There is a prevailing assumption that, in the name of profit, shareholders do not want their corporations to pay taxes. It’s easy to see how less taxes should mean more money in their pockets, but it turns out that’s a common, but understandable, misconception.
Contrary to this belief, shareholders (people who have invested money in a company in exchange for a share of ownership) sometimes prefer that their companies pay taxes to maximize cash flow. But how can this be? Catch current news on offshore tax regimescreative tax planning and businesses cut their taxes, for example. These stories all seem to imply that lower taxes mean higher cash flow for companies and shareholders.
Turns out that’s not always true. Some incentives, such as shareholder credits that reduce the amount of tax owed on dividends, to encourage shareholders prefer their companies to pay the standard tax they owe – not lower tax – to ensure higher cash flow.
A brief overview
Some countries around the world, such as Australia and Canada, operate what is called an “integrated tax system”. This means that corporate income and personal income are taxed only once, together, as money flows from the corporation to the shareholder. Other countries, such as the United States, do not integrate corporate and personal taxes, which results in double taxation where corporations and individuals end up paying twice the tax on the same income.
Let’s take a closer look at why this matters.
Imagine three people: Person A is an employee, Person B operates an unincorporated business, and Person C is the sole shareholder of a corporation. Each of these cases generates an income of $100,000 for the same type of work. It makes sense that because the economic activity is the same, the taxes ultimately are the same. It doesn’t matter who you are or how you organize your professional life.
But because Person C and his corporation pay taxes separately, it may change which of the three people you prefer to be. To fix this, we need a way to account for the difference in taxes each person pays. Integrated tax systems are designed to do just that, ensuring that all three people are taxed the same amount.
Integration in action
Now let’s see how it works for the shareholder.
Shareholders pay taxes on the dividends they receive from a company. Dividend payments are monetary rewards shareholders receive for investing in a company. To achieve tax consolidation, shareholders include their share of the company’s pre-tax income (also called dividend) in their individual taxable income as a dividend. The tax is then calculated and shareholders can reduce their tax liability with a credit for the taxes the company has already paid.
My colleagues and me developed a digital illustration to show the incentive this system creates. Shareholders want the company to pay taxes and avoid spending money on expensive tax planning. the valuable tax credits shareholders wanting their companies to pay taxes, rather than paying for tax planning to reduce taxes, all in the name of greater after-tax cash flow for shareholders.
Next, let’s take this illustration in the real world.
In our study, we used a set of European countries that eliminated their integration systems, mainly in the mid-2000s. We compared these “eliminator” countries to other countries that did not change their tax policy and found that removing credits also removes tax incentives. After the change, corporations in these countries engaged in much greater tax planning to reduce the standard tax they owed.
Why? In the new tax system without integration, income could be taxed twice as it is transferred from the company to the shareholder. So, to maximize shareholder cash flow, the new incentive was to minimize the amount of corporate income that was initially taxed.
In short, shareholders may prefer that their corporations pay taxes. But don’t go overboard – no silver bullet exists to kill taxpayers’ inherent preference to minimize taxes.
Our research has also shown that other important factors can limit the attractiveness of the credit incentive for shareholders. The more a company operates in foreign jurisdictions (which do not offer credits), the less credits it generates and the more the shareholders are dispersed. This results in a lower incentive to generate shareholder credit with higher corporate taxes.
In each of these cases, shareholders would prefer that the company minimize its taxes. Nevertheless, an integrated tax system with its shareholder credits may well change the way you, I or governments think about tax incentives for shareholders. Typical shareholders want more cash and they will do anything, including paying more taxes, to get it.
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