Dividends Received Deduction (DRD)

Definition

The Dividends Received Deduction (DRD) is a tax deduction applicable in certain jurisdictions that allows corporations to deduct a portion of dividends received from related entities. This deduction aims to alleviate the issue of triple taxation which might occur when earnings are taxed at the corporate level, then at the shareholder level as dividends, and then again in corporation’s hands. The percentage of dividend income that can be deducted depends on the corporation’s percentage of ownership in the paying corporation.

Phonetic

Dividends Received Deduction can be phonetically pronounced as “Dih-vi-dendz Re-seevd De-duhk-shun (D-R-D)”.

Key Takeaways

• The Dividends Received Deduction, or DRD, is a tax deduction that U.S. corporations can use to lower their taxable income when they receive dividends from other domestic corporations. This rule is designed to mitigate the impact of triple taxation, i.e. when the same income is taxed at corporate level, dividend level, and personal level.
• The DRD percentage that corporations can claim depends on the percentage of ownership in the company from which they are receiving the dividends. If a corporation owns less than 20% of another company, it may claim a 50% deduction. If it owns between 20% and 80%, the deduction is 65%. If a company owns 80% or more of the other company, it can claim a 100% deduction.
• The deduction only applies to dividends received from other domestic corporations. Dividends received from foreign corporations do not qualify for DRD. Instead, they may be eligible for a foreign tax credit.

Importance

The Dividends Received Deduction (DRD) is crucial in finance because it’s a valuable tax provision for corporations that receive dividends from other corporations in which they have an ownership stake. This deduction mitigates the potential issue of triple taxation, where corporate dividends might be taxed at the corporate level, at the level of the corporation receiving the dividends, and then again at the individual shareholder level when the dividends are passed on. By allowing the receiving corporation to deduct a portion of the dividends income, the DRD lessens the tax burden, thereby fostering more investment and economic activity between corporations. It essentially eases the financial strain on corporations, promotes reinvestment and provides potential for economic growth.

Explanation

The Dividend Received Deduction (DRD) is a significant tool within the corporate tax structure, primarily designed to alleviate the potential issue of triple taxation. Triple taxation refers to the process where the same income is taxed at the corporate level, dividend level, and personal income level. This essentially means that the same money is taxed thrice as it goes from corporation to individual. With the application of the DRD, this is mitigated, as companies that receive dividends from other companies they have equity stakes in are allowed to get a deduction on the income earned from those dividends, significantly reducing the overall taxable income and thereby the tax burden. Moreover, DRD fosters healthier intercorporate investments as corporations hold stakes in each other. It sets a foundation for more strategic corporate alignment and ongoing economic diversification since the substantial tax break makes holding these dividends financially attractive. The use of this deduction fosters the further interconnection of businesses within industries and sectors of the economy, ultimately making it easier and more profitable for companies to invest in each other. Therefore, it could be said that the inherent purpose of the DRD is to stimulate cross-investments and economic growth.

Examples

The Dividends Received Deduction (DRD) is a tax provision in the United States that allows domestic corporations to deduct a portion or all of income received from dividends paid by other domestic corporations in which they hold an ownership stake. Here are three real-world examples of how the DRD could work:

Example 1: ABC Inc. is a large corporation that holds investments in several other smaller domestic companies. One of these companies, XYZ Co, pays out dividends worth $100,000 in a fiscal year. ABC Inc., owning more than 20% but less than 80% of XYZ Co, is able to deduct 65% of the received dividends from its taxable income, thanks to the DRD, leading to a reduction in its tax liability.

Example 2: DEF Corp is a conglomerate holding majority stakes (over 80%) in several smaller companies. One of the companies has a good year and pays DEF Corp dividends of $500,000. DEF Corp, due to its high ownership stake and the current tax law, may take an 80% DRD, potentially significantly decreasing its taxable income.

Example 3: GHI Corp owns a small stake (less than 20%) in a profitable domestic company JKL Co. By the end of the fiscal year, GHI Corp received $50,000 in dividends from JKL Co. Thanks to the DRD, GHI Corp can deduct 50% of those dividends from its taxable income.

Note: These rates are according to the IRS tax code. The actual deduction a company can take depends on its level of ownership in the dividend-paying company. DRD policy may change according to changes in tax law. Please consult a tax expert or advisor to understand the latest policy.

Frequently Asked Questions(FAQ)

Related Finance Terms

• Corporation Income Tax
• Stock Dividends
• Earnings Distribution
• Investment Income
• Double Taxation Relief

Sources for More Information

• WallStreetMojo
• Investopedia
• Wikipedia
• The Motley Fool