Governments impose a retained earnings tax on corporations that accumulate savings above a certain threshold, to make up for income lost through the non-distribution of dividends. This tax is aimed at combating the practice of hoarding cash to avoid double taxation.
A retained earnings tax is an income tax assessment on corporate savings that exceed a certain threshold. Governments expect corporations to distribute most of the profits to shareholders in the form of dividends, which allows the government to tax dividend distributions at the shareholder level. When a corporation withholds its earnings instead of distributing them as dividends, it disrupts the government’s expected tax revenue. In cases where a corporation accumulates an amount above a certain threshold, the government imposes a special tax on retained earnings to make up for income it does not receive through the distribution of dividends.
The corporate tax structure has a feature commonly known as double taxation. Governments actually tax corporate income twice. A corporation files a tax return each year and pays income tax on the net income at the corporate rate. It then distributes a portion of that net income, or profit, to shareholders in the form of dividends. The government taxes this money again at the individual level because shareholders must pay taxes on dividends received when filing individual tax returns.
Corporations and shareholders are always looking for ways to avoid double taxation and lower their overall tax burden. One of the mechanisms that corporations began to use to minimize tax liability was to retain earnings instead of distributing them as dividends. This would increase the corporation’s available cash, and would typically have a positive effect on its share price. Shareholders could sell their shares and make a profit that way. They would have to pay capital gains tax on the sale, but the tax rate for capital gains is generally much less than the assessment on dividends.
To combat this practice, governments instituted a retained earnings tax. This tax goes into effect when a corporation has excess cash on hand that it cannot account for due to anticipated need. For example, a corporation may hoard cash if it expects to have to pay a substantial litigation settlement in the near future, but it may not hoard cash simply to allow its shareholders to avoid paying taxes on dividends. Once corporate coffers exceed a threshold set by the tax code in your jurisdiction without proper justification, you must pay retained earnings tax on the amount.
There may still be cases where a corporation chooses to pay retained earnings tax rather than allow shareholders to be taxed on dividends. The tax code changes periodically in each jurisdiction. Tax rates that apply to dividends, capital gains, and retained earnings are fluid, and the right course to take to minimize the tax liability for the corporation and its shareholders must be assessed on an ongoing basis.
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