Cash Management

Excludable and Deemed Dividends: The Skinny

Confused by Pres. Bush's proposal to end double taxation on dividends? Here are the basics.
Craig SchneiderFebruary 9, 2003

Many CFOs and treasurers are just starting to come to grips with the true complexities of Pres. Bush’s proposal to end double taxation on dividends. And it’s not a moment too soon.

Considering that the proposal may look very different once through Congress, finance executives that take their sweet time digesting the tax terminology and nuances risk being even further behind if and when the proposal finally passes.

For starters, consider what’s at the heart of the President’s plan: excludable dividend accounts. Managers will need to calculate and know their EDA because it is the amount in tax-excludable dividends that a company can distribute to shareholders.

Moreover, the EDA — calculated with a specific EDA formula — is determined in part by how much (or little) the company has paid in income tax on its earnings. The EDA therefore would be non-existent for businesses such as Tyco International, which have incorporated in offshore tax shelters. Companies would also have lower EDAs if they already take tax deductions on R&D expense, for instance.

Of course, lower is a relative term. Microsoft — which has budgeted $4 billion in R&D expense this year — had an EDA of $2.1 billion last year, according to Robert Willens, Lehman Brothers’ tax and accounting analyst. That figure gives management plenty of growing room to increase its recently announced dividend payout, which is costing the company $850 million in 2003.

Taking those figures one step further, the $1.25 billion difference between Microsoft’s EDA and its excludable dividends is what Bush’s proposal refers to as a deemed dividend. A deemed dividend allows companies to retain their earnings (the distributed phantom dividend is deemed reinvested) but still offer shareholders the benefit of a step-up in the cost basis of their stock shares.

Specifically, the step-up in the basis would allow investors to pay less in capital gains tax when shares are ultimately sold. So Microsoft’s shareholders would receive a step-up in basis consistent with their share of the $1.25 billion, on top of their regular 8-cent per share regular dividend.

Concurrently, if a company was excluded from issuing an excludable dividend or simply chose not to start a recurring cash dividend policy, the entirety of its EDA could be distributed to shareholders as a deemed dividend. Such revelations on deemed dividends have given pause to some experts like Willens.

Why? Having deemed dividends, he says, means that there’s not an acute need — at least from the management perspective — for boards of directors to institute any cash dividend because they can offer shareholders the alternative benefit.

Willens, for instance, proposes that companies may instead choose to buy back 2 percent of their stock, thereby shrinking EDA by that slight amount. (The EDA would otherwise take a larger hit if managers opted for an excludable dividend.) Rather, with the share repurchase, the company’s share price would theoretically rise because of the reduced shares outstanding, and the 98 percent left in the EDA could be used entirely for deemed dividends.

Will investors be disappointed that companies like Microsoft have a lower EDA than they thought — or think they’re bad corporate citizens because they’re not paying as much in taxes? Would the EDA change Microsoft’s way of operating, curbing their research spending because management does not want to reduce taxes unduly or be criticized? “I doubt it,” Willens says, answering both questions. “But maybe that’s something to think about.”