Bush's Tax Tornado

Will it force Corporate America to stop playing games with profits?

When George W. Bush rolled out his $674 billion economic package on Jan. 7, corporate finance officers sucked in their collective breath over the sweep of the program. CFOs knew that the centerpiece of his plan--eliminating individual taxes on dividends--could dramatically alter corporate behavior. Trouble is, they weren't sure how.

Today, many financial execs are still trying to gauge the impact of the dividend bombshell. Details released after the official unveiling revealed two crucial provisos. Not only would shareholders get a break on dividends but they would also be in line for a sweet new capital-gains tax cut on retained earnings. The catch: Nobody would get tax relief unless companies first paid income tax on their profits--an incentive for CFOs to pare back shelters. Suddenly, the Bush proposal has the potential to be the most far-reaching tax change for corporations since the landmark Tax Reform Act of 1986.

The White House hopes to build on the pressure corporate execs already feel to reduce debt and stop playing games with profits. Says Treasury Under Secretary Peter R. Fisher: "If we could find another reason to move [companies] off the earnings game, that's very positive."

The Bush foray has left CFOs facing uncertainty and tough decisions. Should they rely more on equity and less on debt to raise capital? Pay dividends or hang on to earnings? How aggressively should they shelter income? "This proposal is very powerful," says tax lawyer Ernest S. Christian. "But people are having trouble getting their minds around it."

Adding to the uncertainty: The plan will change as Congress debates it for months. Many political pros caution that dividend relief could ultimately be trimmed to 50% or less.

Still, the outlines of how corporate financing and tax strategies could change are clear. The plan lowers the aftertax cost of dividends, so some companies will issue more stock, rather than debt, to raise money. Associates say Federal Reserve Chairman Alan Greenspan thinks reduced corporate leverage will make companies--and the economy--less fragile. Ralph V. Whitworth, chairman of Apria Healthcare Group Inc. agrees: "Leverage goes down, leading to healthier balance sheets and fewer bankruptcies."

Companies also may opt to pay more dividends as shareholders push for tax-free payouts. John A. Edwardson, CEO of CDW Computer Centers Inc., a Vernon Hills (Ill.) marketer of high-tech gear, says he may begin paying dividends. "We'll talk to our largest shareholders, consider our future cash flows and capital needs."

Still, the impact on dividends may be muted. The tax break for capital gains on retained earnings could prove extremely generous, encouraging companies to hang on to profits rather than hike dividends.

In addition, many corporations would continue to use tax shelters, though the value of these devices could diminish. Even the more respectable tax breaks, such as the research-and-development tax credit, may be worth less because of the pressure to pay dividends. Finally, the balance of power between management and investors may tilt as shareholders get a clearer picture of the link between earnings and payouts.

Here's a closer look at how companies are likely to react to the Bush tax plan:

Will equity become king?

For many companies, the White House plan would make equity financing look a lot better relative to debt than it does today. The question is whether that will be enough to really tilt decision-making. Says Verizon Communications CFO Doreen A. Toben: "The President's bill may make using equity more attractive. However, we're not going to just start issuing more stock willy-nilly."

Although the tax treatment of dividends and interest will be more equal, debt would still have advantages. That's because companies could still write off borrowing costs, while investors would get the dividend tax break. Since companies pay higher rates than most investors, the corporate benefit is worth more.

Still, equity will have new allure. Because dividends will be tax-free, shareholders will be willing to pay more for stock, cutting companies' cost of raising capital. What's more, a business can slash dividends in tough times, but it can't do that with interest payments.

Cash won't disappear

Certainly, tax-free status will drive some companies to join the dividend club. "To the extent that we have cash we don't have a use for, we're going to look harder at dividends than before," says Alfred P. West Jr., CEO of SEI Investments Co. in Oaks, Pa., and chairman of the American Business Conference, which represents midsize companies.

Nevertheless, the capital-gains wrinkle will counterbalance those pressures. It provides a generous tax incentive for shareholders when companies retain earnings. That will please many fast-growing high-tech companies, which prefer to reinvest profits. "It's not going to cause the Microsofts to start distributing earnings," says Alan J. Auerbach, a tax economist at the University of California at Berkeley.

No end in sight for tax shelters

The White House says the plan should curb the explosion of shelters, which have helped increase the gap between book earnings and taxable earnings to a staggering $287 billion.

Currently, the use of shelters is a financial slam-dunk. A company lowers its tax bill, boosts reported earnings, and pumps up its stock. No one, except Uncle Sam, pays a price. The Bush plan would trim the benefits of shelters by requiring companies to make an explicit trade-off: If they avoid taxes, their shareholders will get socked with the bill. But if corporations do pay taxes, investors will enjoy tax breaks for both dividends and capital gains.

The proposal would also lower the value of more common corporate tax breaks, such as business purchases of municipal bonds, or the R&D credit, an outcome that has research-intensive drug and tech companies nervous. "This will water down the incentive for R&D," says Timothy M. McDonald, tax vice-president at Baxter International Inc.

Still, no one is predicting the death of shelters. Many companies would still be better off lowering their own tax bill, even if it means shareholders have to pay the tax on the dividends they receive. That's because half of all stock is held in tax-free accounts, such as pensions, and because many taxable shareholders prefer higher stock prices to dividends. Brookings Institution economist Peter R. Orszag, co-author of a new study of the proposal, says it "would not eliminate the incentive to shelter. It could reduce it only slightly."

Besides, Wall Street pros and accountants aren't about to close up shop. Even before the plan has been sent to Congress, they're already figuring how their corporate clients can game the new law. One potential gimmick: trading foreign tax credits. They're the only current tax break that would not reduce the ability of companies to pay tax-free dividends. Says Leslie B. Samuels, partner at law firm Cleary, Gottlieb, Steen & Hamilton: "If you can buy a foreign tax credit for 90 cents and get $1 back from the government, it's a good deal."

More scrutiny for management

While the plan won't eliminate tax shelters, it will make them more visible to shareholders. Investors will have a clearer view of the trade-offs corporations make in paying taxes, retaining earnings, and distributing profits through dividends. That will give investors new leverage to demand that companies either distribute earnings or explain why retaining them will boost shareholder value. For example, management will have to show how new capital investment will mean higher returns--or pay the price in falling equity values as investors vote with their feet.

Bush's dividend proposal has CFOs and tax experts wrestling with fundamental questions of corporate finance. He won't get all he wants, but the President is forcing corporate execs to begin rethinking their priorities. The nature of how they raise capital and pay taxes is shifting in ways no CFO would have imagined a few short weeks ago.

By Howard Gleckman and Rich Miller in Washington, with Joseph Weber and Michael Arndt in Chicago, Arlene Weintraub in Los Angeles, and bureau reports

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