For years, policymakers on Capitol Hill have searched for a path forward on tax reform that is “business only,” meaning that it does not affect individuals’ tax rates. The thought was that comprehensive tax reform is too difficult to achieve politically. The trouble with business-only tax reform is that so many businesses are organized as pass-through entities (partnerships and limited liability corporations) that efforts to lower the corporate tax rate without lowering individual tax rates tend to run into opposition from businesses that do not pay corporate-level taxes.

On April 13, 2016, Tax Notes Today reported that the US Senate Committee on Finance has identified a path through the wilderness: “corporate integration,” by way of a dividends paid deduction. But tax-exempt pension funds and other tax-exempt entities may not like where that path leads, because it would likely make them a good deal less exempt than they are under current law.

Corporate integration is the idea that corporate earnings should be taxed once, either at the corporate level or the shareholder or bondholder level, but not at both levels. Under the current US tax system, corporate earnings distributed as dividends are taxed once at the corporate level and again when distributed to shareholders as dividends—two times. Meanwhile, corporate earnings distributed as interest are deductible at the corporate level but taxable at the bondholder level—one time. This creates a tax preference to capitalize a corporation with debt rather than equity, an economic “distortion” that policymakers would like to eliminate. Also, many perceive the comparatively high corporate tax rate in the United States as creating an incentive for US corporations to move earnings offshore.

The proposal would allow corporations to deduct not only interest paid to bondholders but also dividends paid to shareholders. This would eliminate or significantly reduce tax at the corporate level, without adjusting the nominal corporate tax rate. It would also eliminate the distortion between debt and equity as well as the incentive to move earnings abroad to escape US taxation. Mission accomplished!

But there’s a catch. The proposal would require corporations to withhold on dividends and interest at a 35% tax rate and pay that amount to the US Department of the Treasury. Taxable shareholders and bondholders would be able to claim a nonrefundable tax credit on their tax returns equal to the amount withheld, but tax-exempt shareholders and bondholders—including pension and other tax-exempt employee benefit funds—would be unable to use the credit. And therein lies the rub: under the proposal, tax exempts would bear one level of tax on dividend and interest income from US corporate stocks and bonds where they currently bear none.

It’s not difficult to see why the drafters would go this direction; after all, the tax-exempt sector collectively holds a huge amount of US corporate debt and equity. If corporations could deduct dividends and interest, and tax exempts could exclude dividends and interest, then a large portion of corporate profits would escape taxation altogether. But the effect on tax-exempt entities would be profound.

It is unlikely that any significant tax legislation will be enacted prior to the 2016 elections. That said, it is important to give serious consideration to tax reform proposals developed by tax writing committees such as the Senate Finance Committee. This particular proposal has yet to be officially released, and if and when it is, it will likely be in the form of a discussion draft rather than as legislation. The prospects that it will someday be enacted depend in large part on the Joint Committee on Taxation’s microeconomic and macroeconomic revenue estimates and the distributional effects of the proposal. Once we have a better sense of who the winners and losers may be, we can more easily forecast the likelihood of passage. For now, it seems that tax-exempt pension trusts and other tax exempts may well be on the losing side of the ledger.

For more information about this proposal, please see our LawFlash, Corporate Tax Reform Proposal Would Raise Taxes on Exempts.