Dividend Proposal Rattles Renewables - Energy companies initially embraced President Bush’s proposal to eliminate taxes on dividends, but some pulled back after reading the fine pr

Dividend Proposal Rattles Renewables | Norton Rose Fulbright

February 01, 2003 | By Keith Martin in Washington, DC

Energy companies initially embraced President Bush’s proposal to eliminate taxes on dividends, but some pulled back after reading the fine print.

The proposal has the potential to reduce the value of tax credits that the US government offers as an incentive to invest in windpower, geothermal, landfill gas, synfuel and other alternative energy projects.

It could also complicate some debt restructuring talks of merchant power companies.  The president asked Congress to limit the ability of companies with current net operating losses to use them as a carryback to recAnchorover taxes they paid the federal government in the past.  Under current law, such carrybacks are permitted for up to two years in the past.  Under the Bush proposal, losses could only be carried back one year.

News Coverage

News reports — including the first paragraph of this article — leave the impression that the president proposed eliminating taxes on dividends.  In fact what he proposed is more complicated.  Under current law, a corporation is taxed on its earnings and its shareholders are taxed again when the earnings are distributed as dividends.  The proposal is to tax corporate earnings only once.  Thus, to the extent a corporation pays taxes on its earnings, there would be no further tax collected from shareholders when the earnings are distributed as dividends.

This means that corporations would have less incentive in the future to invest in ways that the government encourages by offering tax credits.  All the corporation will have succeeded in doing by reducing its taxes is to shift the tax burden to its shareholders.

Here is how the plan would work.

Suppose a corporation earns $100.  It would normally pay $35 today in taxes and have $65 left over to distribute to its shareholders. (The US corporate income tax rate is 35%.) Under the Bush plan, the $65 could be distributed without shareholders having to pay any further taxes.

Each corporation would calculate the amount it can distribute tax free to shareholders by multiplying the federal income taxes it paid by 65/35ths.  Thus, a corporation that paid $35 in taxes would be allowed to pay up to $35 x 65/35 = $65 in tax-free dividends to its shareholders.

It gets more complicated.

The calculation would be done each year on January 1 to show how much a company could distribute in tax-free dividends during the coming year.  A corporation would start with the taxes it paid on a final tax return filed the year before.  Most US corporations file their federal income tax returns on September 15 reporting taxes owed for the previous year.  For example, a tax return filed on September 15, 2003 would reflect taxes owed for 2002.  Thus, a corporation would use the taxes it paid for 2002 on a return filed in 2003 to calculate the amount of dividends that it could pay tax free in 2004.

There is a two-year lag between when the taxes accrue and when tax-free dividends could be paid.  A corporation that paid $35 in taxes for 2002 could distribute $65 in tax-free dividends in 2004.

Many corporations retain earnings rather than pay dividends.  The Bush administration tried to make the proposal neutral.  If a corporation with $65 to distribute tax free in 2004 failed to distribute the full amount, then each shareholder would receive an equivalent benefit by increasing the basis in its shares at year end by the shortfall. 

Corporations would have to send each shareholder a Form 1099 at the end of the year.  The form would indicate the percentage of dividends that was tax free and how much the shareholder should adjust his stock basis as of the end of the year.  If — in a later year — the corporation distributed more than it was entitled to distribute in tax-free dividends — suppose it could have distributed $65 tax free but distributed $75 — then its shareholders would not be taxed on the additional $10.  Rather, they would have to reduce their stock bases by the $10 until the previous basis increases have been reversed.  Any dividends after that would be taxed.

No basis adjustments would be made in preferred shares that are limited as to dividends.

The president wants the plan to take effect retroactively to the start of 2003.  Corporations would calculate the amount they can distribute tax free during 2003 based on the taxes they paid for 2001.


Many economists like the proposal because it would help reduce some biases in the current tax system.  The US Treasury Department listed as one of the benefits that the proposal would reduce a bias toward corporate borrowing.  Since corporations can deduct interest paid on debt but not earnings paid out as dividends, corporations are more likely to borrow than raise equity.  Heavy corporate debt loads lead to more bankruptcies during economic downturns.

The Bush administration also appears to be hoping that the proposal will lead to a boost in stock prices, thereby helping the economy.  The newspaper columnist George Will called it an “exercise in mass psychotherapy.”

However, at the same time, the proposal would deal a body blow to low-income housing, wind farms, geothermal power plants, methane gas recovery from landfills and other projects that rely on government help in the form of tax credits to be economic.  In the typical wind farm, the sponsor essentially borrows against the value of the tax credits.  If the institutional equity market will have less interest in tax credits, then windpower developers may have a hard time financing their projects.  Many people worry that even if the proposal is not enacted, it will complicate financings this year while it is under debate in Congress.  Opponents of the proposal in Congress have been asking for examples of new construction projects that have been placed on hold because of the uncertainty created by the plan.

Corporations would have less incentive to invest in ways that reduce their taxes.  Congress enacted a 30% depreciation bonus as part of an economic stimulus bill in March last year.  This would have less value as a stimulus.

Opinions differed over the effect on the equipment leasing market.  More companies may find it advantageous to use lease financing for their projects because they will have less use for the accelerated depreciation or tax credits to which owners of equipment are entitled.  At first glance, this should also mean fewer potential lessors.  However, some argue that lessors are like addicts — they become addicted to the acceleration in earnings that they receive from use of lease accounting and must continue to do more leasing or suffer a dramatic dropoff in book earnings.

The proposal should make raising equity for corporations a little less expensive.  There is a debate among economists about whether and how much the proposal might lift share prices.  Higher share prices mean that a corporation can raise the same equity while offering fewer shares.

By the same token, if investors shift into the equity markets and away from debt, then corporate debt will be more expensive (unless corporations borrow commensurately less).  This could be a concern for issuers of floating-rate debt.

Interest rates on tax-exempt bonds can be expected to increase because the pool of investors interested in tax-free returns will have a competing instrument in which to invest.  This means that municipalities will have to pay more to attract the same amount of capital as before.  Roads, schools, hospitals and other public facilities can be expected to cost more.  Yields on municipal bond issues are measured as a percentage of the yields on Treasury bonds with comparable maturities.  By early February, the yields on 30-year investment-grade municipal bonds were roughly 95% of the yield on 30-year Treasury bonds.  Historical averages have been around 87%.  On 10-year municipal bonds, the ratio in early February was 88% compared to an historical average of 77.5%.  Some analysts attributed the higher yields to a record surge in new bond issues and said that the market was “concerned and confused” by the Bush dividend proposal, but that it had not yet affected rates.

The proposal could complicate any plans by companies that are losing money to get back cash from the US Treasury.  Under current law, a company with losses can use them to get a refund of any federal income taxes it paid up to two years in the past.  Under the proposal, losses in 2003 and later years could only be carried back one year.  Some merchant power companies had been counting on the ability to carry back losses up to two years as a way to inject money into restructuring talks.

Wall Street expects a revival of interest in participating preferred stock.  These are shares that entitle the holder to a certain amount in dividends before any distributions on the common shares and a preference at liquidation.  The shares are “participating” because the holder would also have a limited upside out of additional earnings.  Such shares would be more attractive because they would come close to an instrument that pays purely a tax-free return.  The reason for “participating” shares is that corporations stand a better chance of avoiding taxes in a recapitalization in which existing shareholders would be given both preferred shares and new common in place of their existing shares.

Any analysis of the effects of the dividend proposal is complicated by a number of factors.  The Bush administration is hoping that companies will have a greater incentive in the future to distribute their earnings as dividends rather than retain and reinvest them.  The proposal is a form of shareholder populism offered in the same spirit that drives Republican administrations to cut taxes in the belief that voters should decide how to spend their own money rather than have the government or corporations make decisions for them.  However, it is not clear how much pressure will be placed on corporations to pay tax-free dividends.  According to Standard & Poors, 58% of shares are held today by pension plans and other tax-exempt entities.  Even if there were pressure, corporate managers might have a perverse incentive to do things that reduce the “excludable dividend amount” as a way of easing the pressure on the company to distribute all its earnings.

Merchant power companies lack the cash to pay dividends.  Some have speculated that this might open up a larger gap between the “haves” and “have nots” in the power industry, as the regulated utilities that have historically paid dividends would benefit from a boost in their share prices while the merchant power companies are left farther behind.

Other Energy Proposals

Ironically, the Bush administration called on Congress in the same budget that includes the dividend proposal to enact several new tax credits of interest to the project finance community.

The president urged Congress to extend a section 45 tax credit for wind farms.  The credit is 1.8 cents a kWh for producing electricity from wind.  The credit can be claimed on the electricity output for the first 10 years after a project is placed in service.  Wind farms must be put into service by the end of 2003 to qualify under current law.  Bush asked Congress to extend this deadline by another two years through 2005.

He also proposed to allow the credit to be claimed on electricity produced by burning most types of biomass.  The exceptions — where the credit could not be claimed — would be power plants that burn old growth timber, wood waste incidental to pulp and paper production, municipal garbage, or post-consumer waste paper.

Under the Bush proposal, existing biomass power plants would also qualify — not just new plants built after the proposal is enacted — but only for three years of tax credits and then only at 60% of the normal rate.  This potential windfall should be taken into account by anyone refinancing or selling an existing project.

Existing coal-fired power plants that co-fire with biomass would also get a credit, but only for three years and then only at 30% of the normal rate.

Finally, the president proposed to let lessees of wind farms and biomass power plants claim section 45 credits, but only where the lease is signed after this change is enacted.  The wind industry has not been able to use lease financing for its projects in the past because such structures would result in loss of section 45 tax credits.

The president also called on Congress to extend the section 29 tax credit, but only for landfill gas.  This is a credit of $1.082 an mmBtu to induce Americans to look in unusual places for fuel.  Projects had to be in service by either the end of 1992 or by June 1998 — depending on the fuel — to qualify.  Under the Bush proposal, the credit could be claimed on gas from brand new collection systems or from expansion wells that are added to an existing collection system during the period 2003 through 2010.  However, landfills that are subject to new source performance standards that the US Environmental Protection Agency issued in 1996 would receive only 2/3rds of the normal credit.  This haircut would not apply until 2008 to older landfills at which any part of the collection system was in use before July 1998.  It would apply immediately at newer landfills.

The president also asked Congress — again — to enact a new tax credit for cogeneration facilities.  The credit would be 10% of the capital cost of the project.  Both the Clinton and Bush administrations have asked Congress repeatedly to enact this tax credit.  It passed both the House and Senate last year as part of a national energy bill, but failed to make it to the president’s desk.

Finally, the president asked Congress to extend a tax credit for producing ethanol and an exemption from federal excise taxes on gasoline sold with ethanol additives through 2010.  Both the tax credit and the exemption are currently set to expire in theory after 2007 but, because of a quirk in the law, they would actually expire earlier after September 2005.  Bush did not propose any change in the quirk that leads to earlier expiration.


The dividend proposal has been met with a less than enthusiastic reception in Congress.  However, it is too early to rule it out.  The president has only just started to lobby for it.  No one will really be able to gauge its prospects until mid- to late March when the House tax-writing committee is expected to “mark up” the president’s tax plan and send it to the full House for a vote.

The chairman of the House tax-writing committee, Bill Thomas (R.-California), said publicly that the plan is “complicated” and he wants to explore the effects in hearings in early March before deciding what do with it.  At the same time, he told lobbyists in private that its fate will be decided in the next few weeks by whether the Republicans on his committee take to it or not.  Lobbying of the 21 Republicans on the committee (not counting Thomas) is in high gear.

The dividend plan faces a tougher test in the Senate where Republicans have only a one-vote majority of 51-49.  Eight Republican Senators have said they have serious reservations about the plan, while only one Democrat appears on the fence and possibly ready to support it.  The chairman of the Senate tax-writing committee, Charles Grassley (R.-Iowa), appeared in comments to the press on February 5 almost to rule out putting the plan through his committee.  Grassley, who is already thinking about what package of tax proposals to submit to his committee, said, “I don’t have the luxury of saying I’ve got to have the dividend deduction.  The president is not going to get everything he wants.”

Meanwhile, low-income housing developers and alternative energy producers have been lobbying to revise the proposal to treat corporations as having paid taxes that are offset through use of tax credits.  Bush already proposed this approach for foreign tax credits, but not for any other credits.  US Treasury officials said such a change would gut their plan.

However, the administration acknowledges the need for transition rules.  Negotiations were underway about the scope of a possible transition rule as the NewsWire went to press.  It would be unfair for the government to have held out 10 years of tax credits as a carrot to prompt someone to build a wind farm — for example — and then to pull back the carrot after the company is only five years through the tax credits.

There have been five serious attempts in the past 30 years to put legislation through Congress to reduce the double tax on corporate earnings.  None of these proposals has ever gained much traction.  The problem is that the business lobby has always preferred other forms of tax relief.  Martin Sullivan, writing in Tax Notes magazine, said, “Perhaps dividend relief is like strawberry ice cream.  Few would complain if offered it, but most would prefer vanilla or chocolate.”

What distinguishes the latest effort is that Bush called for 100% relief from double taxation.  Past efforts have been more modest.  The big business trade associations were mobilizing in early February — spurred on by the Bush administration — to pressure Congress.

The politics of the plan are miserable.  Most US states link their income taxes to the federal definition of taxable income.  The dividend proposal would reduce state tax collections at a time when many states are already facing record budget deficits and are required by state constitutions to make either deep cuts in services or increase taxes to close the gap.  The US government revised its own budget forecasts in late January and is now also projecting record deficits well into the future — and the latest projections do not take into account the costs of war against Iraq or the economic stimulus plan itself.  The numbers have made many Republican members of Congress skittish.  The distributional effects also do not help in Congress.  One Arkansas Senator asked the incoming Treasury secretary at a hearing in early February how she can support a stimulus plan that spends nearly $400 billion of $665 billion in total on a dividend relief proposal that benefits few people in her state.  Eighty-two percent of Arkansas residents own no stock in corporations.

The main debate will play out this summer in the Senate.  The earliest real indication of the plan’s prospects will come in mid- to late March when the House tax-writing committee takes up the plan.  It may be as late as November before its fate is ultimately decided by Congress.

by Keith Martin, in Washington