Depreciation expenses directly affect a company’s taxable income. An increase in depreciation expense will lead to a taxable income. It will tax deducted from a company’s earnings, thus leading to a operating cash flow.
According to a tax law established in 1969, taxpayers must pay the of the Alternative Minimum Tax (AMT) or regular tax. Which of the following cash outflows cannot be deducted from the operating income to derive the taxable income?
Dividends paid
Interest paid
The correct answer and explanation is :
Correct Answer: Dividends Paid
Explanation:
When calculating a company’s taxable income, certain expenses can be deducted from revenue or operating income, which in turn reduces the amount of tax owed. However, not all cash outflows are deductible for tax purposes. One such non-deductible expense is dividends paid.
Dividends Paid – Not Tax Deductible
Dividends are payments made to shareholders from the company’s profits. These are distributions of earnings rather than expenses incurred during the process of generating income. Because they are profit distributions, not business expenses, the Internal Revenue Code does not allow dividends paid to be deducted when computing taxable income. They are paid after tax has already been assessed and are therefore considered post-tax distributions.
As such, dividends do not reduce taxable income and do not affect operating cash flow. In the statement of cash flows, dividends are classified under financing activities, not operating activities.
Interest Paid – Tax Deductible
In contrast, interest paid is usually considered a business expense, particularly if the company has taken loans or issued bonds to finance its operations. Under most tax laws, including U.S. tax regulations, interest expense is deductible when calculating taxable income—subject to certain limits.
For example, if a company earns $1,000,000 in revenue and incurs $200,000 in interest expenses, that $200,000 can usually be deducted from its income to reduce its taxable base. This is because interest payments are directly tied to financing the operations of the business, unlike dividends which are a return to shareholders.
Alternative Minimum Tax (AMT) Context
The AMT was created to prevent high-income entities from avoiding taxes entirely through deductions. While depreciation methods and interest deductions might be adjusted under AMT rules, dividends remain non-deductible under both regular and AMT tax systems.
Conclusion
Therefore, dividends paid cannot be deducted from operating income to derive taxable income. They are not considered a legitimate tax-deductible business expense.