Committee on Ways and Means, Subcommittee on Oversight, 7-17-01 Statement for the Record

Statement of the National Council of Farmer Cooperatives

The National Council of Farmer Cooperatives ("NCFC") is a nationwide association of cooperative businesses owned and controlled by farmers. Its members include nearly 70 major farmer marketing, supply and credit cooperatives.

In 31 In connection with the Subcommittees’ hearings on the need for simplification of the Internal Revenue Code (the "Code"), NCFC would like to bring to the Subcommittees’ attention a proposal that would significantly simplify the tax treatment of dividends paid by cooperatives to shareholders that furnish start-up and expansion capital to such cooperatives. The proposal is contained in H.R. 2280, introduced by Representative Wally Herger and co-sponsored by Representatives Phil English, John Lewis, Jim Ramstad, Karen Thurman, J.D. Hayworth, Earl Pomeroy, and Fortney Stark. H.R. 2280 would allow cooperatives to pay dividends on capital stock or other proprietary capital interests without those dividends reducing net earnings eligible for the patronage dividend deduction to the extent that the cooperative’s articles of incorporation, bylaws, or other contracts with patrons provide that such dividends are in addition to amounts otherwise payable to patrons from patronage sourced earnings during the taxable year. This bill is identical to a provision that was originally introduced as H.R. 1914 by Congressman Bill Thomas and included in a vetoed tax bill (H.R. 2488) of the 106^th Congress.

NCFC believes that modifying the dividend allocation rule in the manner proposed by H.R. 2280 will promote the overall goals of tax simplification. Accordingly, NCFC urges the Subcommittees to consider including this bill in any future tax simplification measures.

Modification of the Dividend Allocation Rule Promotes Tax Simplification

Both the Joint Committee on Taxation and the Ways and Means Committee have articulated criteria to be used to determine whether a proposal satisfies the goals of tax simplification. (See Exhibit B.) NCFC believes that a modification of the dividend allocation rule in the manner contained in H.R. 2280 would satisfy all of the criteria for tax simplification.

First and foremost, H.R. 2280 would further the underlying policy of Subchapter T of the Code by ensuring that patronage income is subject to one level of tax. (See Exhibit A.) Second, as the current rule is mechanically complex and costly to administer, H.R. 2280 would achieve simplification and improved efficiency, understandability, feasibility and enforceability of Subchapter T of the Code. This simplification would reduce the burdens imposed on taxpayers, tax practitioners, and tax administrators and would greatly outweigh the costs of making a statutory change. Third, the solution proposed by H.R. 2280 would not create opportunities for abusive tax planning by providing an opportunity for nonpatronage income to be converted to patronage income and would comport with generally accepted tax principles. Fourth, H.R. 2280 would avoid the dislocation of tax burdens that occurs when the distribution of nonpatronage income to shareholders results in a third level of tax that falls on the cooperative (and, derivatively, all the members) and not only on the shareholders that are receiving the dividend. Finally, the revenue effect of modifying the dividend allocation rule (approximately $16 million over ten years) would comport with current budgetary constraints. Based on these reasons, NCFC submits that H.R. 2280 meets all of the criteria set forth by the Ways and Means Committee and should be adopted as a tax simplification measure.

Conclusion

The dividend allocation rule is fundamentally inconsistent with the policy goals of Subchapter T of the Code and adds complexity to the Federal tax laws, which should be removed by modifying the rule in a manner consistent with H.R. 2280. Accordingly, NCFC urges this Subcommittee to consider including H.R. 2280 in any future tax simplification measures.

EXHIBIT A

Policy Goals of Subchapter T And DividenD Allocation Rule
One of the overall policy goals of Subchapter T of the Internal Revenue Code (the "Code") is to subject a cooperative’s "patronage income" to one level of tax and "nonpatronage income" to regular corporate income taxation. Patronage income is income derived from the cooperatives’ business done with or for its patrons, and "nonpatronage income" is all of the other income of the cooperative. The single level of tax on the cooperative’s patronage income is achieved by allowing the cooperative to take a patronage dividend deduction for the distribution of its net patronage income annually to its patrons based on their patronage business with the cooperative during the year. No similar deduction exists for the distribution of nonpatronage income. Thus, nonpatronage income is subject to two levels of tax.

The Dividend Allocation Rule

Under current Treasury Department practice and a predominance of the case law, if a cooperative pays a dividend on its capital stock or its other proprietary capital interests, the dividend is subject to the "dividend allocation rule." The "dividend allocation rule" requires this dividend to be treated as if it came from both patronage and nonpatronage operations of the cooperative and the allocation is made by employing the following calculation.

First, the dividend is treated for tax purposes as coming from the patronage and nonpatronage operations of the cooperative in proportion to the amount of business the cooperative has done in each of these operations. (For most cooperatives, this will mean that it will be treated as predominantly patronage income.) Second, the amount allocated to the patronage operation is then used to artificially decrease the cooperative’s net patronage income (for deduction purposes), thus reducing the amount of the patronage dividend deduction and leaving patronage-sourced net earnings subject to tax at the cooperative level. See Treas. Reg. § 1.1388-1(a)(1)(iii). This creates an additional tax at the cooperative level, in effect a triple tax, merely because the cooperative has distributed a dividend on its capital stock.

The effect of the dividend allocation rule on a cooperative’s taxation is illustrated by the following example:

EXAMPLE

A cooperative has gross income from patronage business of $200 and from nonpatronage business of $22. It has patronage expenses of $65 and nonpatronage expenses of $7, so that its patronage net earnings are $135 and its nonpatronage earnings are $15. It pays a tax of $5 on its nonpatronage earnings, leaving $10 in retained earnings from its nonpatronage business. This $5 is the first tax paid on the earnings.

Patronage Sourced Income(90%)		Nonpatronage Business(10%)
Income from patronage business:	$200	Income from nonpatronage business	$22
Patronage expenses	[65]	Nonpatronage expenses	[7]
Patronage earnings	$135	Nonpatronage earnings:	$15
		Corporate taxes on $15	(5)
		After tax earnings	$10

Due to the "dividend allocation rule," if the cooperative pays a Capital Stock Dividend of $10 (the after-tax profits from its non-patronage business, i.e., retained earnings), the $10 will be prorated between the patronage earnings and nonpatronage earnings (which are $135 to $15, a 9 to1 ratio). Thus, $9 of the $10 of retained earnings will be deemed to come from the patronage net earnings, reducing the available patronage dividend from $135 to $126, which reduces the amount of patronage dividend available to the farmer member, a decrease of approximately 7%. This reduction in the patronage dividend deduction means that an additional $9 will become subject to tax. The cooperative has a full $135 in patronage net earnings and it only gets a patronage dividend deduction for $126; the difference ($9) becomes subject to tax at the cooperative level. Therefore, the cooperative pays a second corporate tax of say, $3, due to the reduction of the allowable patronage dividend deduction.

Patronage Sourced Income(90%)
Patronage earnings	$135
Dividend Allocation Rule	[9] ($3 tax)	After tax earnings	$10
Patronage deduction	$126

When the $10 Capital Stock Dividend is received by the stockholders, they are subject to tax on the receipt of this income, say $3 in tax. This $3 is the third tax paid on the earning and distribution of this income.

After Tax Earnings
Dividend to Stockholders $10	$10
Tax to stockholder on distribution	(3)

From the original $15 of nonpatronage earnings to be distributed by the cooperative, approximately $11 or 73 percent has been paid in tax. At the cooperative level, $8 of the $15 or 53 percent is paid in tax, rather than $5 or 33 percent that would have been paid, but for the dividend allocation rule. These high percentages arise only because the cooperative paid a dividend on its capital stock. The effect of this calculation is to create a triple tax for the cooperative and the recipients of the dividend on capital stock, rather than the usual corporate double tax. It is a penalty imposed on the cooperative for paying a dividend on capital stock.

We urge the Committee to simplify the Code by eliminating this mandatory calculation for cooperatives paying dividends on capital stock or other proprietary capital interest, and allowing cooperatives to pay dividends on capital stock from their nonpatronage earnings and have these earnings subject only to the double tax which should apply to such earnings.

EXHIBIT B

criteria for tax simplification

In April 2001, the Joint Committee on Taxation released its Study of the Overall State of The Federal Tax System and Recommendations for Simplification Pursuant to Section 8022(3)(B) of the Internal Revenue Code of 1986 (the "Study"). In Volume I of the Study, the Joint Committee set forth the following criteria that it used to analyze possible simplification recommendations:

the extent to which simplification could be achieved by the recommendation;

whether the recommendation improves the fairness or efficiency of the Federal tax system;

whether the recommendation improves the understandability and predictability (i.e., transparency) of the Federal tax system;

the complexity of the transactions that would be covered by the recommendation and the sophistication of affected taxpayers;

administrative feasibility and enforceability of the recommendation;

the burdens imposed on taxpayers, tax practitioners, and tax administrators by changes in the tax law; and

whether a provision of present law could be eliminated because it is obsolete or duplicative.¹

In addition, the Joint Committee applied the following overriding criterion to each simplification proposal: whether the recommendation would fundamentally alter the underlying policy articulated by Congress in enacting the provision.

The considerations of the Joint Committee on tax simplification generally follow the considerations enunciated by the Ways and Means Committee. In 1990, the Ways and Means Committee articulated the following criteria to be used to determine whether a proposal satisfies the goals of tax simplification:

whether the proposal would significantly reduce mechanical complexity or recordkeeping requirements;

whether the proposal would significantly reduce compliance and administration costs;

whether the proposal would preserve underlying policy objectives of current law and not create or reopen opportunities for abusive tax planning;

whether the proposal comports with generally accepted tax principles;

whether the proposal would avoid significant dislocations of tax burdens among taxpayers;

whether the simplification that the proposal would achieve outweighs the instability resulting from making any statutory change, as opposed to statutory repose; and

whether revenue effects of the proposal would comport with current revenue and budget constraints.²

[An Additional attachment is being retained in the Committee files.]

1. The Study, Vol. I., at p.9.

2. Committee on Ways and Means, U.S. House of Representatives, Written Proposals on Tax Simplification, 101^st Cong., 2^nd Sess., WMCP: 101-27, p. III-IV (May 25, 1990).