- The Dividend Received Deduction (DRD) is a corporate tax deduction necessary for triple taxation prevention. It is a federal tax deduction that is used to reduce dividend income from related entities.
- The corporate tax deduction can also be applied to foreign corporations. However, it does not apply to payments from real estate investment trusts (REITs), capital gains distributions from regulated investment companies, or similar entities.
- DRD rates in the US are subject to a range of 50-100% according to corporate taxation rules.
In this article, we will explain what the dividend received deduction is, and outline the circumstances in which a company is entitled to an income tax reduction.
Table of Contents
How the Dividend Received Deduction Works
The DRD meaning is to reduce the tax burden. The deduction percentage depends on the ownership percentage of the shares. According to the Tax Cuts and Jobs Act (TCJA), corporations receiving dividend income from a domestic payer are entitled to the following deduction tiers (DRD percentages):
- A 50% deduction is available if the company receiving the dividends owns fewer than 20% of the payer’s outstanding shares.
- A 65% deduction applies when the ownership percentage exceeds 20%.
- A 100% deduction is granted to affiliated group companies in which the taxpayer owns more than 80%, as well as to small business investment companies.
At the same time, the DRD deduction must not exceed the taxable income limits. However, this limit does not apply if a net operating loss has been recorded.
Note: when it comes to income from a foreign corporation, owning at least 10% of the shares is sufficient to qualify for a 100% deduction.
Qualification Criteria and Requirements
Frequently asked question: ‘What is DRD dividend, and what are the qualification criteria for it?’ It is important to note that different qualification criteria apply to dividend reduction deduction for both domestic and foreign corporations.
With regard to domestic corporations, the dividend deduction does not apply to payments from:
- tax-exempt entities under section 501 and section 521 of the Internal Revenue Code (taking into account the tax year in which the distribution was received and the previous year);
- common stock held for less than 46 days;
- preferred stock held for less than 91 days;
- debt financed distribution (i.e., dividends on shares purchased with borrowed funds).
A minimum 365-day holding period is established for 10%-owned foreign corporations. Only in this case can a 100% dividends-received deduction be obtained.
Types of Dividends Excluded from DRD
In addition to the categories mentioned in the previous section, the DRD’s corporate dividend exclusions also apply to capital gain dividends received from a regulated investment company.
Dividend exclusion also includes Real Estate Investment Trust (REIT) dividends and payments from other tax-exempt organizations. Foreign source portion dividends are also considered excluded dividends under these same criteria.
Triple Taxation Prevention and Economic Rationale
Frequently asked question: ‘What is the dividends received deduction, and what is the economic rationale behind this provision in the internal revenue code?’ The economic rationale for the DRD is to prevent triple taxation. It also aims for overall tax burden reduction. Now, let’s take a look at how dividend taxation works:
- Company N pays corporate income tax and distributes part of its profits to Company X in the form of dividends. Company X owns shares in Company N.
- Company X pays corporate income tax on its income, including that from N. This is followed by dividend flow-through.
- According to shareholder taxation rules, an individual investor receives dividends from Company X and pays federal income tax of up to 37% on this amount.
These multiple taxation layers make corporate structures economically inefficient. The corporate dividends received deduction rule was therefore introduced to address this issue.
Practical Examples and Calculations (100-120 words)
Let’s look at how to calculate DRD and its taxable income impact, as well as how to account for different deduction rules.
Affiliate dividends example:
A corporation owns 85% of Company X’s shares. Company X earns a net income of $2 million and makes a distribution of $1 million. The dividend received deduction percentages will be 100%. The DRD modified taxable income is $2 million.
20% ownership examples and the practical applications of deduction limitations example:
In conglomerate structures, company N owns 20% of company X’s shares and 20% of REIT’s shares. Company N incurs a loss of $250,000. It also receives a distribution from Company X totalling $300,000, as well as dividends from REIT totalling $200,000. The taxable income is $250,000 ($300,000 + $200,000 – $250,000).
The tax deduction does not apply to the income from REIT because the company paying it is tax-exempt. The maximum DRD for Company N is $195,000 (300 x 65%). Taking this into account, the taxable income drops to $55,000. There is no NOL. Therefore, the company receiving the dividends cannot utilize a tax deduction greater than 65% of the initial taxable income. This amounts to $162,500.
DRD calculation for joint venture dividends considering net operating losses example:
Corporation N owns 15% of the distributing corporation Z’s stocks. In the current tax year, Corporation N has incurred a loss of $250,000 and has received a distribution from Corporation Z amounting to $450,000. Its taxable income is $200,000. The DRD is $225,000 ($450,000 x 50%). Consequently, rather than generating taxable income, a loss of $25,000 is incurred. Therefore, the DRD limitation does not apply in this case.
Limitations and Special Considerations
As shown above, deduction limitations include taxable income limits. The quantity of tax advantages is also impacted by net operating loss (NOL). The detailed technical rules for the DRD are set out in IRS Publication 542 and the instructions for Form 1120 and Schedule C, both of which are issued by the Internal Revenue Service.
Another important consideration is that of small business investment companies. Regardless of their shareholding percentage, they may claim a 100% deduction.
Professional advice may be necessary to answer: ‘Are dividends tax deductible?’ This is because there are so many rules related to the DRD.
FAQ
Are dividends received tax deductible?
To avoid triple taxation, corporations distributing can reduce the tax on received dividends by meeting certain conditions. This rule does not apply to individual investors.
What is the dividend received deduction in the US?
This is a legislative provision that allows companies to reduce tax on dividend income. However, this only applies if the distributing corporation has paid corporate income tax.
How to compute dividend received deduction?
To calculate it, the ownership percentage of the company’s shares must be known and certain limitations related to the type of payer and the amount of taxable income of the dividend recipient must be considered.
What is 70 dividends received deduction?
In tax years beginning before December 31, 2017, companies could claim a 70% DRD if they owned less than 20% of the dividend payer’s stock. However, the introduction of the TCJA reduced this deduction to 50%.
The Bottom Line (40-60 words)
DRD benefits are an effective tool for dividend income optimization within inter-corporate investments. However, corporate tax planning is complex and involves many nuances. To qualify for DRD, it is essential to adhere strictly to all tax compliance and technical requirements. This issue requires professional guidance and should not be left to chance.
Article Sources
- Rumpf, D. (2011). “The dividends received deduction in the corporate income tax and cost of capital.” Working Papers 01/2011, German Council of Economic Experts. RePEc:zbw:svrwwp:012011
- Auerbach, A.J. & King, M.A. (1980). “Taxation, Portfolio Choice, and Debt-Equity Ratios: A General Equilibrium Model.” NBER Working Papers 0546, National Bureau of Economic Research, Inc.
- Feldstein, M. & Slemrod, J. (1980). “Personal Taxation, Portfolio Choice and The Effect of the Corporation Income Tax.” Journal of Political Economy, University of Chicago Press, vol. 88(5), pages 854-866.
- PwC Tax Services (2024). “Corporate Income Determination – Canada.” PricewaterhouseCoopers Tax Summaries, comprehensive analysis of dividend received deduction rules and applications.
