Intercorporate Dividends
What Are Intercorporate Dividends?
Intercorporate dividends are dividends received by a corporation from its ownership of shares in another corporation, which are often eligible for a special tax deduction to prevent triple taxation.
When an individual buys a stock and receives a dividend, they pay tax on it. But what happens when a corporation buys stock in another corporation? This creates a potential tax problem known as "triple taxation." 1. **Company A** earns a profit and pays corporate tax. 2. **Company A** pays a dividend to **Company B** (the shareholder). If fully taxed, Company B pays corporate tax on this income. 3. **Company B** pays a dividend to its individual shareholders, who pay personal income tax. To prevent the government from taking a slice at three different levels, tax codes (like the U.S. Internal Revenue Code) treat "intercorporate dividends" differently. They allow Company B to deduct a significant portion of the dividends received from its taxable income. This is known as the **Dividends Received Deduction (DRD)**.
Key Takeaways
- Intercorporate dividends refer to payouts one company receives from stock it owns in another company.
- These dividends are subject to the Dividends Received Deduction (DRD) in the U.S. tax code.
- The DRD exists to prevent "triple taxation" (tax on original profit, tax on dividend to Corp B, tax on dividend to shareholder).
- The deduction amount (50%, 65%, or 100%) depends on the percentage of ownership the receiving corporation holds.
- Corporations must hold the stock for a minimum holding period (usually 45 days) to qualify for the deduction.
- This tax treatment encourages corporate investment and the formation of subsidiary relationships.
How the Deduction Works
The tax break for intercorporate dividends is tiered based on how much of the paying company the receiving company owns. The logic is that higher ownership implies a closer business relationship (like a parent-subsidiary), which should not be penalized. Current U.S. Federal Rules (Subject to change): * **Less than 20% Ownership:** The corporation can deduct **50%** of the dividends received. This means only half the dividend is taxed. * **20% to 80% Ownership:** The corporation can deduct **65%** of the dividends. * **80% or More Ownership:** The corporation can deduct **100%** of the dividends. In this case, the dividend is effectively tax-free for the receiving corporation. To qualify, the receiving corporation must hold the stock for at least 45 days during the 91-day period surrounding the ex-dividend date. This prevents companies from buying stock just for the dividend and selling it immediately to game the tax system.
Strategic Implications
For corporate treasurers, intercorporate dividends make high-dividend stocks and preferred shares attractive places to park excess cash. For example, a corporation might choose to invest its spare cash in a high-yield preferred stock rather than a bond. The interest from the bond would be fully taxable at the corporate rate (21%). However, the dividend from the preferred stock would be 50% deductible, resulting in a much lower effective tax rate (e.g., 10.5%). This structural incentive helps explain why corporations are major buyers of preferred stock.
Real-World Example: Tax Calculation
Corporation X buys $1 million of stock in Corporation Y (less than 1% ownership). Corporation Y pays a $50,000 dividend to Corporation X. **Scenario A: Without DRD (Bond Interest)** If this $50,000 were interest income, Corporation X would pay the full corporate tax rate (assume 21%). Tax = $50,000 * 21% = $10,500. **Scenario B: With DRD (Intercorporate Dividend)** Because it owns less than 20%, Corporation X deducts 50% of the dividend. Taxable Income = $50,000 - ($50,000 * 50%) = $25,000. Tax = $25,000 * 21% = $5,250. **Result:** The effective tax rate on the dividend is only 10.5%, saving the company $5,250 compared to interest income.
Deduction Tiers
How ownership affects tax benefits.
| Ownership % | Deduction % | Taxable % | Relationship |
|---|---|---|---|
| < 20% | 50% | 50% | Portfolio Investment |
| 20% - 80% | 65% | 35% | Strategic Stake |
| > 80% | 100% | 0% | Parent/Subsidiary |
FAQs
Its primary purpose is to mitigate the effects of triple taxation. Without it, corporate profits would be taxed when earned, taxed again when moved to another corporation, and taxed a third time when paid to individual shareholders.
No. The Dividends Received Deduction (DRD) applies only to C corporations. Individuals pay tax on qualified dividends at the capital gains rate (0%, 15%, or 20%), which is already lower than the ordinary income rate to account for double taxation.
To qualify for the DRD, the corporation must hold the stock for more than 45 days during the 91-day period that begins 45 days before the ex-dividend date. This ensures the investment is genuine and not a short-term trade.
Generally, the standard DRD applies to dividends from domestic U.S. corporations. However, recent tax law changes (like the TCJA) introduced a 100% deduction for the foreign-source portion of dividends from specified 10%-owned foreign corporations to encourage repatriation of funds.
Corporations favor preferred stock because the dividends often qualify for the DRD. This makes the after-tax yield on preferred stock significantly higher for a corporate buyer than the after-tax yield on corporate bonds (where interest is fully taxable).
The Bottom Line
Intercorporate dividends are a crucial concept for corporate finance and tax planning. They refer to the dividends one corporation receives from investing in another. Due to the "Dividends Received Deduction" (DRD), these payments are taxed at a significantly lower rate than other forms of income, such as interest or capital gains. The tax code structures this benefit based on ownership: the more of a company you own, the less tax you pay on the dividends it sends you. For ownership over 80%, the tax is eliminated entirely. This encourages the efficient flow of capital between parent companies and subsidiaries. For corporate treasurers, it makes equity investments—particularly preferred stock—a tax-efficient vehicle for managing corporate cash reserves.
Related Terms
More in Tax Compliance & Rules
At a Glance
Key Takeaways
- Intercorporate dividends refer to payouts one company receives from stock it owns in another company.
- These dividends are subject to the Dividends Received Deduction (DRD) in the U.S. tax code.
- The DRD exists to prevent "triple taxation" (tax on original profit, tax on dividend to Corp B, tax on dividend to shareholder).
- The deduction amount (50%, 65%, or 100%) depends on the percentage of ownership the receiving corporation holds.