Why do we tax corporations?
Don't recoil – this is a tough question. The natural response is to argue that corporations are big and wealthy and can afford to pay taxes. In other words, they can be taxed so they should be taxed.
However, at some point, corporate income must make its way to shareholders, which means a corporate tax results in the same source of income being taxed twice – once at the corporate level and once at the individual level. While there's nothing inherently wrong with taxing the same income in two places, it's more complicated than taxing income once, at its final destination.
Moreover, taxing income at the individual level is easy to justify with any one of a potpourri of theories. I'm a fan of the John Rawls-Ronald Dworkin justification that taxation acts as a sort of societal insurance for bad luck and things we can't control. Some are born poor, some are born brilliant, and some are born a Trudeau; these are fates we don't choose, and a progressive tax regime is a good way to ensure a good society for all. Income tax is easy to justify.
So why tax at the corporate level? This is the question addressed in a wonderful new paper published in CCH Taxes by David Levy, Kevin Jones and Nickolas Gianou of the U.S.-based law firm Skadden Arps (in the spirit of full disclosure, Nick is an old friend and a tremendous contact hitting first baseman).
The paper discusses the policy reasons for corporate taxes in the context of the recent debate in the United States over the tax treatment of real estate investment trusts. Though the tax rules that govern REITs are slightly different in Canada and the U.S., the underlying structure is similar: REITs do not pay taxes at the "entity" level, meaning that, unlike corporations, REITs are not taxed until income is distributed to investors. The catch is that REITs must deliver the vast majority of their taxable income from the real property to investors – 90 per cent in the U.S.
As REITs have started to behave more like traditional corporations – by investing in forms of "real property" such as computer servers and more actively managing properties – and as more corporations have spun off their real-estate assets into REITs, there has been a push to treat REITs as fancy tax-avoidance scams. The critique is that REITs are just corporations that are not subject to corporate taxes. In fact, the U.S. Congress recently passed legislation designed to curb corporation-to-REIT conversions.
Guided by Justice Holmes' dictum that we should understand the purpose and policy behind our laws, in their quest to discover the reason for the corporate tax, the authors look deep into the past to that bastion of civility and discourse: the U.S. Congress of 1909 and the origins of the U.S. corporate tax.
The Congress of 1909 disagreed with my (somewhat misleading) statement that there is little difference between taxing income at the corporate level and the shareholder level. Corporations could, and do, accumulate massive amounts of retained earnings. Retained earnings can be reinvested to help a corporation grow, and in the world of 1909, rapid corporate growth meant potential monopolies. The corporate tax represented a drain on retained earnings and was enacted as an anti-monopoly regulation.
Similarly, tax deferral was a great advantage to corporate managers. By deferring tax, managers could choose to pay when their tax burden would be lowest. As income tax rates increased in the U.S. in the early 20th century and corporate tax rates remained static, corporations increased their retained earnings. Eventually, the corporate tax was increased to solve the problem of corporate managers deferring tax by keeping it in the corporation.
These two policy rationales have important interpretive consequences – namely, entities that store income should be taxed as an entity, while entities that distribute income should be taxed at the individual level. In fact, entities that distribute income do the government's work for it by acting as a drain on retained corporate earnings and limiting the ability of corporations to grow into monopolies.
Instead of serving as a tax policy Rosetta Stone, this rationale was mostly ignored in subsequent regulatory and judicial rule-making. Early income-distributing entities such as REITs were taxed as corporations under something called the "corporate resemblance test," which sought to classify as corporations for tax purposes all legal entities that had similar characteristics to a corporation. However, the coporate resemblance test did not consider whether such a classification promoted the goals of the corporate tax.
In the 1960s, however, policy makers exempted REITs from the corporate tax in order to encourage pooled investment in real estate. While wealthy investors could set up real-estate partnerships that were generously treated by tax laws, without the REIT structure, less wealthy investors who wanted to invest in real estate were either boxed out of the market entirely or unable to diversify their real-estate portfolios – they simply didn't have enough wealth to invest directly, and corporate tax gobbled up the yield on corporate real-estate investments. Exempting REITs from taxation served a Bernie Sanders-style populist goal: opening up real-estate investment to the common man.
Tensions abound! By arguing that the goal of the corporate tax is to curtail retained earnings, the authors conclude that taxing REITs as corporations would undermine the initial policy goals of the corporate tax. Limiting the REIT structure today would further undermine the semi-populist rationale of encouraging the non-wealthy to invest in diversified real estate. REITs, as big and wealthy as they may be, augment the corporate tax, and taxing REITs would undermine the goals of our tax policy.
All that said, perhaps reinvestment of retained earnings is a fount of economic growth, REITs encourage over-investment in the real-estate sector, corporate taxes are too high, and REITs should therefore be taxed at the entity level. In any case, the questions are difficult, and the answers perhaps counterintuitive.
So here is an even more difficult question: Lots of things can be taxed, but what should we tax?
Adrian Myers is a lawyer at Torkin Manes LLP.