduction, the shareholder recognizes ``gain'' (not ordinary income) 
---------------------------------------------------------------------------
equal to the dividend minus his/her basis.

        EXAMPLE: In 2016, A, a U.S. citizen invested $1 in USCO, a 
        publicly traded corporation in an initial public offering for 
        1% of USCO's shares. A then sold those shares to B, a U.S. 
        citizen, for $4 in 2017. In 2022, USCO has $1,000 of E&P. USCO 
        has a stock buy-back program where it periodically goes out 
        into the market and redeems shares from those shareholders who 
        choose to tender their shares. In 2022, B tenders all of his 
        shares in USCO for $10.\13\
---------------------------------------------------------------------------
    \13\ The example assumes that USCO received $100 of initial equity 
capital, earned another $1,000, but nevertheless is only worth $1,000, 
which suggests USCO has $100 of assets on its balance sheet that have 
depreciated in value but USCO has not been able to deduct them for tax 
purposes.

    Under current law, USCO would reduce its E&P by $10 (1%  
$1,000) and not receive a deduction. A would recognize a gain of $3 in 
2017, but the gain would be ``capital'' in nature. B would recognize 
gain of $6 ($10 minus $4) and, again, the gain would be ``capital'' in 
nature. If a DPD were enacted and drafted so that it applied to share-
buy backs, the issuer would presumably get an ordinary deduction of 
$10, assuming E&P equaled taxable income.\14\ USCO's preference for 
debt financing would thus be reduced. The rates applicable to A and B's 
income, however, will be more favorable than they would be had A loaned 
money for a contingent debt instrument and sold it to B who then had it 
redeemed by USCO.\15\ Thus, A and B would now have a tax preference for 
equity financing under this scenario.
---------------------------------------------------------------------------
    \14\ I am assuming for purposes of this example that the committee 
would only permit a DPD for amounts paid out of E&P to the extent the 
earnings were reflected in taxable income and would not permit a 
deduction for E&P generated from untaxed earnings like municipal bond 
income, etc. . . .
    \15\ Had A loaned the money to USCO for a contingent debt 
instrument, at least a portion of A's income would be ``ordinary'' 
income that it accrued on a constant accrual basis until it sold the 
instrument to B. Similarly, at least a portion of B's income would be 
ordinary income that he accrued on a constant accrual basis prior to 
having the instrument redeemed.
---------------------------------------------------------------------------

                                 Timing

    Holders of instruments with original issue discount (``OID'') and 
contingent debt instruments have to recognize income over the term of 
the instrument even if they do not necessarily receive cash. A holder 
of an equity instrument only recognizes income when there is a 
realization event, like a dividend or a redemption.

    Unlike the rate difference described above, however, this 
distinction is merited by the different economic terms between debt and 
equity. As the committee is aware, ``debt'' and ``equity'' lie on 
either ends of a continuum with repayment of principal and yield on 
``debt'' being more certain than with ``equity.'' Thus, allowing 
holders of ``equity'' to defer income recognition does not 
automatically mean that holders will prefer equity over debt. To be 
``equity'' in the first instance, the payments on the instrument would 
typically have to be more uncertain than those of a debt instrument, 
and so allowing holders to defer taxation until there is a realization 
event would seem appropriate.
              b. Corporate Holders
    There is no capital gains rate differential for corporations. But 
corporations do receive a dividends received deduction with respect to 
dividends from other corporations.\16\ Presumably, if a DPD were 
enacted, the dividends received deduction would be removed. If so, that 
would bring the treatment of equity financing more in line with debt 
financing for corporate holders.
---------------------------------------------------------------------------
    \16\ Sec. Sec. 243, 245, 246, and 246A.
---------------------------------------------------------------------------
              c. U.S. Tax-Exempt Entities
    Subject to some exceptions, interest and dividends received by a 
tax-exempt entity are not considered Unrelated Business Taxable Income 
(``UBTI''). Yet, corporate tax is paid on the earnings out which 
corporate dividends are paid, whereas, corporate tax is not paid on 
interest payments made to tax-exempt entities. Thus, the tax-exempt 
investor gets an exclusion with debt or equity financing but only debt 
financing generates a corporate tax deduction.

    If Congress were to enact a DPD and retain the current treatment of 
dividends, the DPD would equalize the treatment of debt and equity for 
tax-exempt entities. Yet, it would also result in lost revenue, as no 
business tax would be paid on earnings that were paid to tax-exempts as 
dividends or interest. In this committee's May 17th hearing, it heard 
about the tremendous growth in ownership of U.S. corporations by tax-
exempt shareholders. Thus, the revenue loss would likely be 
significant.

    If, instead, Congress were to cause dividends from domestic 
corporations (but not interest) to be UBTI (in order to compensate for 
the lost corporate tax revenue), then U.S. tax-exempt entities would 
presumably prefer offering debt financing. This is because even if 
yields on equity were adjusted to reflect the treatment of dividends as 
UBTI, tax-exempt entities cannot earn an unlimited amount of UBTI 
without endangering their tax-exempt status.\17\ Thus, one approach 
would be to impose tax on dividends and interest paid by domestic 
corporations to tax-exempt entities, but not count those dividend and 
interest payments against the tax-exempt entity in determining its tax-
exempt status.
---------------------------------------------------------------------------
    \17\ Similarly, if both interest and dividends paid by domestic 
corporations were included in UBTI, one could see some tax-exempt 
entities preferring investments in non-dividend paying stocks or 
foreign entities to limit their overall amount of UBTI.

    During this committee's May 17th hearing, there was significant 
discussion about the impact that a withholding tax on dividends would 
have on retirement savings accounts, such as 401(k) plans. I would 
offer a couple of thoughts in this regard.\18\ First, page 4 of Ms. 
Miller's testimony assumes that withdrawals from a 401(k) plan would 
still be taxable even if the withdrawal is made from income that has 
already been subjected to withholding tax. This may be true, but need 
not necessarily be true. There are a lot of correlative changes this 
committee needs to consider when enacting a DPD, and the taxation of 
amounts withdrawn from a 401(k) that have already borne shareholder 
level tax may be one of those changes. Possibilities would include 
exempting that income from tax when withdrawn or providing a refundable 
credit for the taxes that have been paid on that income when the income 
is withdrawn by the taxpayer. Second, like all taxpayers, 401(k) plan 
participants will adjust to any new tax system. They can shift their 
investment preferences (if given a sufficient transition period) from 
dividend paying stocks to growth stocks that are reinvesting all of 
their cash flow in the business.\19\
---------------------------------------------------------------------------
    \18\ I do not address whether, in fact, 401(k) plan participants 
are already bearing the corporate income tax through lower stock prices 
and dividends. This is because making that argument first requires the 
determination as to whether shareholders are currently bearing the 
economic burden of the corporate income tax, something that tax 
professionals have been arguing about for a very long time.
    \19\ Admittedly, this is easier for a younger individual who has a 
much longer investment horizon than an older plan participant who has 
transitioned his or her portfolio to income generating securities.

    I would suggest that the real issue for tax-exempts, including but 
not limited to retirement accounts, is the possibility that a DPD would 
usher in a withholding tax on interest. Right now, as noted above, a 
U.S. corporation's interest payment to a tax-exempt entity is not 
subject to any business tax. The question for this committee is whether 
that is the appropriate answer from a policy perspective.
            2. Foreign Shareholder's Perspective
    As the committee is aware, the United States imposes a 30% 
withholding tax on U.S. source interest and dividend payments, but the 
United States has largely relinquished taxing jurisdiction on interest 
payments through its treaty network. In contrast, most U.S. tax 
treaties do not fully eliminate the withholding tax on dividends. The 
ones that do only do so for significant (80%+) shareholders who satisfy 
an enhanced limitations on benefits test. In addition, certain types of 
debt extended from unrelated parties can qualify for the ``portfolio 
interest exemption'' \20\ and escape U.S. withholding tax without 
resorting to a treaty. These differences favor debt financing over 
equity financing.
---------------------------------------------------------------------------
    \20\ See Sec. 881(c) and Treas. Reg. Sec. 1.871-14(g).

    Presumably, if Congress enacts a DPD, it will have to revisit the 
treatment of dividend withholding taxes under applicable treaties in 
order to offset the revenue loss that would otherwise occur. This, in 
turn, will likely require a similar reassessment of how interest is 
withheld upon. After all, if Congress enacts a DPD, but fails to 
equalize the manner in which interest and dividends are withheld upon, 
foreign persons will still have a significant preference for offering 
debt financing vs. equity financing.\21\
---------------------------------------------------------------------------
    \21\ I address the treaty override issues associated with a DPD 
more fully in my article cited above.
---------------------------------------------------------------------------
B. Issuer's Perspective
    A corporate issuer's ability to derive an interest deduction for 
debt financing is obviously a significant tax advantage over equity 
financing. Yet, there are a number of places in the code where an 
interest deduction is either limited or has a negative corollary 
effect. Each provision has its own rationale and this committee will 
have to consider whether the rationale for the provision applies 
equally to a DPD.
            1. Limitations on Interest Deductibility
    The amount of interest deduction a corporate taxpayer may deduct in 
any given year with respect to debt issued to, or guaranteed by, a 
foreign related party is limited by section 163(j). Whether this limit 
also applies to a DPD would likely depend greatly on how Congress 
chooses to resolve the withholding tax issue mentioned above. For 
example, if dividends subject to a DPD are subject to full withholding, 
there may not be any reason to subject them to the section 163(j) 
limitation.

    Some interest expense must be capitalized.\22\ If similar rules are 
not provided for the DPD, all other things being equal, an issuer may 
have a preference for equity financing over debt financing.
---------------------------------------------------------------------------
    \22\ See Sec. 263A(f).

    Interest on debt used to fund tax-exempt income is not deductible 
under section 265. That does not automatically mean a similar rule is 
required for a DPD. Given that the income generated from the investment 
is not taxable, a subsequent distribution of that income would 
presumably not be entitled a deduction.\23\ Hence, it is not clear that 
the DPD arising from equity used to finance a tax-exempt investment 
would have to be subject to section 265.
---------------------------------------------------------------------------
    \23\ I am assuming that the DPD would be limited to distributions 
out of taxed earnings and would not allow a deduction for income that 
had been subject to a preference. But if that is incorrect, then that 
could cause the committee to consider whether section 265 should also 
apply to deny a portion of the DPD.

    The interest deduction with respect to related party debt is 
deferred until ``paid'' under sections 267(a)(2) and (3). This 
committee will have to consider whether it is appropriate to, for 
example, allow a corporate taxpayer to receive a DPD by simply issuing 
its own note to the shareholder, or whether payment in cash or other 
property will be required to crystalize the deduction.\24\
---------------------------------------------------------------------------
    \24\ There is already significant case law that determines whether 
a corporation's issuance of an obligation is sufficient to cause a 
``dividend'' to have been ``paid.'' Compare, Moser v. Commissioner, 914 
F.2d 1040 (8th Cir. 1990) and Estate of McWhorter v. Commissioner, 69 
T.C. 650, aff'd without opinion, 590 F2.d 340 (8th Cir. 1978).
---------------------------------------------------------------------------
            2. Correlative Effects
    Interest deductions have a number of unfavorable correlative 
effects to U.S. corporations. The question is which of these 
correlative effects should apply equally to a DPD.

    For example, U.S. corporations have to apportion interest expense 
to U.S. and foreign sources in order to compute their foreign tax 
credit limitation.\25\ Any interest apportioned to foreign sources 
reduces the U.S. corporation's foreign tax credit limitation and its 
ability to claim foreign tax credits. The underlying theory is that 
money is fungible and if the taxpayer chooses to finance the business 
by having a U.S. corporation issue debt (instead of having its foreign 
subsidiaries issue the debt) then the interest expense should be 
apportioned. Presumably the DPD would also have to be apportioned under 
the same theory.
---------------------------------------------------------------------------
    \25\ Sec. 864(e) and Treas. Reg. Sec. 1.861-9T.

    Corporations also have to apportion interest expense to gross 
income from activities that do, and activities that do not, qualify for 
the section 199 domestic production deduction. Presumably, the DPD 
---------------------------------------------------------------------------
would be similarly apportioned.

    A similar issue will arise for foreign corporations that generate 
effectively connected income. If a foreign corporation generates 
effectively connected income, the code has rules that apportion its 
interest expenses to that effectively connected income and ensure that 
proper withholding tax is charged.\26\ Moreover, since 2004, the United 
States has exempted dividends paid by foreign corporations with 
significant effectively connected income from U.S. withholding tax.\27\ 
If a DPD were enacted, decisions would have to be made as to whether 
the DPD would be deductible against effectively connected income. If it 
is, a decision will have to be made as to how it is apportioned and 
withheld upon when distributed.
---------------------------------------------------------------------------
    \26\  Sec. 884(f).
    \27\ Sec. 871(i)(2)(D) enacted in Sec. 409(a) of The American Jobs 
Creation Act of 2004.
---------------------------------------------------------------------------
C. Enactment of a DPD will Remove the Rationale for a Number of the 
        Code's Anti-Abuse Provisions
    There are a whole host of code provisions that were enacted to 
prevent corporate taxpayers from issuing instruments that were 
characterized as debt under the common law, but nevertheless contained 
``equity-like'' features. The underlying rationale for these provisions 
as that an interest deduction should not be permitted for instruments 
that were sufficiently ``equity-like.'' If Congress were to enact a 
DPD, however, the rationale for these provisions presumably disappears. 
In the interest of simplifying the code, Congress may consider removing 
these provisions. I list some examples below.

    Section 163(l) prohibits deductions on debt where a substantial 
portion of the principal or interest is payable in equity. Section 279, 
similarly, limits deductions with respect to debt issued in 
acquisitions that have certain equity-like features. Interestingly, 
section 279 was enacted at the same time as section 385 in 1969,\28\ 
when Congress sought to better define the distinction between debt and 
equity. Presumably, the rationale for sections 163(l) and 279 would 
fall away if Congress were to enact a DPD. If so, Congress should 
consider repealing them.
---------------------------------------------------------------------------
    \28\ See An Act to Reform the Income Tax Laws, Pub. L. 91-172, 
Sec. 411(a), 83 Stat. 487, 604-05 (1969).

    Other examples are less clear-cut. For example, the applicable high 
yield debt obligation (``AHYDO'') rules in section 163(e)(5) were 
enacted as an anti-abuse provision. Yet, unlike sections 163(l) and 
279, it is not as obvious that the rationale for the AHYDO rules would 
fall away with a DPD. On the one hand, Congress enacted the AHYDO rules 
because they believed that high-yield instruments with significant 
deferred payments were very equity-like. In that sense, enactment of a 
DPD would eliminate the rationale for the AHYDO rules. Yet, the AHYDO 
rules also prevent a corporation from claiming a deduction for original 
issue discount accrued long before it is paid. That rationale would 
appear to remain intact even after the enactment of a DPD.
D. The DPD May Impact Other Common Reorganization Transactions
    As a threshold matter, the code contains rules governing the 
movement and allocation of accumulated E&P in corporate 
reorganizations.\29\ The rules do not address the movement and 
allocation of accumulated taxable income. Thus, if the DPD is only 
allowed for a payment out of accumulated taxable income (rather than 
E&P), companies will need rules to track and allocate their accumulated 
taxable income which they currently do not have.
---------------------------------------------------------------------------
    \29\ Sec. 381 (governing tax-free liquidations and non-divisive 
asset reorganizations); and Treas. Reg. Sec. 1.312-10 (in the case of 
divisive transactions).

    In addition, the enactment of the DPD may impact the ability and 
desire of corporations to engage in divisive transactions. Under the 
code, when a corporation distributes appreciated property (including 
stock of a subsidiary) to its shareholders, a tax is imposed at the 
distributing corporate level and at the shareholder level. Section 355 
provides an exception to this rule in certain specific fact patterns 
many of which require the taxpayer to analyze the preceding 5 years of 
shareholder and business activity. If section 355 applies, no gain is 
---------------------------------------------------------------------------
recognized at the corporate or shareholder level.

    It is unlikely that the enactment of a DPD will incentivize 
corporations to engage in divisive transactions that do not satisfy the 
rigorous requirements of section 355. This is because the DPD will only 
eliminate the corporate-level gain, not the shareholder level income 
event. Moreover, the government will not allow distributing 
corporations to ``withhold'' on shares of a controlled subsidiary. 
Thus, if the distribution is taxable and withholding is required, the 
distributing corporation would have to come up with additional cash to 
pay over to the government. This would create an additional taxable 
event to the shareholders.\30\ Thus, corporations will still need to 
satisfy the requirements of section 355 to do divisive transactions.
---------------------------------------------------------------------------
    \30\ See Old Colony Trust Co. v. Commissioner, 279 U.S. 716 (1929) 
and Enoch v. Commissioner, 57 T.C. 781 (1972) (acq. in part).

    The question is whether it must comply with all of the requirements 
of section 355. It is possible that a divisive transaction can qualify 
for section 355, but corporate level tax can nevertheless be triggered 
---------------------------------------------------------------------------
under, for example, sections 355(d) and (e).

        EXAMPLE: USCO is a U.S. publicly traded corporation that wholly 
        owns all of the stock of USSUB, a domestic subsidiary. USCO has 
        a $10 tax basis in USSUB. USSUB is worth $100. USCO distributes 
        all of the stock in USSUB to its shareholders in a transaction 
        that satisfies section 355 in 2017. Later, in 2017, an 
        unrelated corporation (``XYZCO'') acquires all of the stock of 
        USSUB in a transaction that runs afoul of section 355(e). The 
        distribution remains tax-deferred to the shareholders, but USCO 
        must recognize a $90 gain.

    Presumably, a DPD would be denied in the foregoing example or else 
USCO would be somewhat ambivalent about complying with section 355(e).
                            vii. conclusion
    Thank you again for the opportunity to testify on tax reform and 
corporate integration. I am happy to answer any questions.

                                 ______
                                 
Prepared Statement of Alvin C. Warren, Jr., Ropes and Gray Professor of 
              Law, Harvard Law School, Harvard University
    Chairman Hatch, Ranking Member Wyden, and members of the committee, 
thank you for inviting me to testify today on the treatment of 
corporate debt and equity under proposals to integrate the individual 
and corporate income taxes.\1\ I would like to emphasize three points: 
(1) current law creates significant distortions between debt and equity 
finance for U.S. companies, (2) integration could substantially reduce 
or eliminate those distortions, but (3) reduction of those distortions 
requires careful attention to other discontinuities under current law, 
such as the taxation of investment income of exempt entities, including 
retirement plans.
---------------------------------------------------------------------------
    \1\ I appear on my own behalf. This statement does not purport to 
represent the views of any institution with which I am affiliated. In 
preparing this testimony, I have drawn freely on my previous writings 
on the subject.

                             1. current law
    The United States has long had a ``classical'' income tax system, 
under which income is taxed to corporations and to shareholders as 
distinct taxpayers. Interest paid to suppliers of corporate debt 
capital is deductible by the corporation, but dividends paid to 
shareholders are not. Taxable income earned by a corporation and then 
distributed to individual shareholders as a dividend is thus taxed 
twice, once to the corporation, and again to the shareholder on receipt 
of the dividend. As a result, the current regime is often characterized 
as a ``double tax'' system.

    The actual U.S. tax system is considerably more complex. For 
example, some income earned through corporate enterprise is taxed only 
once, at the corporate level. This is the result for corporate taxable 
income distributed as dividends to tax-
exempt shareholders, such as pension funds and charitable endowments. 
Other income earned through corporate enterprise is taxed only once, at 
the investor level. This occurs when corporate earnings are distributed 
as deductible interest payments to taxable debtholders. Finally, some 
income earned through corporate enterprise is not taxed in the United 
States at either the corporate or investor level. This is the result 
for deductible interest paid to certain foreign and tax-exempt holders 
of U.S. corporate debt. Accordingly, domestic corporate income is 
sometimes taxed twice in the United States, sometimes once, and 
sometimes not at all.

    This system creates many financial and economic distortions, which 
can include (1) a disincentive for investment in new corporate capital, 
(2) an incentive for corporate financing by debt or retained earnings, 
(3) an incentive to retain (or distribute) corporate earnings, and (4) 
an incentive to distribute corporate earnings in tax-preferred forms. 
The extent and direction of these distortions depend on the 
relationship of four tax rates: the rate on corporate income, the rate 
on individual investment income, the rate on dividend receipts, and the 
rate on the sale of corporate shares. The U.S. rate of tax on corporate 
income is currently significantly higher than in many other major 
economies, which creates incentives to shift income abroad, including 
by converting U.S. companies into foreign entities.

    This hearing is focused on distortion, particularly the tax 
preference for corporate debt over equity. Economists tend to emphasize 
the deleterious economic consequences of the distortion, such as the 
difficulties faced by highly leveraged companies in economic downturns. 
Lawyers tend to emphasize the wasteful transactional costs of designing 
complex financial instruments to fall on one side or the other of the 
fuzzy border between debt and equity.
                  2. integration by shareholder credit
    How would integration of the individual and corporate taxes reduce 
or eliminate the tax preference for corporate debt? Consider first 
shareholder-credit integration. Under this approach, the corporate tax 
would be converted into a withholding tax that is creditable against 
the shareholder tax due on dividends.

    By way of example, assume that the corporate tax rate is 35% and 
dividends are taxed as ordinary income. A company that earns $100 of 
income would pay $35 in corporate tax, leaving $65 for distribution as 
a dividend. Assume now that the $65 cash dividend is paid to a domestic 
shareholder whose individual tax rate is 20%, 25% or 40%. Individual 
shareholders would include $100 in their taxable income (just as 
employees include pre-withholding wages in income), apply their normal 
tax rate, and, assuming that the credit is refundable, offset the 
resulting tax by a credit for the $35 corporate tax (just as employees 
receive a credit for taxes withheld by their employers).

    As shown in Table 1 below,\2\ the ultimate tax burden would be the 
same as if the shareholders had earned the business income directly.
---------------------------------------------------------------------------
    \2\ Example 1 is taken from Michael J. Graetz and Alvin C. Warren, 
Integration of Corporate and Shareholder Taxes, National Tax Journal 
(forthcoming, 2016), current version: http://ssrn.com/abstract=2780490.


 Table 1. Shareholder-Credit Integration  $65 Cash Dividend Out of $100
            Corporate Income After $35 Corporate Tax Payment
------------------------------------------------------------------------
           Shareholder tax rate                20%       25%       40%
------------------------------------------------------------------------
1. Shareholders' taxable income                 100       100       100
------------------------------------------------------------------------
2. Initial tax                                   20        25        40
------------------------------------------------------------------------
3. Tax credit (35%  line 1)             35        35        35
------------------------------------------------------------------------
4. Final tax or refund (line 2 - line 3)        -15       -10         5
------------------------------------------------------------------------
5. Net shareholder cash ($65 - line 4)           80        75        60
------------------------------------------------------------------------


    As this example illustrates, a refundable shareholder credit would 
incorporate the entity-level business tax into the graduated individual 
income tax. The resulting integration of the two taxes would advance 
the goal of ultimately taxing income, from whatever source derived, at 
an individual's personal tax rate. As corporate interest payments are 
currently so taxed, shareholder-credit integration could reduce or 
eliminate the differential treatment of corporate debt and equity under 
current law.

    The system illustrated in Table 1 has been used in many major 
economies and was recommended for the U.S. in a 1993 study of the 
American Law Institute.\3\
---------------------------------------------------------------------------
    \3\ Alvin C. Warren, ``Reporter's Study of Corporate Tax 
Integration'' (American Law Institute), reprinted in Michael J. Graetz 
and Alvin C. Warren, Integration of the U.S. Corporate and Individual 
Income Taxes: The Treasury Department and American Law Institute 
Reports (Tax Analysts, 1998; Amazon.com e-book, 2014).
---------------------------------------------------------------------------
          3. integration by dividend deduction and withholding
    The committee staff has been developing a related proposal for the 
chairman.\4\ Under this approach, corporations would deduct dividend 
payments and withhold a shareholder tax on those payments. The result 
can be similar or identical to shareholder-credit integration, because 
the withholding tax and credit function similarly to a shareholder 
credit for corporate taxes. Table 2 provides an example of identical 
cash flows under the two approaches, assuming a corporate and 
withholding tax rate of 35%.\5\
---------------------------------------------------------------------------
    \4\ U.S. Senate, Committee on Finance, The Business Income Tax--
Bipartisan Tax Working Group Report (July 2015); U.S. Senate, Committee 
on Finance, Republican Staff, Comprehensive Tax Reform for 2015 and 
Beyond (December 2014).
    \5\ Example 2 is taken from Graetz and Warren, supra note 2. For 
similar examples, see Warren, supra note 2 at 54-55; U.S. Senate, 
Committee on Finance (2014), supra note 4 at 202-203.


  Table 2. Comparison of Present Law, Shareholder Credit, and Dividend
            Deduction  With Withholding Cash Dividend of $30
  Assumptions: Corporate and withholding tax rates are 35%. Shareholder
 tax rate is 20% under current law and 40% with a shareholder credit or
 dividend deduction. The corporation receives $100 in taxable income and
  pays a cash dividend of $30 (i.e., a dividend that reduces corporate
           cash by $30 and increases shareholder cash by $30).
------------------------------------------------------------------------
                                                              Dividend
                                                              deduction
           Taxpayer              Present Law   Imputation        and
                                                 credit      withholding
                                                                 tax
------------------------------------------------------------------------
CORPORATION
1. Taxable income before            $100.00       $100.00       $100.00
 dividend
2. Corporate tax before              $35.00        $35.00        $35.00
 dividend
3. Corporate cash before             $65.00        $65.00        $65.00
 dividend
4. Declared dividend                 $30.00        $30.00        $46.15
5. Corporate tax to be imputed           NA        $16.15            NA
 to shareholder (35/65  line 4)
6. Dividend withholding (35%             NA            NA        $16.15
  line 4)
7. Tax reduction due to                  NA            NA        $16.15
 dividend deduction (35%
  line 4)
8. Total corporate tax (line 2       $35.00        $35.00        $18.85
 - line 7)
9. Remaining corporate cash          $35.00        $35.00        $35.00
 (line 3 - line 4 + line 7)
10. Reduction in corporate           $30.00        $30.00        $30.00
 cash (line 3 - line 9)
11. Effective corporate tax             35%           35%        18.85%
 rate* (line 8/line 1)
 
U.S. SHAREHOLDER
12. Cash dividend (line 4 -          $30.00        $30.00        $30.00
 line 6)
13. Taxable dividend (line 4 +       $30.00        $46.15        $46.15
 line 5)
14. Shareholder tax before            $6.00        $18.46        $18.46
 imputation or withholding
 credit
15. Imputation or withholding             0        $16.15        $16.15
 credit (line 5 or 6)
16. Net shareholder tax (line         $6.00         $2.31         $2.31
 14 - line 15)
17. Net shareholder cash (line       $24.00        $27.69        $27.69
 12 - line 16)
 
COMBINED CORPORATE AND
 SHAREHOLDER TAXES
18. Total tax (line 6 + line 8       $41.00        $37.31        $37.31
 + line 16)
19. Corporate tax on                 $16.15        $16.15             0
 distributed income [(35/65 x
 line 10) - line 7]
20. Shareholder tax on                $6.00         $2.31        $18.46
 distributed income (line 16 +
 line 6)
21. Total tax on distributed         $22.15        $18.46        $18.46
 income (line 19 + line 20)
22. Pre-tax distributed income       $46.15        $46.15        $46.15
 (line 10/.65)
23. Total effective tax rate            48%           40%           40%
 on distributed income * (line
 21/line 22)
------------------------------------------------------------------------
* Assumes book and taxable income are the same


    As Table 2 illustrates, identical cash flows can be reached under a 
shareholder credit and a dividend deduction with withholding. There 
are, however, important differences in the characterization of those 
results. The declared dividend under the deduction in Table 2 is 
higher, because it includes the withholding tax of $16.15. As compared 
to the shareholder credit, the dividend deduction reduces the 
``corporate'' tax to $18.85. If the accounting authorities agreed with 
that characterization, the company's effective tax rate would be 18.85% 
(assuming that book income also equals $100), rather than 35% under the 
shareholder credit. In both cases, the government receives total 
payments from the corporation of $35 and a total 40% tax on the 
distributed earnings, but, as shown in lines 6, 16 and 19, those 
amounts are classified differently, as among corporate, withholding, 
and shareholder taxes.

    This example shows that a corporation may achieve results 
equivalent to a shareholder credit if it increases its declared 
dividend by the amount of withheld taxes. Most importantly for our 
subject today, a dividend deduction would eliminate the current 
preference for corporate debt due to the deduction for interest 
payments. Given the proposed withholding tax on dividends, a new 
distinction between debt and equity could be eliminated by extending 
withholding to payments of interest.
  4. interrelated design issues, particularly with respect to exempt 
                                entities
    As illustrated in the foregoing examples, the tax preference for 
debt over equity finance could be eliminated or substantially reduced 
under integration. The real world is, of course, much more complicated 
than these examples, so a number of important design issues would have 
to be addressed, including the treatment of corporate income that has 
not borne U.S. corporate tax, retained earnings, tax-exempt 
shareholders (including retirement accounts), foreign income, foreign 
shareholders, and distributions other than dividends (such as share 
repurchases). Substantial work has already been done on these issues, 
many of which are interrelated.

    Given its importance, I want to focus here on the relationship 
between eliminating the corporate debt bias of current law and the 
taxation of exempt entities, particularly retirement accounts. To 
clarify the discussion, I would like to make a distinction between the 
absolute tax burden and the relative tax advantage of exempt entities 
relating to their corporate investments.
a. Absolute Tax Burden
    By absolute tax burden, I mean simply the total taxes due on income 
ultimately realized by an exempt entity from its corporate investments. 
As indicated above, current law imposes a tax at the company level on 
dividends out of corporate taxable income, but no tax on interest 
payments out of corporate income. As exempt investors pay no tax in 
either case, the result is a discontinuity not only at the corporate 
level, but also at the investor level. We cannot eliminate the first 
discontinuity without affecting the second.

    Suppose, for example, we adopted a shareholder credit (as in Table 
1) that was refundable to exempt shareholders. That form of integration 
would decrease the absolute tax burden on corporate income distributed 
to exempt investors, because dividends would now be burdened by a tax 
at neither the corporate nor the investor level. Now suppose we adopted 
a dividend deduction with withholding at the corporate tax rate (as in 
Table 2). If the dividend withholding were nonrefundable, the amount an 
exempt entity would receive from a dividend out of corporate taxable 
income would neither increase nor decrease. Further suppose that we 
adopted nonrefundable withholding on corporate payments of interest as 
well as dividends. Assuming first that such interest payments were not 
increased to reflect the new withholding tax, that tax would increase 
the absolute burden on corporate income distributed to exempts. Now 
assume that competitive pressure from other sources of interest on 
which there was no withholding induced corporations to increase 
interest payments, so that investors received the same net amount they 
had received without the withholding tax. That result would effectively 
increase corporate-level taxes, while leaving unchanged the amount of 
interest received by exempt entities

    Finally, suppose that we wanted to eliminate the debt-equity 
distortions of current law without increasing or decreasing the overall 
absolute tax burden on exempt entities. Nearly 40 years ago, the 
Assistant Secretary of the Treasury for Tax Policy raised this issue 
using a paradoxical question: ``at what rate of tax are tax-exempts tax 
exempt?'' \6\
---------------------------------------------------------------------------
    \6\ Statement of Acting Assistant Secretary of the Treasury for Tax 
Policy Donald C. Lubick, The President's 1978 Tax Reduction and Reform 
Proposals: Hearings Before the House Committee on Ways and Means, 95th 
Congress, 2d Session at 6254 (1978).

    One approach would be to determine the corporate taxes paid on 
dividends to exempt entities and then to enact an explicit tax on their 
income from corporate investments, against which corporate taxes (or 
withholding) would be creditable and refundable. The level of the new 
tax could be set to maintain, decrease or increase the current tax 
burden on corporate income received by exempt entities. In 1992, the 
Treasury estimated that such a tax in the range of 6% to 8% would 
approximate the then current corporate tax on dividends paid to exempt 
entities.\7\ This general approach, which was recommended in the 1993 
American Law Institute study, has the advantage of minimizing tax 
differentials. Some would say it has the disadvantage of recognizing 
explicitly the rate of tax at which tax-exempts are taxed on their 
investment income.
---------------------------------------------------------------------------
    \7\ U.S. Treasury Department, ``Integration of the Individual and 
Corporate Tax Systems: Taxing Business Income Once,'' at 71 (1992), 
reprinted in Michael J. Graetz and Alvin C. Warren, Integration of the 
U.S. Corporate and Individual Income Taxes: The Treasury Department and 
American Law Institute Reports (Tax Analysts, 1998; Amazon.com e-book, 
2014).

    The foregoing discussion suggests that the method chosen to reduce 
the corporate-level distortion between debt and equity could have 
significant effects on the taxation of exempt entities, including tax-
preferred retirement accounts. Given the important role played by tax-
preferred accounts in the Nation's savings, it is therefore crucial 
that careful attention be paid to the effects of integration on the 
absolute tax burden on retirement savings to achieve whatever results 
are considered appropriate for such savings.
b. Relative Tax Advantage
    Even if there is no increase in the absolute tax burden of exempts, 
integration might affect their relative tax advantage. Consider again a 
dividend deduction with nonrefundable withholding at the corporate tax 
rate. Cash dividends paid out of corporate taxable income to a 
qualified retirement account would neither decrease or increase if 
dividends were grossed-up to reflect the deduction (as shown in Table 
2). On the other hand, after-tax amounts from dividends received by 
taxable shareholders could increase, because the credit could eliminate 
or reduce the additional investor-level tax due under current law. For 
example, a shareholder whose tax rate on dividends did not exceed the 
corporate rate would no longer owe any investor-level tax.

    Should the resulting reduction in the relative advantage of 
investing through a qualified account be considered a defect of 
integration in such a case? Assuming tax rates do not change, the key 
advantage of qualified retirement accounts is that investment income 
compounds at a zero rate of tax. (This is the well-known present-value 
equivalence of qualified accounts and Roth IRAs).\8\ The relative 
advantage of compounding at a zero rate of tax (or any other preferred 
rate) necessarily declines if the tax burden on investments outside 
qualified accounts goes down. In my view, the resulting decline in the 
relative tax advantage of tax-preferred accounts should not be regarded 
as a reason to oppose a reduction in taxes on other forms of saving. 
The logic of such opposition would lead to supporting the highest 
possible tax rate for investment income outside qualified retirement 
accounts.
---------------------------------------------------------------------------
    \8\ See e.g., Michael J. Graetz and Deborah H. Schenk, Federal 
Income Taxation: Principles and Policies 275-281, 696 (7th edition, 
2013).

    By the same token, the fact that an integration structure could 
reduce taxes for investments outside qualified accounts, while holding 
constant the absolute tax burden inside retirement accounts, should not 
be considered a defect. The policy of encouraging retirement saving 
through tax-preferred accounts should not require opposition to 
reducing taxes on other forms of saving.
                             5. conclusions
    Integration, whether by shareholder credit or a dividend deduction 
with withholding, could substantially reduce many distortions and 
problems of current law (including certain international problems, 
which are not the subject of today's hearing). In particular, 
integration could reduce or eliminate important distortions caused by 
differences in the taxation of corporate debt and equity. Any 
integration proposal should, however, be carefully crafted to achieve 
the desired results regarding the absolute tax burden on income earned 
by exempt entities (including retirement accounts) from their 
investment in corporate debt and equity.

                                 ______
                                 
                 Prepared Statement of Hon. Ron Wyden, 
                       a U.S. Senator From Oregon
    One of the biggest challenges in tax reform is figuring out the 
right ways to slash the thicket of tax rules that today have too much 
influence over our economy.

    Democrats and Republicans, in my view, share the goal of getting 
the tax code out of the businesses of picking economic winners and 
losers.

    That's why I've put forward proposals for a technology-neutral 
energy tax policy that cuts energy subsidies in half, a simpler set of 
depreciation rules that ends the expensing headaches for small 
businesses, and closing the loopholes on financial tricksters who want 
to rip off the system at the expense of middle-class taxpayers.

    Another major question is how tax reform should unwind the code's 
bias in favor of taking on debt. For businesses, this issue is all 
about how you're going to finance investment, growth, and hiring.

    Maybe you've designed a new product line and you need to build a 
facility to produce it. Maybe you need to put up new cell towers with 
the latest technology. Or maybe your firm is ready to launch a west-
coast branch and hire a new team, and you've made just the right 
decision: you're setting up shop in Oregon.

    The question is whether you're going to finance those plans with 
debt by selling bonds, or with equity by selling stock. Today the tax 
code pushes businesses toward debt with a tax write-off for interest 
payments on the bonds they sell.

    Without any question, that has a big influence over our economy. On 
one hand, it makes bonds an attractive investment tool. But on the 
other hand, there are probably a lot of businesses with debt that they 
wouldn't have taken on if the tax code didn't encourage it.

    In my view, business decisions should be made for business reasons, 
not tax reasons. And I believe reducing the tax code's economic 
distortions is a bipartisan proposition when it comes to tax reform.

    Today the committee is continuing its examination of a proposal 
known as corporate integration, which is one strategy that has been put 
forward as a way to help limit the preference for debt. It would 
accomplish that by offering companies a write-off for dividend payments 
they make to their shareholders. Americans have questions about how 
you'd finance that tax cut, other than by withholding some amount from 
dividend and bond interest payments.

    This is a complicated area of tax policy, and any change would no 
doubt have big effects on our economy, so it's an important issue for 
the committee to dissect.

    I want to thank our witnesses for joining the committee here today, 
and I look forward to your testimony.

                                 ______
                                 

                             Communication

                              ----------                              


                      The Center for Fiscal Equity

                           237 Hannes Street

                        Silver Spring, MD 20901

               Comments for the Record by Michael Bindner

                      Senate Committee on Finance

        Debt Versus Equity: Corporate Integration Considerations

                         Tuesday, May 24, 2016

Chairman Hatch and Ranking Member Wyden, thank you for the opportunity 
to submit my comments on this topic, which are largely a restatement of 
our submission to a Joint Committee Hearing on July 13, 2011.

The main change to our comments is to our four-part tax reform 
proposal, which is as follows:

      A Value Added Tax (VAT) to fund domestic military spending and 
domestic discretionary spending with a rate between 10% and 13%, which 
makes sure very American pays something.
      Personal income surtaxes on joint and widowed filers with net 
annual incomes of $100,000 and single filers earning $50,000 per year 
to fund net interest payments, debt retirement, and overseas and 
strategic military spending and other international spending, with 
graduated rates between 5% and 25% in either 5% or 10% increments. 
Heirs would also pay taxes on distributions from estates, but not the 
assets themselves, with distributions from sales to a qualified ESOP 
continuing to be exempt.
      Employee contributions to Old-Age and Survivors Insurance (OASI) 
with a lower income cap, which allows for lower payment levels to 
wealthier retirees without making bend points more progressive.
      A VAT-like Net Business Receipts Tax (NBRT), essentially a 
subtraction VAT with additional tax expenditures for family support, 
health care and the private delivery of governmental services, to fund 
entitlement spending and replace income tax filing for most people 
(including people who file without paying), the corporate income tax, 
business tax filing through individual income taxes and the employer 
contribution to OASI, all payroll taxes for hospital insurance, 
disability insurance, unemployment insurance and survivors under age 
60.

We preface our analysis by noting that debt and equity are not taxed, 
per se. Instead, the interest on debt is taxed as income to the lender 
and their depositors or investors and is considered an expense to those 
who incur it for the purchase of capital or for home financing while 
dividends are taxed rather than equity. Indeed, equity cannot be 
federally taxed--only the dividend income earned as a result of holding 
such equity. State governments can, of course, tax equity under 
personal property tax provisions and it could potentially be taxed 
under a state level Equity Value Tax, which would operate on the same 
principal as a Land Value Tax on economic rent.

Two perspectives on taxing interest and dividends are important to 
note--the perspective of the producer/business owner and the 
perspective of the consumer. Identifying both points of view is 
essential to any analysis of the economic and equity impacts of tax 
reform on interest and dividend taxation.

Under the VAT and NBRT elements of our proposal, interest paid would 
continue to be an expense while increases to equity would be considered 
a result of adding value and therefore subject to tax, whether paid out 
in dividends or not. The equity itself, however, is not taxed--rather 
the income which grows income is.

Under VAT and NBRT regimes, labor is also taxed while interest paid is 
not, however the return on equity and labor would ideally be taxed at 
the same rate--rather than taxing dividends at either a higher or lower 
rate than income, depending on the tax bracket of the taxpayer and 
their primary source of income.

An advantage to both VAT and NERT is that they are potentially much 
simpler with regard to the tax treatment of interest expenses than the 
current personal and corporate income tax systems, although that 
simplicity is as much a function of how the tax laws are written as the 
inherent nature of these taxes.

Under our proposals, wages, interest income, and dividend income for 
most households would not be taxed directly. In order to facilitate the 
payment of VAT, net income would increase by the same percentage as the 
VAT plus any adjustment due to receipt of refundable Child Tax Credits 
through NBRT, while gross income would decline to Net Income plus OASI 
taxes and for high income individuals and families, continued income 
surtax withholding.

For most families, taxation would occur through consumption rather than 
through wages. The loss of gross income would be for wages which were 
never paid anyway, as the responsibility for being an object of 
taxation shifts from the employee to the employer. Of course, 
economically, the consumer is the already the ultimate funder of all 
income taxes currently paid by both labor and capital under the current 
system.

There is extensive literature already in existence on the tax treatment 
of interest income to financial services firms. We will leave review 
and comment of this highly technical literature to those who are expert 
in it, as we believe it is beyond the purposes of this hearing. Such 
issues are important to consider when implementing legislation and 
regulation are in the drafting stage--and we surmise that this debate 
is nowhere near that point.

OASI contributions have no impact on the question of interest and 
dividends unless personal accounts are included as a feature. Whether 
such accounts are on the Cato Institute model, with diversified 
investment, or our model with insured investment in the employing 
company, equity would largely replace debt and value added to equity 
would be taxed as income under VAT and NBRT rather than as interest 
income to the financial institution making the loan.

High-income individuals are more likely to be taxed both as consumers 
and as producers; however, their greater propensity to consume less of 
a percentage of income in any current period requires a separate 
surtax, especially if dividends are reinvested rather than spent and 
capital gains remain unrealized. In the short term, reinvestment or 
holding investments leaves this potential income outside the reach of 
taxation, creating real vertical equity issues that can only be 
resolved with the adoption of surtaxes on all income above a certain 
level.

Under our proposal, there would be no separate rate for interest, 
dividends, disbursements from inheritance or sale of inherited assets 
(unless the sale is to a qualified Employee Stock Ownership Plan), 
capital gains or wages. All income would be taxed at the same rate. For 
high income tax payers, all income is fungible. It matters not whether 
it comes from dividends or from interest on deposits loaned out to 
firms who pursue debt finance rather than equity finance.

We propose graduated rates from the $100,000 per year income level to 
the $550,000 per year level, as it is no more complicated to look up 
tax due on a tax table for graduated rates than for a single rate, so 
tax simplification concerns provide no justification for abandoning 
graduated tax rates. Indeed, such rates are necessary to compensate for 
the fact that at higher levels, families are more likely to defer 
spending for decades, if not generations, and may attempt to avoid 
taxation permanently. While in the long term, all income must 
eventually be spent to have any value, in the short term there are 
serious equity concerns from not taxing high income individuals at a 
higher rate because they are less likely to consume within a given 
period.

Without high-income surtaxes, the pool of potential investment becomes 
more and more concentrated until the vast majority of the population is 
reduced to wage slavery alone. Indeed, the lowering of tax rates in the 
last three decades has produced such a result, with productivity gains 
going to an ever shrinking high income population at the top of the 
income distribution, while most workers see income levels rise only by 
the rate of inflation, even when they are the source of the increased 
productivity that is growing the economy.

Drawing this distinction is much more important than the impact of tax 
reform on debt finance versus equity finance.

Thank you for this opportunity to share these ideas with the committee.

                                  [all]