What is a 'Dividends Received Deduction - DRD'
The dividends received deduction (DRD) is an American federal tax deduction applicable to certain corporations that receive dividends from related entities. The purpose of this deduction is to alleviate the potential consequences of triple taxation. Triple taxation occurs when the same income is taxed in the hands of the company paying the dividend, then in the hands of the company receiving the dividend, and again when the ultimate shareholder is in turn paid a dividend.
BREAKING DOWN 'Dividends Received Deduction - DRD'In its simplest expression, the DRD allows a company that receives a dividend from another company to deduct that dividend from its income and reduce its income tax accordingly. However, there are several technical rules that must be followed for corporate shareholders to be entitled to the DRD.
Technical Rules for the Application of the DRD
The amount of DRD that a company may claim depends on its percentage of ownership in the company paying the dividend. There are three tiers of possible deductions. First, the general rule is that the DRD is equal to 70% of the dividend received. Second, if the company receiving the dividend owns more than 20% but less than 80% of the company paying the dividend, the DRD is 80% of the dividend received. Finally, if the company receiving the dividend owns more than 80% of the company paying the dividend, the DRD is 100% of the dividend.
Another important limitation is known as the taxable income limitation. Under this rule, which is applicable to dividends received from companies in which the payee has less than 80% ownership, the DRD is limited to 70% or 80% of its taxable income figure if the taxable income of the corporation receiving the dividend is less than what the DRD would otherwise be. However, the taxable income limitation does not apply if the DRD creates or adds to a net operating loss.
Another important technical rule is that, in order to receive the dividend to claim the DRD, the company must have owned the shares of the company paying the dividend for at least 45 days prior to the dividend payment.
Example of DRD Calculation
Assume that ABC Inc. owns 60% of its affiliate, DEF Inc. If ABC has taxable income of $10,000, and including a dividend of $9,000 from DEF, it would be entitled to a DRD of $7,200, or 80% of $9,000.
However, if ABC's income was $9,000 including a dividend of $10,000, then the income limitation rule would apply. Fundamentally, in light of its 60% ownership, ABC should have been entitled to a DRD equal to $10,000 X 80%, or $8,000. However, the DRD is limited to 80% ABC's taxable income, or $7,200 ($9,000 X 80%).