[House Hearing, 105 Congress]
[From the U.S. Government Publishing Office]




 
       REVENUE PROVISIONS IN PRESIDENT'S FISCAL YEAR 1999 BUDGET

=======================================================================

                                HEARING

                               before the

                      COMMITTEE ON WAYS AND MEANS
                        HOUSE OF REPRESENTATIVES

                       ONE HUNDRED FIFTH CONGRESS

                             SECOND SESSION

                               __________

                           FEBRUARY 25, 1998

                               __________

                             Serial 105-55

                               __________

         Printed for the use of the Committee on Ways and Means




                    U.S. GOVERNMENT PRINTING OFFICE                    
51-685                     WASHINGTON : 1999


                      COMMITTEE ON WAYS AND MEANS

                      BILL ARCHER, Texas, Chairman

PHILIP M. CRANE, Illinois            CHARLES B. RANGEL, New York
BILL THOMAS, California              FORTNEY PETE STARK, California
E. CLAY SHAW, Jr., Florida           ROBERT T. MATSUI, California
NANCY L. JOHNSON, Connecticut        BARBARA B. KENNELLY, Connecticut
JIM BUNNING, Kentucky                WILLIAM J. COYNE, Pennsylvania
AMO HOUGHTON, New York               SANDER M. LEVIN, Michigan
WALLY HERGER, California             BENJAMIN L. CARDIN, Maryland
JIM McCRERY, Louisiana               JIM McDERMOTT, Washington
DAVE CAMP, Michigan                  GERALD D. KLECZKA, Wisconsin
JIM RAMSTAD, Minnesota               JOHN LEWIS, Georgia
JIM NUSSLE, Iowa                     RICHARD E. NEAL, Massachusetts
SAM JOHNSON, Texas                   MICHAEL R. McNULTY, New York
JENNIFER DUNN, Washington            WILLIAM J. JEFFERSON, Louisiana
MAC COLLINS, Georgia                 JOHN S. TANNER, Tennessee
ROB PORTMAN, Ohio                    XAVIER BECERRA, California
PHILIP S. ENGLISH, Pennsylvania      KAREN L. THURMAN, Florida
JOHN ENSIGN, Nevada
JON CHRISTENSEN, Nebraska
WES WATKINS, Oklahoma
J.D. HAYWORTH, Arizona
JERRY WELLER, Illinois
KENNY HULSHOF, Missouri

                     A.L. Singleton, Chief of Staff

                  Janice Mays, Minority Chief Counsel



Pursuant to clause 2(e)(4) of Rule XI of the Rules of the House, public 
hearing records of the Committee on Ways and Means are also published 
in electronic form. The printed hearing record remains the official 
version. Because electronic submissions are used to prepare both 
printed and electronic versions of the hearing record, the process of 
converting between various electronic formats may introduce 
unintentional errors or omissions. Such occurrences are inherent in the 
current publication process and should diminish as the process is 
further refined.



                            C O N T E N T S

                               __________

                                                                   Page

Advisory of February 18, 1998, announcing the hearing............     2

                                WITNESS

U.S. Department of the Treasury, Hon. Lawrence H. Summers, Deputy 
  Secretary......................................................     7

                                 ______

                       SUBMISSIONS FOR THE RECORD

American Bankers Association, statement..........................    27
America's Community Bankers, statement...........................    30
America's Community Bankers, Independent Bankers Association of 
  America, New York Clearing House Association, New York, NY, and 
  Securities Industry Association, joint statement...............    34
American Council for an Energy-Efficient Economy, Howard Geller, 
  letter and attachments.........................................    37
American Petroleum Institute, statement..........................    39
American Skandia Life Assurance Corporation, Shelton, CT, Wade 
  Dokken, and Gordon C. Boronow, joint letter....................    47
American Wind Energy Association, Jaime Steve, statement.........    48
Blum, Jared O., Polyisocyanurate Insulation Manufacturers 
  Association, statement.........................................   206
Bond Market Association, statement and attachment................    50
Boronow, Gordon C., American Skandia Life Assurance Corporation, 
  Shelton, CT, joint letter......................................    47
Business Insurance Coalition, John F. Jonas, statement...........    56
Chen, Grace, R&D Credit Coalition, statement and attachments.....   210
Committee of Annuity Insurers, statement and attachment..........    59
Corporate Property Investors, First Union Real Estate 
  Investments, Meditrust, Patriot American Hospitality, and 
  Starwood Hotels & Resorts, joint statement.....................    64
Dokken, Wade, American Skandia Life Assurance Corporation, 
  Shelton, CT, joint letter......................................    47
Employer-Owned Life Insurance Coalition, Kenneth J. Kies, 
  statement......................................................    68
Enron Wind Corp., Tehachapi, CA, Kenneth C. Karas, statement.....    73
Export Source Coalition, statement and attachments...............    74
Financial Executives Institute, John Porter, statement...........    91
First Union Real Estate Investments, joint statement (See listing 
  under Corporate Property Investors)............................    64
FPL Energy, Inc., Michael W. Yackira, statement..................    97
Geller, Howard, American Council for an Energy-Efficient Economy, 
  letter and attachments.........................................    37
Guttman, Steven J., National Association of Real Estate 
  Investment Trusts, statement...................................   157
Hybrid Branch Coalition, statement...............................    99
Independent Bankers Association of America, joint statement (See 
  listing under America's Community Bankers).....................    34
INMC Mortgage Holdings, Inc., statement..........................   105
Interstate Conference of Employment Security Agencies, 
  Washington, DC, and Service Bureau Consortium, Roseland, NJ, 
  joint statement................................................   108
Investment Company Institute, statement..........................   110
Joint Venture's Council on Tax and Fiscal Policy, San Jose, CA, 
  statement......................................................   115
Jonas, John F., Business Insurance Coalition, statement..........    56
Karas, Kenneth C., Enron Wind Corp., Tehachapi, CA, statement....    73
Kies, Kenneth J., Employer-Owned Life Insurance Coalition, 
  statement......................................................    68
M Financial Holdings Inc., statement.............................   119
Management Compensation Group, statement.........................   125
Massachusetts Mutual Life Insurance Company, Springfield, MA, 
  statement......................................................   128
Meditrust, joint statement (See listing under Corporate Property 
  Investors).....................................................    64
Merrill Lynch & Co., Inc., statement.............................   133
Multinational Tax Coalition, statement and attachment............   140
Murray, Fred F., National Foreign Trade Council, Inc., statement.   165
Nabers, Drayton, Jr., Protective Life Insurance Company, 
  Birmingham, AL, statement......................................   208
National Association of Manufacturers, statement.................   150
National Association of Real Estate Investment Trusts, Steven J. 
  Guttman, statement.............................................   157
National Foreign Trade Council, Inc., Fred F. Murray, statement..   165
National Mining Association, statement...........................   175
National Realty Committee, statement.............................   177
National Structured Settlements Trade Association, statement and 
  attachments....................................................   183
Nationwide Insurance Enterprise, statement.......................   200
New York Clearing House Association, New York, NY, joint 
  statement (See listing under America's Community Bankers)......    34
Notice 98-11 Coalition, statement................................   203
Patriot American Hospitality, joint statement (See listing under 
  Corporate Property Investors)..................................    64
Polyisocyanurate Insulation Manufacturers Association, Jared O. 
  Blum, statement................................................   206
Porter, John, Financial Executives Institute, statement..........    91
Protective Life Insurance Company, Birmingham, AL, Drayton 
  Nabers, Jr., statement.........................................   208
Ramstad, Hon. Jim, a Representative in Congress from the State of 
  Minnesota......................................................   210
R&D Credit Coalition, Grace Chen, statement and attachments......   210
Regalia, Martin A., U.S. Chamber of Commerce, statement..........   239
Securities Industry Association, joint statement (See listing 
  under America's Community Bankers).............................    34
Service Bureau Consortium, Roseland, NJ, joint statement.........   108
Starwood Hotels & Resorts, joint statement (See listing under 
  Corporate Property Investors)..................................    64
Steve, Jaime, American Wind Energy Association, statement........    48
Tax Council, statement...........................................   230
U.S. Chamber of Commerce, Martin A. Regalia, statement...........   239
United States Council for International Business, New York, NY, 
  statement......................................................   243
Yackira, Michael W., FPL Energy, Inc., statement.................    97



       REVENUE PROVISIONS IN PRESIDENT'S FISCAL YEAR 1999 BUDGET

                              ----------                              


                      WEDNESDAY, FEBRUARY 25, 1998

                          House of Representatives,
                               Committee on Ways and Means,
                                                    Washington, DC.
    The Committee met, pursuant to notice, at 1:03 p.m., in 
room 1100, Longworth House Office Building, Hon. Bill Archer 
(Chairman of the Committee) presiding.
    [The advisory announcing the hearing follows:]

ADVISORY

FROM THE COMMITTEE ON WAYS AND MEANS

FOR IMMEDIATE RELEASE                          CONTACT: (202) 225-1721
February 18, 1998
No. FC-11


                Archer Announces Hearing on the Revenue

           Provisions in President's Fiscal Year 1999 Budget

    Congressman Bill Archer (R-TX), Chairman of the Committee on Ways 
and Means, today announced that the Committee will hold a hearing on 
the revenue provisions in President Clinton's fiscal year 1999 budget 
proposals that are under the jurisdiction of the Committee. The hearing 
will take place on Wednesday, February 25, 1998, in the main Committee 
hearing room, 1100 Longworth House Office Building, beginning at 1:00 
p.m.
      
    In view of the limited time available to hear witnesses, oral 
testimony at this hearing will be from Treasury Department witnesses 
only. However, any individual or organization not scheduled for an oral 
appearance may submit a written statement for consideration by the 
Committee and for inclusion in the printed record of the hearing.
      

BACKGROUND:

      
    On February 2nd, President Clinton submitted his fiscal year 1999 
budget to the Congress. This budget submission contains numerous 
revenue provisions not included in the Administration's budget 
proposals in previous years. The hearing will give the Committee the 
opportunity to consider these revenue initiatives more carefully.
      
    In announcing the hearings, Chairman Archer stated: ``This hearing 
is an opportunity for the Administration to be an advocate for the 
revenue proposals in its budget. Given the public reaction to the 
numerous tax increase proposals in the budget, including proposals 
which have been rejected previously and new proposals increasing the 
tax burden on savings and investment, the Administration has a very 
heavy burden to carry.''
      

FOCUS OF THE HEARING:

      
    The Committee expects to receive testimony on the President's 
revenue proposals from the Secretary of the Treasury or his designee, 
who also will be asked to discuss general spending trends, and revenue 
and deficit projections, including economic trends forecasted by the 
Administration.
      

DETAILS FOR SUBMISSION OF WRITTEN COMMENTS:

      
    Any person or organization wishing to submit a written statement 
for the printed record of the hearing should submit at least six (6) 
single-space legal-size copies of their statement, along with an IBM 
compatible 3.5-inch diskette in ASCII DOS Text or WordPerfect 5.1 
format only, with their name, address, and hearing date noted on a 
label, by the close of business, Wednesday, March 11, 1998, to A.L. 
Singleton, Chief of Staff, Committee on Ways and Means, U.S. House of 
Representatives, 1102 Longworth House Office Building, Washington, D.C. 
20515. If those filing written statements wish to have their statements 
distributed to the press and interested public at the hearing, they may 
deliver 300 additional copies for this purpose to the Committee office, 
room 1102 Longworth House Office Building, at least one hour before the 
hearing begins.
      

FORMATTING REQUIREMENTS:

      
    Each statement presented for printing to the Committee by a 
witness, any written statement or exhibit submitted for the printed 
record or any written comments in response to a request for written 
comments must conform to the guidelines listed below. Any statement or 
exhibit not in compliance with these guidelines will not be printed, 
but will be maintained in the Committee files for review and use by the 
Committee.
      
    1. All statements and any accompanying exhibits for printing must 
be typed in single space on legal-size paper and may not exceed a total 
of 10 pages including attachments. At the same time written statements 
are submitted to the Committee, witnesses are now requested to submit 
their statements on an IBM compatible 3.5-inch diskette in ASCII DOS 
Text or WordPerfect 5.1 format. Witnesses are advised that the 
Committee will rely on electronic submissions for printing the official 
hearing record.
      
    2. Copies of whole documents submitted as exhibit material will not 
be accepted for printing. Instead, exhibit material should be 
referenced and quoted or paraphrased. All exhibit material not meeting 
these specifications will be maintained in the Committee files for 
review and use by the Committee.
      
    3. A witness appearing at a public hearing, or submitting a 
statement for the record of a public hearing, or submitting written 
comments in response to a published request for comments by the 
Committee, must include on his statement or submission a list of all 
clients, persons, or organizations on whose behalf the witness appears.
      
    4. A supplemental sheet must accompany each statement listing the 
name, full address, a telephone number where the witness or the 
designated representative may be reached and a topical outline or 
summary of the comments and recommendations in the full statement. This 
supplemental sheet will not be included in the printed record.
      
    The above restrictions and limitations apply only to material being 
submitted for printing. Statements and exhibits or supplementary 
material submitted solely for distribution to the Members, the press 
and the public during the course of a public hearing may be submitted 
in other forms.
      

    Note: All Committee advisories and news releases are available on 
the World Wide Web at `HTTP://WWW.HOUSE.GOV/WAYS__MEANS/'.
      


    The Committee seeks to make its facilities accessible to persons 
with disabilities. If you are in need of special accommodations, please 
call 202-225-1721 or 202-226-3411 TTD/TTY in advance of the event (four 
business days notice is requested). Questions with regard to special 
accommodation needs in general (including availability of Committee 
materials in alternative formats) may be directed to the Committee as 
noted above.
      

                                

    Chairman Archer [presiding]. The Committee will come to 
order.
    Our hearing this afternoon has been called to examine the 
revenue provisions in the President's budget.
    I thank my colleagues in both parties for the comments, 
letters, and thoughts that you have shared with me concerning 
the administration's plan. And if I hear you right, the 
administration's tax hikes have met massive bipartisan 
opposition. And the reason is simple: The vast majority of 
these proposals are not what we would call loophole closures; 
instead they are proposing a series of tax hikes on women, 
widows, and middle-income Americans who save--savers--the very 
place where I believe we should not be attacking our system.
    Taxes would be hiked on millions of airline passengers, 
small businesses that create jobs and manufactures that export, 
which we desperately need more of. Rather than increasing the 
taxation on companies that export, we should be talking about 
how we reduce the taxation so that our corporations are not 
double taxed and can compete with foreign corporations that 
determine how successful they're going to be in creating jobs 
and in sales of American products.
    I've closed abusive loopholes over the last 3 years--since 
becoming Chairman of this Committee--and I'll continue to close 
them again. But when it comes to protecting taxpayers, I have 
fought tax hikes before and it looks like it is time to fight 
them again. Taxes are at the highest level in our Nation's 
peacetime history as a percent of GDP, gross domestic product, 
and yet President Clinton's budget raises them even higher.
    According to an analysis released yesterday by the Joint 
Committee on Taxation, the President's budget includes 43 
separate tax hikes that raise a total of $38.9 billion over 5 
years. The budget also calls for $65 billion from an undefined 
increase in tobacco revenues. The 10-year tax hike in this 
budget is $236.8 billion.
    [The analysis is being held in the Committee files.]
    Thirteen of these provisions are reruns that got bad 
bipartisan ratings the first time they were sent up. Given the 
administration's failure to win support for these proposals in 
the past, I question why the White House is trying them again. 
When I announced the Committee agenda, I said if the 
administration makes the same tax hiking mistakes it made in 
previous budgets, those hikes will be dead before arriving. To 
protect the taxpayers, let me be clear--and I could not say it 
more clearly--these tax hikes remain dead.
    As for the rest of the tax hikes, Mr. Rangel and I have 
received a letter from virtually every Committee Member urging 
our opposition to the proposals that increase taxes on people 
who save and invest in life insurance and annuities. At a time 
when our Nation should increase incentives to save, I must 
question why the administration is raising these taxes.
    The budget calls for a $6 billion increase in airline 
taxes. Last year's budget agreement provided a long-term, 
stable resolution to this thorny issue, yet the administration 
now wants to reopen it and to collect more money from the 
traveling public. This provision is an old-fashioned tax hike 
on millions of traveling Americans, and I oppose it.
    On the other side of the ledger, the budget contains a 
mind-boggling series of provisions that add further complexity 
to the Code. If you think the tax forms are complicated now, 
just wait until the IRS gets deeper into your private life so 
you can qualify for many of these new proposals.
    Targeted tax cuts are a code phrase for let's make the Tax 
Code more complex. Now, I have participated myself in putting 
provisions in the Code that added to the complexity of the Code 
in order to give taxpayers relief from too high a tax burden. 
But I would hope that this year we will concentrate on reducing 
complexities, on simplification, and make every effort not to 
further complicate the Code no matter how desirable some of 
these provisions may appear.
    And the last thing we need to do is turn the IRS into 
another Department of Energy. Didn't we learn in the seventies 
when this Committee passed innumerable tax credits on the basis 
of ``oh, well we've got an energy crisis,'' only to find that 
we had to dismantle all of them in the succeeding years because 
we were attempting to micromanage the market system. And here 
we go again with the President's proposals in this budget: More 
complex effort to micromanage by energy credits of a variety of 
kinds.
    One of the reasons that I want to change the holding period 
on capital gains from 18 months to 12 months is to simplify the 
Code. I've just recently looked at schedule D--the new schedule 
D--for 1997, and I defy the average citizen to work through 
that form. By reducing the 18-month holding period to 12 months 
so that it is uniform, will greatly simplify that form.
    The President's new complicated loopholes, as they are 
called, are a step in the wrong direction and they will be hard 
to support. It appears to me that the administration's budget 
is beginning to unravel. Unless President Clinton can convince 
Congress to raise taxes on the American people, his budget will 
be out of balance. Having worked so hard to get the budget into 
balance, we must not return to the failed policies of the past. 
I intend to protect the taxpayer; and so I urge President 
Clinton to abandon his unacceptable tax hikes as well his $123 
billion in new government spending. What we should be doing is 
working harder to reduce wasteful, inappropriate, and 
unnecessary Federal spending. Hard-working taxpayers should not 
be stuck with the bill for the return of big government.
    [The opening statement follows:]

Opening Statement of Hon. Bill Archer, a Representative in Congress 
from the State of Texas

    Good Afternoon.
    Today's hearing has been called to examine the revenue 
provisions in the President's budget.
    I want to thank my colleagues in both parties for the 
comments, letters, and thoughts you have shared with me 
concerning the Administration's plan. If I hear you right, the 
Administration's tax hikes have met massive bi-partisan 
opposition.
    The reason is simple. The vast majority of these proposals 
aren't loophole closers. Instead, the President has proposed a 
series of tax hikes on women, widows and middle-income 
Americans who save; millions of airline passengers; small 
businesses that create jobs; and manufacturers that export.
    I've closed abusive loopholes before and I'll close them 
again. But when it comes to protecting taxpayers, I've fought 
tax hikes before and it looks like it's time to fight them 
again. Taxes are at the highest level in our nation's peacetime 
history, yet President Clinton's budget raises them even 
higher.
    According to an analysis released yesterday by the Joint 
Committee on Taxation, the President's budget includes 43 
separate tax hikes that raise a total of $38.9 billion over 
five years. The budget also calls for $65 billion from an 
undefined increase in tobacco revenues. The ten year tax hike 
in this budget is $236.8 billion.
    Thirteen of these provisions are reruns that got bad 
bipartisan ratings the first time. Given the Administration's 
failure to win support for these proposals in the past, I 
question why the White House is trying again. When I announced 
the Committee agenda, I said if the Administration makes the 
same tax hiking mistakes it made in previous budgets, those 
hikes will be dead before arrival. To protect the taxpayers, 
let me be clear. These tax hikes remain dead.
    As for the rest of the tax hikes, Mr. Rangel and I have 
received a letter from virtually every Committee member urging 
our opposition to the proposals that increase taxes on people 
who save and invest in life insurance and annuities. At a time 
when our nation should increase incentives to save, I question 
why the Administration is raising these taxes.
    The budget calls for a $6 billion increase in airline 
taxes. Last year's budget agreement provided a long-term, 
stable resolution to this thorny issue, yet the Administration 
now wants to collect more money from the traveling public. This 
provision is an old-fashioned tax hike on millions of traveling 
Americans and I oppose it.
    On the other side of the ledger, the budget contains a mind 
boggling series of provisions that add further complexity to 
the code. If you think the tax forms are complicated now, just 
wait until the IRS gets deeper into your private life so you 
can qualify for many of these new proposals. The last thing we 
should do is turn the IRS into another Department of Energy.
    Last year's tax law made the code complicated enough. This 
year, our efforts should focus on simplifying the code. That's 
why I want to modify the new capital gains law that's driving 
sixteen million taxpayers crazy as they struggle to fill out 
their tax returns. But the President's new, complicated 
loopholes are a step in the wrong direction and they'll be hard 
to support.
    It appears to me that the Administration's budget is 
beginning to unravel. Unless President Clinton can convince 
Congress to raise taxes on the American people, his budget will 
be out of balance.
    Having worked so hard to get the budget into balance, we 
must not return to the failed policies of the past. I intend to 
protect the taxpayers and so I urge President Clinton to 
abandon his unacceptable tax hikes as well as his $123 billion 
in new government spending. Hard working taxpayers shouldn't be 
stuck with the bill for the return of big government.
      

                                

    Chairman Archer. And now, I'm happy to recognize Mr. Rangel 
for any statement that he might like to make.
    Mr. Rangel. Mr. Chairman, let me join with you in 
congratulating the administration for the great job that they 
have done in the last several years in improving the economy. 
Federal Reserve Chairman Greenspan believes a large part of 
that improvement was due to the 1993 Budget Act. But I think we 
can get beyond that and recognize this is not a Democratic 
victory, but a victory for all of the people of our country. 
Indeed, the way things look it may be a victory for the whole 
world. We're going through a fantastic economic expansion. 
Interest rates, inflation, and unemployment are down and 
there's a general feeling of prosperity--or at least the hope 
that all Americans will be able to enjoy the benefits of this 
economic expansion.
    The President now has come forward with some ideas that, I 
gather from the Chairman's remarks, about which you have some 
reservations. In view of the fact that the President has been 
so successful in reducing the deficit and providing us an 
opportunity to dedicate the surplus to the improvement of the 
Social Security system--and in my opinion, attempting to 
provide health care for those people who find themselves unable 
to afford it and to reduce class size. It would seem to me 
that, notwithstanding the reservations that people may have 
about some of these programs, we have to have some assurances 
that the President's proposals will have a hearing. I want to 
thank you for allowing this process to begin today.
    I know your primary concern is sunsetting the Code and the 
IRS and pulling it up by the roots and replacing it with a 
postcard, simple, flat tax system. But it doesn't look like 
we'll be able to do that anytime soon--at least not before the 
election.
    Between now and the time that we go back home to run for 
reelection, the leadership has not provided us with many 
working days. This means we will have limited time to review 
the program that the Republican leadership has--and that's an 
assumption on my part, that there is a program--but even a more 
limited time to review the recommendations made by the 
President. So, I don't want to take time out today just lauding 
you for having this meeting, but I'm taking this time because, 
based on the scheduling process, I have no idea as to when we 
will be meeting again, whether this month or next.
    In any event, I want to thank the administration for its 
patience, but do hope at some point in time that the President 
would insist that if his recommendations are not passed, that 
at least they be considered and debated. Knowing that fairness 
and the equity the Chair has demonstrated in the past, there's 
no question in my mind that, for those issues that come within 
the jurisdiction of this Committee, we should have a time for 
debate, to legislate, and to dispose of--one way or the other--
the President's recommendations.
    Thank you, Mr. Chairman.
    Chairman Archer. We're pleased to have with us today 
representing the administration and standing in for Secretary 
Rubin his chief right-hand-man, the Deputy Secretary of the 
Treasury, Larry Summers.
    We're happy to have you with us today to give your 
presentation of the President's revenue portions of the budget 
proposal. We will be delighted to receive your testimony, and 
you may proceed.

 STATEMENT OF HON. LAWRENCE H. SUMMERS, DEPUTY SECRETARY, U.S. 
                   DEPARTMENT OF THE TREASURY

    Mr. Summers. Thank you very much, Mr. Chairman. And I am 
very glad to have the opportunity to appear before this 
Committee and speak about the President's budget.
    I have a longer statement which I will submit, with your 
permission, for the record.
    Chairman Archer. Without objection, your entire written 
statement will be inserted in the record.
    Mr. Summers. I want to make three primary points here this 
afternoon, Mr. Chairman. First, the American economy is in far 
better shape today than it was 5 years ago because of our 
progress in deficit reduction. We are enjoying an economy today 
with 4.7 percent unemployment; the creation of 14 million jobs; 
a higher share of equipment investment than at any time since 
the statistics began to be calculated; real wages starting to 
rise for the first time in 20 years; inflation at lower levels 
than we have seen in many, many years. That is something that I 
think most economists would agree reflects many factors. But 
probably no single factor is as important as the profound 
progress that we have made in deficit reduction since 1993 that 
brought the budget deficit down to $21 billion last year and 
puts us on the verge of substantial budget surpluses.
    As a consequence of the fiscal actions that the President 
entered into in 1993, of course with Congressional support, the 
budget deficit reductions will free up nearly $1 trillion that 
otherwise would have been invested in government bonds, in 
productive equipment, in productive new structures--homes, 
factories--for Americans. In our judgment, preserving this 
fiscal triumph is priority No. 1.
    Second, the best way to preserve and build on the progress 
we have made is to put Social Security first, as the President 
has suggested. It's the best way, in fiscal terms, because it 
helps best to prepare us for the challenge of an aging society. 
It is the best way in national economic terms because it 
provides for the increased national savings that we need if we 
are to meet the challenge of an aging society. And it is the 
best way in national social terms given the importance of the 
basic benefits that Social Security provides. Nearly half of 
Americans over the age of 65 would be in poverty without Social 
Security. Now, at a time of very strong economic performance, 
when we face a major economic challenge, that is a time to 
save. And the best way to save is to preserve the surpluses 
until we have resolved the challenges facing the Social 
Security system.
    Third, a strategy of Social Security first does not 
preclude the important new initiatives to address important 
national goals. What is crucial, however, is that any such 
initiatives be fully paid for and paid for within the budget. 
That is the approach that is reflected in the President's 
budget. The President's budget provides moderate tax cuts that 
are fully paid for and new spending in areas that are crucial 
to increasing future productivity and to protecting America's 
key national interests.
    Let me just highlight a few of the measures contained 
within the President's budget.
    Increased funding for education--the one national economic 
strategy that both increases productivity and increases 
equality--including an additional $5 billion to support school 
construction and modernization projects, subsidies to recruit 
and train more teachers.
    Far-reaching measures to make child care more affordable, 
including a $5 billion expansion of the child and dependent 
care credit that will grant 3 million taxpayers an average 
annual tax cut of $330. Helping parents with child care is not 
only good for families, it's good for the economy because it 
helps all to participate in the workplace to the full extent of 
their abilities and wishes.
    Measures to promote growth in our inner cities and other 
economically distressed areas by increasing the low-income tax 
credit and increasing funding for community development banks. 
Democratizing the access to capital is a national issue. Our 
economy will never achieve its full potential until we equip 
the people of these areas to enter the economic mainstream.
    Crucial new steps to protect the environment with $3.6 
billion and nine tax incentives to promote energy efficiency 
and improve the environment. Tax incentives not directed at 
encouraging the purchase of goods that are ordinarily on the 
market, but encouraging leapfrog technologies such as the major 
innovations we've seen in fuel-efficient vehicles.
    Mr. Chairman, a beneficial byproduct of our policy to 
reduce youth smoking through comprehensive tobacco legislation 
is that it will raise revenues for public needs. Our budget 
proposes to share these revenues among three uses. First, we'll 
return to the States roughly the amount of revenues that they 
would have received under the original settlement. A large part 
of this money will be unrestricted; States can use it for 
whatever purposes they choose. The rest of the money will go to 
States for State-administered programs to provide child care 
subsidies, reduce class size, and expand coverage of children 
by public health insurance. Second, we are providing funding 
for a dramatic expansion of health-related research in America 
through our research fund. Finally, we divide the remaining 
dollars into other uses including cessation programs and farm 
support programs to deal with the adjustments associated with 
tobacco legislation.
    The budget does contain, because of our commitment to 
maintaining fiscal discipline and paying in full for any new 
initiatives, $23 billion in revenue raising measures--$11.1 
billion have been proposed in prior budgets. These items 
include: The repeal of the sales source rule; the repeal of the 
lower of cost or market inventory method; and repeal of the 
percentage depletion for nonfuel minerals mined on Federal 
lands; and the reinstatement of the oil spill excise tax.
    The budget also provides $11.9 billion from new measures to 
eliminate unintended subsidies and other revenue raising 
provisions. These include: Several new insurance provisions 
which raise approximately $4.6 billion in revenues; three 
provisions restricting unintended consequences of the current 
REIT, real estate investment trust, rules, which raise 
approximately $135 million; and eliminating several unwarranted 
subsidies relating to estate and gift taxes, including a 
provision to stop nonbusiness valuation discounts, which raises 
approximately $1 billion.
    Mr. Chairman, these revenue-raising proposals will no doubt 
be the subject of debate. But we look forward to working with 
the Congress in the process of identifying unwarranted 
subsidies where it is necessary to raise revenue in order to 
ensure that we maintain the fiscal discipline that has been so 
important. What is crucial is that any new expenditure or 
reduction in tax burdens be fully paid for. We have finally put 
our Nation's fiscal house in order. It is an enormous 
achievement we must protect, and it is an enormous opportunity 
to seize. As the old saying goes: You fix your roof while the 
sun is shining. And that is the approach that the President's 
budget takes.
    Thank you very much.
    [The prepared statement follows:]

Statement of Hon. Lawrence H. Summers, Deputy Secretary, U.S. 
Department of the Treasury

    Mr. Chairman and members of this committee, it is a 
pleasure to speak with you today about the President's FY 1999 
budget. This is an historic moment: The President is proposing 
a balanced budget for the upcoming fiscal year, the first since 
1969. The budget is rooted in fiscal discipline, yet invests in 
areas critical to future productivity and the American people. 
Perhaps most importantly, this budget provides a clear answer 
to the question of how to use the projected budget surpluses. 
The President proposes that surpluses be reserved pending 
reform of the Social Security system.
    This budget carries forward the President's successful 
economic strategy. As the President said last month during the 
State of the Union, from the beginning of this Administration 
we have ``pursued a new strategy for prosperity: fiscal 
discipline to cut interest rates and spur growth; investments 
in education and skills, in science and technology and 
transportation to prepare our people for the new economy; new 
markets for American products and workers.''
    Before I discuss the specifics of this budget, I think it 
is important to review the progress we have made in getting our 
fiscal house in order.
    When President Clinton entered office in 1993, the federal 
debt had quadrupled from 1980 to 1992 and the 1992 deficit was 
$290 billion, an all time high. These huge deficits kept 
interest rates high, diminished confidence, lowered investment 
and stifled growth. Budgets were based on economic assumptions 
that were far too optimistic. When these assumptions failed to 
materialize, the result was higher deficits than forecast, and 
cynicism about the budget process.
    In 1993, President Clinton fought for, and Congress 
approved, a powerful deficit reduction plan that was based on 
conservative economic assumptions and which brought the deficit 
down by $500 billion over five years. The deficit reduction 
increased confidence, helped bring interest rates down, and 
that, in turn, helped generate and sustain the economic 
recovery, which, in turn, reduced the deficit further. The 
result was a healthy, mutually reinforcing interaction of 
deficit reduction policy and consequent economic growth, that 
brought the deficit down to $22.3 billion in 1997, and sets the 
stage for going to balance.
    Today, unemployment is 4.7 percent; it has been under 6 
percent for the last three years. Over the last five years, the 
economy has generated over 14 million new jobs, inflation and 
interest rates are low and real wages are rising, although too 
many Americans are still not participating fully in the 
economic well-being that most are sharing. Last year's 
bipartisan deficit reduction package has further improved our 
fiscal picture, even while increasing investments and cutting 
taxes for the middle class.
    Moreover, for a median income family of four, the federal 
income and payroll tax burden will be lower in 1998 than at any 
time in the last 20 years. And for a family of four earning 
half the median income, in part because of the expansion of the 
Earned Income Tax Credit for 15 million families, the federal 
income and payroll tax burden is lower than at any time in the 
last 30 years. Families' tax burden will fall further next year 
when the child credit enacted last year is fully phased in.
    Mr. Chairman, the efforts over the past five years have 
paid off: the current projection anticipates surpluses well 
into the next century, although long-term budget forecasts 
inherently involve a great deal of uncertainty. How we use 
these surpluses is a critically important issue in the years 
ahead, and a key focus of the President's budget.
    The overarching point of the President's economic strategy 
going forward and his 1999 budget is clear: under no 
circumstances can we take any steps that will undo the fiscal 
discipline we have worked so hard to achieve. The last few 
years clearly demonstrate the economic benefits of a strong 
fiscal position and the global financial markets that have 
emerged in recent years greatly heighten its importance. The 
global capital markets impose swift and strict penalties on 
countries with unsound policies as we have seen in recent 
months in Asia and confer great benefits on countries with 
sound policies.
    The surpluses present an enormous opportunity, one that so 
many have worked hard to achieve, and one that we must not 
squander. Because this nation has a major challenge ahead: the 
challenge of moving from a younger society to an older one.
    A time of surplus, a time when a major change is coming, is 
not a time to spend. It is a time to save. And the best way to 
save for our future is to save Social Security. That is why we 
believe the surpluses should be reserved until Social Security 
is placed on a sound financial footing for the 21st century.
    This is the right policy for our nation. It is the right 
policy from the standpoint of the economy, which needs to save 
more in order to invest and grow fast enough to shoulder the 
burdens of the next century. It is the right policy from the 
standpoint of our long-term fiscal health, which will otherwise 
be placed under growing strain by the costs associated with 
aging. And it is the right policy from the standpoint of 
individuals, who need to make plans to ensure their long-term 
security in retirement, and a substantial proportion of whom 
will inevitably rely on Social Security. That is why the 
President believes very firmly that nothing should be done with 
the surpluses until Social Security reform is addressed.
    Of course, as we go forward there will be a need for new 
measures to equip our nation for the challenges ahead and to 
compete successfully in this new global economy. The 
President's commitment to preserving the surpluses does not 
preclude undertaking these kinds of initiatives--including 
cutting taxes and increasing spending. But what is critical is 
that all those initiatives are paid for in full.
    We propose moderate targeted tax cuts that are fully paid 
for and propose new spending in areas that are critical to 
increasing future productivity and to protecting and promoting 
America's global economic and national security interests. 
Today I would like to focus on just a few significant measures 
that reflect those priorities.
    First, to enhance productivity and maintain our country's 
competitive position in the years ahead, the Administration 
proposes:
     increased funding for education, including an 
additional $5 billion to support school construction and 
modernization projects, subsidies to recruit and train more 
teachers.
     far-reaching measures to make child care more 
affordable including a $5.1 billion expansion of the child and 
dependent care tax credit that will grant 3 million taxpayers 
an average annual tax cut of $330; a new employer credit to 
promote employee child care and expand its availability; and 
new spending for child-care subsidies for children from poor 
families. Helping parents with child care is not only good for 
families, it is also good for the economy, because it helps all 
to participate in the workforce to the full extent of their 
abilities and wishes,
     measures to promote growth in our inner cities and 
other economically distressed areas, by increasing the low-
income housing tax credit and increasing funding for community 
development banks. This is a national economic issue: Our 
economy will never achieve its full potential until we equip 
the people of these areas to enter the economic mainstream.
    Second, our budget proposes major new steps to protect the 
environment, with $3.6 billion in nine tax incentives to 
promote energy efficiency and improve the environment. These 
include: tax credits of up to $4,000 for purchasers of highly 
fuel-efficient vehicles and up to $2,000 for buying rooftop 
solar equipment; new credits for buying energy-efficient homes 
and certain energy-efficient building equipment; and a range of 
new incentives to clean up environmentally contaminated sites.
    Mr Chairman, a beneficial byproduct of our policy to reduce 
youth smoking by increasing the prices of tobacco products is 
that we will raise revenues for the government. Our budget 
proposes to share these revenues among three sources. First, we 
will return to the states roughly the amount of revenues that 
they would have received under the original tobacco settlement. 
A large part of this money will be unrestricted; states can use 
it for whatever purposes they choose. The rest of the money 
will go to states for state-administered programs to provide 
child care subsidies, reduce class size, and expand coverage of 
children by public health insurance. Second, we are providing 
funding for a dramatic expansion of health-related research in 
America through our Research Fund. Finally, we divide the 
remaining dollars into other uses including cessation programs, 
farm support programs, etc.
    Of the $23 billion in revenue-raising measures we propose, 
$11.1 billion have been proposed in prior budgets. These items 
include the repeal of the sales source rule ($6.6 billion); the 
repeal of the lower-of-cost-or market inventory method ($1.6 
billion); repeal of the percentage depletion for non-fuel 
minerals mined on Federal lands ($500 million); and the 
reinstatement of the oil spill excise tax ($1.2 billion). The 
budget also raises approximately $11.9 billion from new 
measures to eliminate unintended subsidies and other revenue-
raising provisions. These include several new insurance 
provisions, which raise approximately $4.6 billion in revenue; 
three provisions restricting unintended consequences of the 
current real estate investment trust (REIT) rules, which raise 
approximately $135 million; and eliminating several unwarranted 
subsidies relating to estate and gift taxes, including a 
proposal to stop non-business valuation discounts, which raises 
approximately $1 billion.
    Mr. Chairman, these revenue-raising proposals will no doubt 
be the subject of debate. What is crucial is that any new 
expenditure or reductions in tax burdens be paid for. Let me 
repeat: all of the initiatives in the President's budget are 
fully paid for. This budget is in full accordance with the 
Budget Enforcement Act. It does not exceed the discretionary 
caps.
    We have finally put our nation's fiscal house in order. 
That is an enormous achievement we must protect. And it is an 
enormous opportunity we must seize. We face significant 
challenges in fostering a strong economy and maintaining fiscal 
responsibility in the years and decades ahead, particularly 
with the coming retirement of the baby boom. So, as the old 
saying goes, you fix your roof when the sun is shining.
    Mr. Chairman, the President's budget carries forward the 
President's economic strategy that has been so central to the 
strong economic conditions of the past five years. This budget 
preserves the surpluses until we strengthen Social Security, 
invests in areas that are critical to the future of this 
country, provides for programs that protect and promote our 
critical economic and national security interests in the global 
economy, and, of absolutely critical importance, it keeps us on 
the path of fiscal discipline that is so crucial to our 
economic well-being. I look forward to working with all of you 
in the days and weeks ahead to approve this budget. Thank you 
very much.
      

                                

    Chairman Archer. Thank you, Secretary Summers. I'll try to 
keep my inquiry brief and permit adequate time for all the 
Members. Do you have a time constraint today? How long?
    Mr. Summers. I've got plenty of time, Mr. Chairman.
    Chairman Archer. OK, great. You mentioned----
    Mr. Summers. I may develop one depending on how the 
questioning goes here, but at this point I have plenty of time.
    Chairman Archer [continuing]. You mentioned the reduction 
in borrowing at the Federal level, which I applaud. Of course, 
we're continuing to increase borrowing, but we're reducing the 
rate that otherwise would have occurred had we not taken action 
against the deficit. Is that fair?
    Mr. Summers. Well, starting this year, if as expected the 
surplus materializes, we would actually be in a situation where 
the Federal Government as a whole would not be involved in net 
borrowing from the public and the stock of outstanding debt 
held by the public would start to decline.
    Chairman Archer. You specifically refer to debt held by the 
public. As we see, the Social Security Trust Fund continues to 
lend money to the Treasury, money that is not coming from the 
public--unless you consider that the payroll taxes paid by the 
public into the trust fund is drawn out of the public sector. 
But the debt service charges are continuing to increase because 
the overall debt is continuing to increase. And the debt 
ceiling is going to have to be raised again as proof of that. I 
don't want to get into an economic debate with you about 
whether the public holds it or the trust funds hold it, because 
I understand the differences there. But the point that I want 
to make, without belaboring that, is that whereas we have 
reached the point--and it's been a cooperative effort, as you 
mentioned, between the Congress and the President to get to 
this point--to where we've got a balanced budget, that as the 
Federal Government's rate of increase of borrowing has gone 
down, thereby leaving more money in the private sector, we've 
also witnessed a major decline in personal savings in this 
country that has offset that. And I wonder if that disturbs 
you? I think we're at a virtual historic low in personal 
savings, and certainly, of all the industrial countries in the 
world, I believe we're right at the bottom.
    Mr. Summers. Mr. Chairman, as you know, going back a long 
time to the time that I was involved in academic work, I've 
been very concerned about the problem of savings in the United 
States. I think we can all take some satisfaction from the fact 
that the net national savings rate of our country--adding 
together personal savings, corporate savings, and government 
savings--which was approximately 3.1 percent in 1992, has 
increased to 6.5 percent--more than doubled--by 1997, largely, 
as a consequence of the reduction in government budget 
deficits. Unfortunately, that savings rate is still 
substantially lower than our country enjoyed during the high-
growth fifties and sixties, and is still low by international 
standards. But I think in the last few years, after a period of 
12 years when we saw declining national savings rates, we have 
at last started to see the total savings in our country 
increase. And I think that's a very important thing on which we 
can build.
    Chairman Archer. But, I think you share my concern that the 
personal savings rate needs to come up.
    Mr. Summers. I do.
    Chairman Archer. Instead of going down. And that leads me 
to the question of why do you want to attack one of the best 
sources of individual savings in this country which is the 
inside buildup in insurance policies where millions of 
Americans buy insurance and depend on ultimately being able to 
get a payback from that and the annuities. And yet, the 
proposals that you have made directly attack these areas which, 
once again, will erode personal savings in this country.
    Mr. Summers. Mr. Chairman, it is not our intent, and I 
believe it is not the content of our proposals, to attack 
inside buildup. There are a number of insurance proposals and 
they are somewhat technical in their nature. One of the 
proposals, without attacking the basic rule that defers tax on 
inside buildup, does provide for parallel treatment in the case 
of deferred annuities where investments in contracts or funds 
within contracts are realized and switched, parallel with other 
financial instruments. These are provisions that do not change 
the basic rule that defers tax on inside buildup, and affect 
financial instruments that are held by only a very, very small 
fraction of Americans.
    There are also proposals which address not the taxes on 
beneficiaries, because inside buildup is indeed very important 
for savings, but affects certain taxes on insurance companies 
that are associated with reserving practices that go beyond 
what is associated, according to generally accepted accounting 
principles, with the measurement of economic income. And there 
are provisions which affect the corporate-owned life insurance 
case which is primarily a financial devise that is used by 
corporations.
    But, I would be--I am very much committed to the objective 
of increasing savings. And we were very pleased to work with 
you last year on the expansion of IRA provisions and other 
forms of tax-deferred saving. And I would be very troubled 
about anything that interfered in a substantial way with 
savings. But I don't believe that these provisions run that 
risk. The vast majority of the revenue in the insurance area 
comes from things that do not affect taxes on beneficiaries at 
all. And the one provision that does is a provision which does 
not change the basic rule that defers tax on inside buildup.
    Chairman Archer. Well, the net effect of all of these 
provisions that raise taxes out of the insurance industry are 
going to directly attack savings, no matter how you describe 
it.
    Now, let me get into another area very quickly, and then 
move on to other Members of the Committee. The Joint Tax 
Committee has now done an analysis of the recommendations of 
the administration, and they have concluded that there is a net 
tax increase of $80 billion over 5 years, and $174 billion over 
10 years. Now, that is over and above whatever tax benefits 
that you have recommended in your proposal. And in your own 
budget documents, you cite that in 1997 Federal tax receipts 
were 19.9 percent of GDP, and if your administration proposal 
is enacted, they would go to 20.1 percent. Now, 19.9 percent is 
already a historic, peacetime high for this country. And 20.1 
percent increases that to where there will only be 2 years in 
the history of this country where the Federal Government's take 
of GDP has been higher, and those were both in World War II.
    Now, I want to ask you a couple of things after also 
referring you back to the President's comment that he made in 
my own home city of Houston, Texas, where he agreed that he had 
raised taxes too much in the 1993 bill. Well now, considering 
all of that, do you now think that the Tax Relief Act of 1997 
gave back too much in the way of taxes? And is that the reason 
why you are recommending an additional $174 billion net tax 
increase over the next 10 years? Do you believe that 19.9 
percent is an appropriate percent of GDP for the Federal 
Government to take? Do you think that burden is too high on the 
American people? And if so, do you have any plans to bring the 
net tax burden down?
    Mr. Summers. Mr. Chairman, you've asked a number----
    Chairman Archer. A lot of questions.
    Mr. Summers [continuing]. You've asked a number of 
questions. Let me, if I could, just make a few points in 
response. First, I very much support the 1997 tax bill, as the 
other tax bills that have passed in the last few years, as a 
result of which, I think, we can all take a great deal of 
satisfaction in the fact that the tax burden, adding in both 
income and payroll taxes on median-income Americans, is now 
lower than it has been in 20 years. And income tax burden on 
median-income Americans is now lower than it has been in 30 
years. I think that's an important accomplishment in which we 
can all take pride.
    Second, on the figures that you referred to, I think I have 
a slightly different perspective. There's a technical issue 
which is that the 19.9 percent figure is not actually a figure 
for tax collections, but includes all receipts, such as fines, 
and the profits from the Federal Reserve, and so forth. And if 
you look at the share of receipts that go to the Federal 
Government, the administration does indeed want to see it go 
down, and its budget provides for a measure that you used, 
which isn't quite the taxes, for it to go from 19.9 percent 
this year to 19.6 percent in 2003. Of course, there are 
fluctuations from year to year reflecting changes in profit 
shares and things of that kind, but our budget does provide for 
that to go down.
    Third, on the question of tax increases, the issue, Mr. 
Chairman, is largely or entirely due to the treatment of 
possible tobacco revenues, which as you know, the 
administration regards as being part of the context of a 
settlement, and doesn't think should be viewed as a tax 
increase. And indeed, it has not been viewed as a tax increase 
so far in the context of those settlement discussions. And so 
if you take the tobacco out of it, ours is a budget that does 
not raise taxes. Ours is a projection that reduces the Federal 
share of GNP, gross national product, and ours is a budget that 
reduces tax burdens on middle-income families from their 
current level, which is lower relative to income than they have 
been in 20 years.
    Chairman Archer. Well, let me if I may, and I didn't intend 
to do this, but since you brought up the cigarette tax, let me 
pursue that for just a moment. I'm fortunately one who has 
never smoked in my life. I despise cigarette smoke. I wish 
everybody in this country would stop smoking--we'd be a much 
better Nation. But, a tax on cigarettes is a tax. It's called a 
tax, and it is a tax. And for those people who do continue to 
smoke, though unwise to their own personal health, they will be 
paying that as a tax into the Federal Government, which means 
that they will have less money to spend on other items in the 
marketplace. So it is clearly a tax. And to call it anything 
else, although you may be able to find that it's more popular 
than other taxes, is to ignore an economic basic reality that 
it is a tax. And it impacts on the economy in the same way 
other taxes would, except that it hits lower income people the 
hardest. It is one of the most regressive taxes that there is. 
And all of the data, whether done by the Treasury, or the Joint 
Committee on Taxation, shows that to be true. So it is a tax. 
And to say: Well, we can ignore that in determining what the 
net tax impact of this bill is, is just not accurate.
    But I do appreciate your comments, and I yield to Mr. 
Rangel. In fact, I recognize Mr. Rangel.
    Mr. Rangel. And I recognize you too, Mr. Chairman. 
[Laughter.]
    That compassionate display for the poor as it relates to 
cigarette tax, is really something that I was moved by. I just 
wanted to indicate that.
    I know you have a lot of time, but, I hate to raise this, 
this election is kind of closing in on me, and I don't know how 
much time the President has. I have to agree with the Chairman 
that there are some rather provocative tax increases that you 
presented. They have brought a degree of bipartisanship, of 
opposition. But there are some pretty exciting social programs: 
Social Security, education, health care, child care, and the 
economic development of inner cities.
    Now this is the President's program, and I just got a copy 
of the Majority Whip's program, which I share with the Chair, 
of course. As I look at this, Mr. Chairman, all the red dates 
are days we're not here. So, that's half of February we're not 
here. The President will be in Africa in March. We'll be here 
for about 5 or 6 days in April; half of May; most of June; half 
of July; a little bit in August; half of September; and then, 
Tom DeLay, the Majority Whip says that the target adjournment 
date is October 9. Now, I haven't added the days that we 
actually are going to be working, but has the President or his 
representative worked out some type of an agreement with the 
Majority so that the President's proposals, as well as the 
Majority's--for lack of a better word--legislative program, 
would be discussed? I mean is there any timeframe that you know 
of that you could share with us?
    Mr. Summers. Congressman Rangel, I'm not aware of agreed 
legislative timetable. I think we in the administration believe 
that the President's budget contains a variety of very 
important proposals that are very much in the national 
interests. Others, of course, will have a different view. And 
our hope is that the proposals will receive full and careful 
consideration by the Congress this year. But I don't have a 
particular set of timetables to share with this----
    Mr. Rangel. Well, let me say this: I'm certain that the 
Majority and the Chairman make certain that they're fair in 
reviewing the President's proposal. But suppose, just for the 
purpose of our discussion, they decided to do nothing with any 
of the President's proposals and just decided not to work this 
year at all. What happens then? I have no idea how this thing 
works, but since we don't see each other that often, what would 
the President say or do?
    Mr. Summers. I would think that all of us have an 
obligation to pass a budget so that the government----
    Mr. Rangel. Well let's talk about that----
    Mr. Summers [continuing]. So that the government can 
continue to function into the next year. I think that if we 
passed a status quo budget rather than advanced initiatives of 
the kind that are contained in the President's budget, we would 
be passing up important opportunities to invest in education, 
to invest in child care, to invest in basic medical research, 
and we would leave what I feel is a very serious problem: The 
million young people who begin smoking each year--nearly 
300,000 of whom will die as a result of that smoking--we would 
leave that problem unaddressed.
    Mr. Rangel. OK, well, just on the question of the budget, 
I'm not certain, but don't we have a legal responsibility to 
have a budget passed by the 15th of April? Now, if that's so, 
and we are only scheduled to work in March, and we're out of 
here for April, I don't think we'll be able to do that. So I 
hope the President might share with us, Republican and 
Democrats, some timetable that you might just recommend so that 
when I work with my Republican friends we might be able to fold 
in some of the President's proposals in the few days that we 
intend to be in session this year.
    Thank you, Mr. Chairman.
    Chairman Archer. Mr. Crane.
    Mr. Crane. Thank you, Mr. Chairman. On the positive side, 
the budget did include a provision I've supported and that's 
funding for the Conservation Trust Fund for Puerto Rico. And I 
want to commend you for that and ask unanimous consent, Mr. 
Chairman, that a printed statement I have might be inserted in 
the record at this point.
    Chairman Archer. Without objection. So ordered.
    Mr. Crane. I yield back the balance of my time. Thank you.
    [The prepared statement follows:]

Statement of Hon. Philip M. Crane, a Representative in Congress from 
the State of Illinois

    Mr. Chairman, The Conservation Trust Fund of Puerto Rico is 
an organization dedicated to the preservation of the natural 
resources of that magnificent island. For the past two years I 
have been seeking a solution to an impending financial crisis 
that would render the Trust Fund unable to perform its valuable 
mission. The termination of the so-called ``Section 936'' 
provision within the tax code ended the source of the Trust's 
funding. This year's FY99 Federal Budget adopts a proposal that 
I first put forward last year and incorporates it in the 
recovery of excise taxes back to the Commonwealth of Puerto 
Rico. By designating 50 cents to the Trust Fund out of the 
$13.50 excise tax collected on each gallon of distilled spirits 
exported from Puerto Rico, for a period of 5 years, the 
recommendation allows the Trust to complete its endowment fund 
and perform its work in perpetuity.
    The Trust Fund was established in 1968 by a Memorandum of 
Understanding between the Secretary of the Interior, Steward L. 
Udall and the Governor of the Commonwealth of Puerto Rico, 
Roberto Sanchez Velella, and the Administrator of the Economic 
Development Administration of Puerto Rico, Sergio Camero, to 
protect the natural resources of the island. During the past 29 
years the only significant efforts to preserve critical land 
resources have been conducted by the Conservation Trust Fund. 
Even with this active role, only 5% of the Island of Puerto 
Rico is under some protection either by federal or local 
conservation agencies or the Trust. This number is half of the 
percentage in the United States and less than 25% of Costa 
Rica. In the aftermath of Hurricane Hugo, when the island was 
devastated, it was the Conservation Trust Fund that led the 
reforestation effort of the rain forest. It was the 
Conservation Trust Fund that used this opportunity to prepare 
critical environmental areas for restoration and at the same 
time utilize them as an educational tool for the children and 
people of the island.
    Mr. Chairman, funding for the Trust was initially provided 
through contributions imposed by the Department of Interior in 
the Oil Import Allocations of petroleum and petrochemical 
companies operating in the island. This lasted for a period of 
ten years. Later the Trust became a participant in the QPSII 
program within Section 936 of the Internal Revenue Co realized 
that the changes being made in Section 936 would call for the 
gradual phase out of the program. The Trust embarked on an 
aggressive saving campaign. They cut back all capital 
expenditures, including land procurement and major improvements 
to existing properties. During that time the Trust has been 
able to accumulate approximately $30 million in the endowment 
fund. The goal was to reach somewhere near $80 million and this 
would have been accomplished had Section 936 phased out in the 
projected time period.
    Two years ago this committee abruptly changed those plans. 
With the passage of the Small Business Job Protection Act we 
ended Section 936. The Conservation Trust Fund was the 
unintended victim of this action. Left without a source for 80 
percent of its funds, the Trust has endeavored to work with my 
office to find a solution. My staff has discussed this problem 
with the committee staff on numerous occasions. The proposal in 
the FY99 Budget is a natural outgrowth of a proposal that I 
made last year. The support of the Secretary of the Interior 
has been critical in shepherding this through the budget maze. 
The Governor of Puerto Rico is in support of this proposal and 
I urge my colleagues on the Committee to support this effort to 
save the endeavors of the Conservation Trust Fund.
      

                                

    Chairman Archer. Mr. Bunning.
    Mr. Bunning. Thank you, Mr. Chairman.
    Mr. Summers, would you explain the administration's 
proposal for the treatment of the budget surplus in reform of 
the Social Security system.
    Mr. Summers. The President has simply said that in light of 
the very great importance of the Social Security issue to the 
future well-being of all Americans, that we should not violate 
current budget rules and spend the surplus on either new 
expenditure programs or tax cuts that are not fully paid for 
within the budget until we have reached a resolution with 
respect to the long-term future of the Social Security system. 
And he----
    Mr. Bunning. Does that mean--excuse me.
    Mr. Summers. And he has called for a process of national 
dialog, including a number of conferences and a number of other 
steps during 1998, to set the stage for the process of coming 
together on legislation that would begin in January 1999.
    Mr. Bunning. Does that mean the President is not proposing 
to take the OASDI reserves out of the budget? In other words, 
are we going to be able to recycle? As you well know, what 
happens now--I don't have to explain this to you, but some 
people out here might not understand--is when we bring in the 
FICA funds into the Treasury, we bring them into the Social 
Security Trust Funds, there are nonnegotiable bonds issued, and 
then we recycle the money out and spend it for other reasons, 
other purposes of the Federal Government. Would you think that 
we would not do that with the surplus, or that we would reissue 
bonds, and we would recycle the surplus and spend it for other 
purposes?
    Mr. Summers. There are a number of possibilities that can 
be described in a number of ways. At this point, what the 
President has said is that the unified surplus is not something 
we should eat into until and unless we have put the Social 
Security system on a long-run viable path.
    Mr. Bunning. Let me ask you then: Yesterday before the 
Senate Budget Committee, you suggested that the surpluses, up 
to $100 billion or more, be transferred to the OASDI fund and 
invested in Treasury bonds. That means that they could be 
recycled and spent for other purposes then. In other words, 
under the budget, as it presently is constructed.
    Mr. Summers. Congressman Bunning, I didn't make any policy 
suggestion----
    Mr. Bunning. Am I misquoting you?
    Mr. Summers. A little bit, I think.
    Mr. Bunning. Oh, really?
    Mr. Summers. What I said yesterday was that there were a 
variety of possibilities and I had no recommendation. Then I 
observed, referring to one of those possibilities, that if $100 
billion of money was credited to the Social Security Trust Fund 
and allowed to accumulate in the Social Security Trust Fund, 
that the result would be to push the expiration date of the 
Social Security Trust Fund out by 1 year only, only if we 
didn't recycle the money.
    Mr. Bunning. Because obviously, if we recycled the money, 
we'd be spending it and putting more liability into the trust 
fund. Was that what your suggestion was?
    Mr. Summers. There was no suggestion. The assumption was, 
and I think for the reasons you suggest it's completely right, 
that clearly if the trust fund took on an asset of $100 billion 
and took on an extra liability of $100 billion, nothing would 
be accomplished.
    Mr. Bunning. That's correct.
    Mr. Summers. And so, that line of thought--which again is 
one possibility, it is not a recommendation--would call for 
adding $100 billion to the surplus, in effect, transferring the 
money from the unified budget to the Social Security Trust Fund 
which would strengthen the Social Security Trust Fund and 
would, as a byproduct--because the money would then be 
allocated there--assure that the unified surplus would be 
maintained.
    Mr. Bunning. Only if we walled off the surplus and said: No 
further use of this money could be used for any other purpose 
than the Social Security Trust Fund and you couldn't issue new 
debt against that money.
    Mr. Summers. In a sense, Congressman, those who think about 
that proposal are regarding the transfer of the revenues to the 
Social Security Trust Fund as a way of accomplishing exactly 
the kind of walling off that you're speaking of.
    Mr. Bunning. One more question. What would the budget 
deficit be if the Social Security Trust Funds were not used to 
offset the budget deficit from now until the year 2008?
    Mr. Summers. It would be--the budget would be--certainly 
for the next half dozen years and probably a little bit beyond 
that, the budget would be in quite significant deficit but for 
the unified budget which reflects a unification of the trust 
funds. The trust funds are in surplus, the other parts of the 
budget are in deficit; together we will emerge with a surplus--
that's the unified surplus--but the non-trust fund budget is, 
as your question suggests, in deficit.
    Mr. Bunning. Thank you very much.
    Mr. Crane [presiding]. Mr. Matsui.
    Mr. Matsui. Thank you, Mr. Chairman.
    There's a lot of talk about simplification and not wanting 
to clutter up the Code, particularly by Chairman Archer. Will 
you help me with this because I don't understand it: To go on 
the capital gains holding period from 18 months down to 12 
months, which is what, I think, a number of Republicans want to 
do, does that do anything to decrease the rate from 28 percent? 
Does that change the number of lines on the tax form?
    Mr. Summers. I think at this point, Congressman Matsui, any 
change in the capital gains rules would be, on net, 
complicating of the Tax Code for two reasons. First, the IRS, 
which I think the Committee is aware, faces a number of very 
serious challenges, including the year 2000 problem, including 
a reorientation toward customer service, and would, I think, 
have a difficult time handling and managing the amendment to 
provisions that are only now being phased in. And so a 
transitional adjustment would be very complicating in that way.
    Second, I think that the, to use the euphemism, I think the 
tax bill that we enacted last year reflected a carefully 
crafted and balanced set of compromises. And an effort to undo 
those compromises in one area will inevitably raise questions 
about many other areas.
    Mr. Matsui. Let me get to my main point. Obviously you 
support the change on the IRS and the restructuring effort. Is 
that correct?
    Mr. Summers. We very much support it.
    Mr. Matsui. You support it. And so, you're no longer 
concerned about the fact that we have an independent commission 
overseeing the IRS and the whole issue of confidentiality, and 
many of the issues that were raised a little earlier.
    Mr. Summers. I think we found----
    Mr. Matsui. But let me get to my main point, because I 
think what I want to do is address the issue of complexity. 
Last year we had an additional 824 amendments that were added 
to the Internal Revenue Code as a result of the tax bill, and 
we had 285 new sections. I've just counted the administration's 
proposal here; we have 75 new tax cuts--I don't know whether 
these are new sections or new amendments--and we also have 42 
new tax increases, and 7 other provisions. So that's about 120 
or so new provisions in the Code, coupled with the 285 and the 
824. I know that Mr. Rossotti is trying to do a good job, and I 
do understand that you are trying to clean up the whole 
Internal Revenue Service. I commend you, Mr. Rubin, and 
obviously, Mr. Rossotti, and many of those who have preceded 
you.
    But I guess what I'm troubled by is some of the hypocrisy 
here. We're trying to clean up the Code and I keep seeing 
amendments being offered. I had somebody do a little research--
one of those LEXIS-NEXIS searches--and Members of this 
Committee, Members of the House, who were talking about 
simplifying the Code are offering all kinds of credits and 
deductions and preferences. And your proposal is just packed 
with more of these. You know, I think we have to come to terms, 
because we can't go out there and talk about tax reform and 
simplifying the Code, and at the same time, quietly, behind 
everyone's back, offer literally hundreds of changes in the Tax 
Code. I think we're being a little unfair to Mr. Rossotti. I 
think we're being unfair to the employees of the Internal 
Revenue Service, and certainly I think we're misleading people.
    And so, you may want to have a comment on it; you may not 
want to have a comment on it. It's not totally your 
responsibility. I mean, I think a lot of Members of Congress 
last year played a significant role in this particular effort. 
It was interesting, at least the 1981 bill had a philosophy: It 
wanted to promote economic growth. The 1986 bill had a 
philosophy of simplifying the Code. Last year's bill had no 
philosophy at all. It was just: Let's just put everybody's tax 
cuts together and make that a tax bill, and make everybody 
happy. But there was no growth, economic philosophy, or 
simplification philosophy to it. And I'm afraid that's what's 
going to happen again if you embark upon another tax bill and 
at the same time blame it on the IRS.
    Mr. Summers. Congressman Matsui, I think you raise a very, 
very important issue. We've tried to be very conscious of that 
as we tried to balance the various objectives here, and I think 
a substantial fraction--more than 40--of the initiatives and 
amendments that are contained in the President's budget that 
you referred to are Taxpayer Bill of Rights for simplification 
items that would have the net effect of reducing burdens on 
taxpayers and reducing compliance and striking out other forms 
of complexity.
    But I do think in looking at the various kinds of 
incentives we provide through the Tax Code that we do need, if 
you like, to put a higher price on measures which complicate 
the Code and try to recognize that each thing we add adds to 
the weight of the whole system and that at a certain point the 
system might fall of its own weight. And I think that is an 
important concern.
    Mr. Crane. Mr. Summers, if you'll hang in there, I want to 
recess the Committee subject to the call of the Chair, because 
we're down to 5 minutes on this vote.
    [Recess.]
    Mr. Shaw [presiding]. There's going to be another vote 
shortly, so we're going to be disrupted again, but I was asked 
to start the hearing, so we won't unnecessarily delay the 
witnesses.
    So Mr. English is recognized
    Mr. English. Thank you, Mr. Chairman.
    Secretary Summers, I noted that the administration's 
proposal includes an exemption for severance pay from the 
income tax of up to $2,000 with a variety of restrictions--
after 6 months, applying the severance packages below under 
$125,000. I have a couple of questions. One is you would apply 
this severance pay exemption specifically for separations from 
service that are connected with a reduction in employer's work 
force. How would you define that?
    Mr. Summers. It's a technical question, and I'm not a tax 
lawyer, but I would assume that the employers would qualify 
instances of severance based on a comparison of the total size 
of the work force in the tax year with the total size of their 
work force in the preceding year.
    Mr. English. Do you think this provision substantially adds 
to the complexity of the Tax Code? Do you think it's a 
provision that you would anticipate the administration would 
seek to expand down the road?
    Mr. Summers. I don't particularly see any plan for 
subsequent expansion, and I don't think it adds substantially 
to the complexity of the Code. I think it serves an important, 
very important function at a time of greater globalization in 
the economy, and at a time of greater change in helping people 
to adjust to change. I think in that way it allows market 
forces to operate more effectively.
    Mr. English. Mr. Secretary, I think I understand that part 
of the intent, and, again, I presume you're familiar with the 
provision. What I wanted to get a feel for--$2,000 seems to be 
a fairly arbitrary number and a very small part of any 
severance package. I guess, recognizing that there might be 
some benefits for this kind of a tax exclusion, I was wondering 
if the administration saw this as part of a long-term strategy. 
I am judging from your comments probably not. Do you have 
anything to add?
    Mr. Summers. This is not part of any long-run strategy of 
which I am aware to--it is, I think, you know, $2,000, not some 
of the severance packages you read about for executives in the 
newspaper, but I think for a lot of people who are laid off I 
think $2,000 and the tax deductibility on $2,000 makes a real 
difference.
    Mr. English. Thank you. Let me move on. Under the energy 
and environmental tax credits, have you done any studies in-
house on the distributional effects of these proposals?
    Mr. Summers. We do not have distributional analyses of 
them, and to do the distributional analysis would be very 
complex. You think, for example, about, say, the incentive for 
purchasing very highly fuel-efficient cars. Part of the 
incidence might be on the buyers of those cars, but part of the 
incidence would be on the producers and the workers who are 
involved in making those cars. So I think to look at an 
incentive of that size and do a distributional analysis would 
be, our analysts report, very, very difficult.
    Mr. English. OK. I notice in your energy and environmental 
tax credit proposals you do not include an extension of the 
ethanol credit. What is the significance of that?
    Mr. Summers. I think the incentives in our energy and 
environmental credit are really all measures that are directed 
at market-based approaches to----
    Mr. English. And ethanol----
    Mr. Summers [continuing]. Supporting reductions in carbon 
usage, and the fuel from carbon. And so I think a subsidy----
    Mr. English. So you don't regard----
    Mr. Summers [continuing]. A subsidy to a fossil fuel, I 
mean, I think----
    Mr. English. You don't regard auto emissions as greenhouse 
gas then or----
    Mr. Summers [continuing]. Well, I think--certainly carbon 
dioxide, which comes from any fossil fuel, is a greenhouse gas, 
but the focus of our incentives is on greenhouse gas 
reductions.
    Mr. English. OK. And I guess a final question: One of the 
perennial provisions that comes out of the administration has 
to do with changing the deposit requirements for FUTA taxes 
from quarterly to monthly. This has been proposed before, and 
it's been fairly consistently shot down. Is there any policy 
reason why you would be continually proposing this, because it 
appears primarily to harass businesses, particularly small 
businesses, and does not appear, at least from my perspective, 
to generate any real positive effects from the standpoint of 
tax enforcement.
    Mr. Summers. Let me say, Congressman English, that the 
proposal is crafted to include an exclusion for small 
businesses in order to respond to the small business concern, 
and that the rationale is that it will improve compliance, and 
in that way make possible reductions in other taxes, and that 
it will more closely match the inflows of money into State 
funds with the outflows from State unemployment insurance 
funds.
    If I might just return to your previous question, I'm told 
that the extension of the ethanol provisions is contained in 
the administration's ISTEA proposal, the highways proposal, but 
that the ethanol provisions do not expire this year. And so we 
are providing for that.
    Mr. English. OK.
    Mr. Summers. It's just not a global greenhouse gas.
    Mr. English. I understand the distinction, and I appreciate 
that. Thank you very much.
    Mr. Summers. Thank you.
    Mr. English. Thank you, Mr. Chairman.
    Mr. Shaw. Mr. Weller.
    Mr. Weller. Thank you, Mr. Chairman, and, Mr. Secretary, I 
appreciate your taking time to be with us today.
    I represent a pretty diverse district, the south side of 
Chicago and the south suburbs, both city suburbs and a lot of 
rural areas. I always listen for concerns and thoughts that are 
fairly consistent, whether you live in the city, the suburbs, 
or country. This past week I had a meeting with a group of 
women, entrepreneurs and community leaders, and we talked about 
the President's budget. Frankly, they liked what the President 
said about Social Security, but they then question why he would 
then use the surplus in the Social Security Trust Fund to 
offset new spending initiatives. They were concerned about, of 
course, the President proposing to raise the tax burden on 
Americans to its highest level since World War II, and they 
were also very concerned about the President's new proposal for 
a tax increase on a retirement vehicle that many of the women 
in the group that I met with were using.
    I found it interesting. They shared some statistics, and 
when it comes to annuities which you propose taxing, a majority 
of these annuities that are sold today are held by women. 
Ninety percent of them are over 50 years of age, and two-thirds 
of the women who purchase these make less than $50,000. They're 
middle-class individuals.
    What I was just trying--so I can better understand your tax 
increase on retirement, I was wondering, how much revenue is 
generated by your tax increase on retirement?
    Mr. Summers. The annuities provision that you're referring 
to I believe has a revenue impact of approximately $1 billion.
    Mr. Weller. A year?
    Mr. Summers. No, $1 billion over 5 years.
    Mr. Weller. So it's a $1 billion tax increase over 5 years 
on retirement. Money that would have gone toward retirement, 
that instead will come to Washington and be spent on the 
President's new spending initiatives?
    Mr. Summers. No, Congressman, I think the principal 
incidence will be on commissions received by those who sell a 
particular class of financial products, and in particular, 
those who encourage the churning of those products. Anyone who 
purchases a deferred annuity and holds the same investments 
inside the deferred annuity will have no change whatsoever in 
their tax practice. What will be discouraged is transfers from 
one deferred annuity to another. And therefore, those who are 
involved in encouraging the churning of the deferred annuities 
and who receive--I think it's been well documented--rather 
substantial commissions, when those deferred annuities are 
churned, will be affected. Again, for someone who purchases a 
deferred annuity and holds the same funds inside the deferred 
annuity, they will get full inside buildup, with no significant 
change in----
    Mr. Weller. Let me, Mr. Secretary, let me----
    Mr. Summers [continuing]. Tax liability.
    Mr. Weller. Then you really raise an issue of fairness. As 
a Federal employee, if you're in the Thrift Savings Plan, you 
can shift your funds around in your Thrift Savings Plan from 
one fund to another, choose options, without a transaction tax 
which you're proposing, but you're turning around, and on the 
women that I met with last week who are using this as part of 
their retirement plan, imposing a tax on their decision to 
shift it from one investment option to the other. How is that 
fair?
    Mr. Summers. Congressman Weller, the Congress has, in 
crafting the legislation in this area, established a set of 
particular tax preferences for pensions and 401(k)s that are 
circumscribed, that include limits on contributions, that 
include top-heavy rules to assure that the benefits are equally 
shared, and in that category it is, indeed, possible to make 
transfers.
    Deferred annuities have never been thought of as being 
within that category. There are no top-heavy rules; there are 
no limits on the quantity of contributions. So I think that is 
not usually thought of as the appropriate analogy in looking at 
deferred annuity provisions. Deferred annuities investments are 
in many ways more like mutual fund investments, although they 
are mutual fund investments that are very substantially 
preferred because the inside buildup is preferred, is tax-
deferred, unlike the situation with respect to mutual funds.
    Mr. Weller. But, Mr. Secretary, you are taxing one of the 
choices and one of the options they have, and frankly, I think 
from a fairness standpoint, it doesn't make sense to tax one 
and not the other. Of course, I don't support your tax, but the 
question I have is: You know, in your testimony, you point out 
that you're spending initiatives are paid for with these tax 
increases that the President's proposing in his budget. And I 
was wondering, specifically, which spending initiative does the 
President pay for with this tax increase on retirement?
    Mr. Summers. No. What I suggested, the spending initiatives 
that the President has undertaken are financed through other 
spending cuts or are financed through proceeds from the tax 
settlement. The President's budget is balanced, essentially 
balanced, in the tax area with tax incentives and tax cuts that 
are contained in the budget being matched by the revenue-
raisers that are included in the budget.
    Mr. Weller. So which spending initiative is matched with 
those tax increases on retirement----
    Mr. Summers. It's a package. That's not a question--money 
is fungible, Congressman. There's a package of revenue-raisers 
and a package of tax cuts, and the package of tax cuts is 
financed by the package of revenue-raisers.
    Mr. Shaw. The time of the gentleman has expired.
    Mr. Weller. Thank you, Mr. Chairman.
    Mr. Shaw. Mr. McCrery.
    Mr. McCrery. Thank you, Mr. Chairman.
    Mr. Summers, just to follow up on Mr. Weller's questioning 
about the administration's proposals on annuities and variable 
life products, clarify, if you will, who is taxed when there 
is, say, an exchange for a life insurance policy, for an 
annuity? Or if an investor in an annuity, for example, decides 
to change the mix of the investment within the annuity, who 
exactly is taxed?
    Mr. Summers. If you'll pardon me 1 second, I will consult 
with the experts behind me and I will give you an answer.
    Mr. McCrery. Sure.
    Mr. Summers. In the area of the deferred annuity, which is 
13 percent of the total set of insurance proposals, the holder 
of the annuity who makes a transfer from one asset to another 
asset is taxed. A holder who chooses a balanced portfolio and 
sticks with that balanced portfolio would not bear any tax 
burden.
    Mr. McCrery. When you say the ``holder,'' who is that?
    Mr. Summers. That's the potential beneficiary.
    Mr. McCrery. So that's usually the purchaser of the 
annuity, the consumer?
    Mr. Summers. That is usually the purchaser of the annuity, 
indeed.
    Mr. McCrery. So at least in this case you are taxing 
directly or imposing a new tax directly on the consumer of 
those products, and not the agents or the insurance companies?
    Mr. Summers. Well, as I tried to suggest in my answer, this 
13 percent of the insurance does affect beneficiaries directly. 
It also affects those who are involved in encouraging transfers 
from one deferred annuity contract to another. Depending on 
what choices are made, it's difficult to sort out the 
incidence. In response to this tax, people do not churn their 
investments. Then the result will be that the revenue loss will 
be to the agents who would have encouraged--would have earned 
commissions on the churning. If behavior doesn't change and the 
same commissions are paid, then those individuals who are 
churning will face a tax treatment on their deferred annuities 
that is similar on asset transfers, though not similar with 
respect to inside buildup, to the tax treatment with respect to 
mutual funds.
    Mr. McCrery. But at least on the instance which I 
described, and to which you initially responded, it's the 
consumer that would experience an increase in taxes. And don't 
you think that that is contrary to good public policy that 
should encourage people to plan wisely for their retirement? I 
mean, if you've got somebody that's 30 years old that enters 
into an agreement or contract like this, the mix of his 
investment--I'll wait until your staff gets through, so you 
could listen. A 30-year-old who enters into one of these 
contracts is going to have a different investment mix than he 
will have when he's 55 years old. So shouldn't he have the 
right to shift those investment choices within that contract 
without having to face a tax? That seems to me to be totally 
contrary to what we want people to do, which is wisely plan for 
their retirement.
    Mr. Summers. Well, of course, a 30-year-old who is 
following a normal path would be making contributions each 
year, and so would not have difficulty in adjusting their 
overall mix between stocks and bonds, for example, simply by 
adjusting the pattern of their contributions, or could do that 
in the areas where there would be tax neutrality between those 
within the 401(k)s, within the pensions.
    Mr. McCrery. I think you're wrong on that. I don't think 
there is enough flexibility to change the mix just on the basis 
of new contributions to plans.
    Also, before my time is up, I just want to point out that 
there is a distinct difference between these types of contracts 
and mutual funds. You try to equate the two, and, in fact, on 
these kinds of contracts there are penalties for early 
withdrawal; there are regulatory barriers to people getting out 
of these before they reach retirement age. So they are not the 
same as mutual funds, Mr. Summers, are they?
    Mr. Summers. They are not the same instruments as mutual 
funds, obviously, Congressman, but I think the general 
principle is something that we've long recognized in the tax 
law, that when an event that is concomitant to, or the same as, 
a realization of the sale of an asset takes place, that that is 
something that we tax.
    I might note, just parenthetically, that most of these 
assets are actually marketed to those who have retired or who 
are about to retire. So the situation of a changing need over 
the life cycle is not one that arises with any great 
frequency----
    Mr. McCrery. That is changing. That is changing, though, 
Mr. Summers. That statistic won't be the same 5 years from now.
    Mr. Summers. Well, I'm not sure. I mean, I think these 
products have been subject to rather extensive and not wholly 
favorable analysis in the financial press just in terms of 
relative rates of return. So I'm not sure what the future will 
hold for them.
    Mr. Shaw. If the gentleman would suspend, the time of the 
gentleman has expired.
    Mr. Summers, I may inquire as to what your schedule is. We 
have a series of votes on the floor which is going to take the 
better part of an hour. Can you stay with us?
    Mr. Summers. I will have a difficult--I need to get back to 
my office for a fairly important, quite important meeting 
sometime between 3:30 and 4 o'clock.
    Mr. Shaw. Well, if you could stay with us at least until 
3:30, we'll try to wrap it up or make arrangements for you to 
come back.
    Mr. Summers. I'd be delighted to.
    Mr. Shaw. Thank you. I appreciate it.
    Mr. Summers. Thank you.
    Mr. Shaw. The Committee will be in recess for the better 
part of an hour, but at the conclusion of the votes that are 
scheduled we shall reconvene.
    [Recess.]
    Mrs. Johnson of Connecticut [presiding]. I'd like to 
announce that the hearing is formally adjourned. Mr. Summers 
had to depart and has indicated that he will respond promptly 
to questions in writing from Members. We thank him for that.
    [The following questions submitted by Mr. Houghton, and 
Deputy Secretary Summers' responses are as follows:]

Questions Submitted to Deputy Treasury Secretary Summers by 
Representative Amo Houghton

    (1) Regarding the Foreign Application of the Frequent Flyer Tax:

    Last year's tax bill extended the aviation tax to purchases 
from air carriers of frequent-flyer award miles by credit card 
companies, hotels, rental car companies, and others to be 
awarded to their customers. It is my understanding that this 
new law is being interpreted as applying to foreign-based 
frequent-flyer programs run by both U.S. and foreign companies, 
and that foreign application of this tax will have the impact 
of taxing frequent flyer miles that may never be used for U.S. 
air travel. I also understand that at least 20 foreign 
governments have filed protests with the State Department 
arguing that the tax should not apply when the ultimate air 
travel largely involves points outside the United States.
    Would the Treasury Department support a legislative 
alternative to apply the tax more directly to travel to and 
from the United States, since the current foreign application 
of the tax appears to be overly broad, creates collection 
problems for the IRS, and will produce revenues that will have 
little connection to the use of FAA facilities and programs?

         Questions on Revenue Estimate for PS-REIT Elimination:

    Can you share with me some of your methodologies concerning 
your revenue estimate for the PS-REIT proposal?
    The answers provided below should provide you with a 
reasonably good understanding of the main assumptions in the 
methodology used by the Administration to produce the revenue 
estimate for the PS-REIT proposal.
    Have you had a chance to review the Joint Tax Committee's 
estimate and do you have any comments on it?
    Given the large amount of uncertainty in predicting the 
growth rate of acquisitions by paired REITs under current law, 
the Joint Tax Committee's estimate, although somewhat different 
from the Administration estimate, does not seem unreasonable.
    In your revenue estimate of the Administration's proposal 
to limit the tax benefits of the existing paired REITs, what 
assumptions did you make about the growth rate of the paired 
REITs under current law?
    Despite the recent large acquisitions by paired REITs, we 
assumed that growth rates of paired REITs under current law 
would in the long run be about 10 percent per year.
    What are your assumptions about the revenue loss that 
occurs under current policy because the attractiveness of the 
paired-share structure induces some businesses to become REITs 
that otherwise would have remained C-corporations?
    The only firms that can use the paired-share structure are 
those that were grandfathered by a provision in the Deficit 
Reduction Act of 1984. C-corporations cannot elect to become 
paired-share REITs. Our assumptions concerning the effect of 
paired-share REITs acquiring C-corporations under current 
policy is discussed in the answer to Question 3.
    What are your assumptions about the revenue loss that 
occurs under current policy due to the fact that paired-share 
REITs can achieve income shifting for tax purposes that 
ordinary REITs cannot?
    We assumed that nearly all of the estimated revenue loss 
occurs from paired-share REITs shifting income for tax 
purposes.
    Assuming the Administration's proposal is implemented, what 
percentage of those assets that would otherwise have converted 
to paired-REIT staus do you assume will place their real estate 
assets in a REIT, and what percentage will continue to operate 
as non-REIT C-corporations?
    We assumed that nearly all of the assets that would have 
acquired by the paired REITs under current law would continue 
to operate as non-REIT C-corporations if the Administration's 
proposal is implemented.
      

                                

    [Whereupon, at 2:53 p.m., the hearing was adjourned subject 
to the call of the Chair.]
    [Submissions for the record follow:]

Statement of American Bankers Association

    The American Bankers Association (ABA) is pleased to have 
an opportunity to submit this statement for the record on 
certain of the revenue provisions of the Administration's 
fiscal year 1999 budget.
    The American Bankers Association brings together all 
categories of banking institutions to best represent the 
interests of the rapidly changing industry. Its membership--
which includes community, regional and money center banks and 
holding companies, as well as savings associations, trust 
companies and savings banks--makes ABA the largest banking 
trade association in the country.
    The Administration's 1999 budget proposal contains several 
provisions of interest and concern to banking institutions. 
Although we believe that the Administration's revenue plan 
contains several significant tax incentive provisions that 
would amplify well established policies, we are deeply 
concerned with a number of its revenue measures. The subject 
revenue provisions would, in fact, impose new and additional 
taxes on the banking industry rather than ``closing 
loopholes.'' As a package, such revenue measures would, inter 
alia, inhibit job creation and the provision of employee and 
retiree benefits provided by employers while inequitably 
penalizing business.
    Our preliminary views on the subject provisions are set out 
below.

                            Revenue Measures

Modify the Corporate-Owned Life Insurance Rules

    The ABA strongly opposes the Administration's proposal to 
modify the corporate-owned life insurance rules. The subject 
provision would effectively eliminate corporate owned life 
insurance that is used to offset escalating employee and 
retiree benefit liabilities (such as health insurance, survivor 
benefits, etc.)--an activity that promotes socially responsible 
behavior and should be encouraged rather than discouraged. 
Cutbacks in such programs may also lead to the reduction of 
benefits provided by employers.
    Specifically, the Administration's proposal would eliminate 
the exception under the pro rata disallowance rule for 
employees, officers and directors. Accordingly, as un-borrowed 
cash values increase, the amount of interest deduction would be 
reduced. Such modification to current law would have unintended 
consequences that are inconsistent with other Congressional 
policies, which encourage businesses to act in a prudent manner 
in meeting their liabilities to employees.
    Corporate owned life insurance as a funding source has a 
long history in tax law as a respected tool. Moreover, federal 
banking regulators recognize that corporate owned life 
insurance serves a necessary and useful business purpose. Their 
guidelines confirm that purchasing life insurance for the 
purpose of recovering or offsetting the costs of employee 
benefit plans is an appropriate purpose that is incidental to 
banking.
    The Administration's proposal seeks to revisit this issue 
irrespective of the fact that business use of corporate owned 
life insurance has been closely examined and was, in effect, 
confirmed by Congress when it passed the Taxpayer Relief Act of 
1997. That law created a specific exception for certain key 
employees. The subject provision would impose a retroactive tax 
penalty on banking institutions that have fully complied with 
established rules and have, in good faith, made long term 
business decisions based on existing tax law. They should be 
protected from the retroactive effects of legislation that 
would result in substantial tax and non-tax penalties. Even 
though the provision is applicable on a prospective basis, the 
effect is a retroactive tax on policies already written.
    We urge you to reject this revenue provision.

Increased Information Reporting Penalties

    The ABA strongly opposes the Administration's proposal to 
increase information reporting penalties. The banking industry 
prepares and files information returns to report items such as 
employee wages, dividends, and interest annually, in good 
faith, for the sole benefit of the IRS. The Administration 
reasons that the current penalty provisions may not be 
sufficient to encourage timely and accurate reporting. We 
disagree. Information reporting penalties were raised to the 
current levels as part of the Omnibus Budget Reconciliation Act 
of 1989, P.L. 101-239. The suggestion that this proposal would 
raise revenue presumes that corporations are non-compliant, a 
conclusion for which there is no substantiating evidence.
    Further, penalties typically are intended to discourage 
``bad'' behavior and encourage ``good'' behavior, not to serve 
as revenue raisers. The Administration's reasoning that 
increasing the penalty amounts would decrease the number of 
taxpayers that incur penalties suggests that the penalties 
could be continually increased, from year-to-year to maintain 
the revenue flow. Certainly, the proposed increase in penalties 
is unnecessary and would not be based on sound tax policy.

Repeal Tax-Free Conversions of Large C Corporations to S 
Corporations

    The ABA opposes the proposal to repeal Internal Revenue 
Code section 1374 for large S corporations. The proposal would 
accelerate net unrealized built-in gains (BIG) and impose a 
corporate level tax on BIG assets along with a shareholder 
level tax with respect to their stock. The BIG tax would apply 
to gains attributable to assets held at the time of conversion, 
negative adjustments due to accounting method change, 
intangibles such as core deposits and excess servicing rights, 
and recapture of the bad debt reserve.
    The Small Business Job Protection Act of 1996, P.L. 104-
188, allowed financial institutions to elect S corporation 
status for the first time. Effectively, the Administration's 
proposal would shut the window of opportunity for those 
financial institutions to elect S corporation status by making 
the cost of conversion prohibitively expensive. We believe that 
such a change would be contrary to Congressional intent to 
permit banking institutions to elect S corporation status.

Modify the Treatment of Closely Held REITs

    The Administration's proposal to impose additional 
restrictions on the ownership of real estate investment trusts 
(REITs) would have the unintended consequence of eliminating a 
valid method used by banks and thrifts to raise regulatory 
capital. The proposal would go beyond the current law 100 
shareholder requirement for REITs by prohibiting any one entity 
from owning more than 50 percent (measured by both value and 
voting power) of a REIT. The proposal appears to be based on 
the notion that closely held REITs can be used by taxpayers in 
abusive transactions. However, raising bank capital to protect 
institutions from future economic downturns is a legitimate use 
of a closely held REIT.
    Currently, banks and thrifts may transfer real estate 
assets, e.g. mortgage loans, in a REIT, with 100 percent of the 
common stock of the REIT held by the financial institution and 
with preferred stock being issued to at least 100 outside 
investors. The funds raised from the preferred stock issuance 
count as Tier 1 regulatory capital, which provides a cushion 
for the safety of the institution and its depositors. The 
closely held REIT preferred stock issuance is an important 
alternative for banks to have available as a funding source. 
The Federal Reserve Board has approved the use of certain 
preferred stock arrangements as a valid method for raising Tier 
1 bank capital, because, otherwise, bank holding companies 
would be at a competitive disadvantage compared to non-bank 
financial companies and foreign-owned banking institutions that 
can use tax advantaged structures to raise capital.
    The Administration's proposal is overly broad. Closely held 
REITs serve valid functions that are consistent with the 
underlying purposes of the REIT provisions as well as the 
broader concept of sound tax policy. The Service has 
demonstrated that it can use regulations and notices to deal 
with its concerns about specific investment structures without 
asking Congress to restrict legitimate REIT structures.

Repeal the Crummey case rule

    The Administration's proposal would overrule the Crummey 
decision by amending Section 2503(c) to apply only to outright 
gifts of present interests. Gifts to minors under a uniform act 
would be deemed to be outright gifts.
    The ABA opposes the Administration's proposal to eliminate 
the Crummey rule (Crummey v. Commissioner, 397 F.2d 82 (9th 
Cir. 1968). Many existing trusts, which are administered by 
banks through their trust departments, rely upon the Crummey 
rule as a tax planning technique. The Administration asserts, 
in the General Explanation of its proposal, that ``[t]ypically 
by pre-arrangement or understanding in more recent cases, none 
of the Crummey withdrawal rights will be exercised'' 
[referencing the Estate of Cristofani v. Commissioner, 97 T.C. 
74 (1991)].
    We believe the Administration's assertion is incorrect. If 
there is a pre-arrangement or understanding that the Crummey 
rights will not be exercised, the Crummey rule will not be 
applied by the courts. In fact, in Cristofani the Tax Court 
determined that there was no arrangement or understanding 
between the decedent, the trustees, and the beneficiaries that 
the decedent's grandchildren would not exercise their 
withdrawal rights. The Court said that the question was not 
whether the power was exercised, but whether it in fact 
existed.
    The proposal to legislatively overrule the Crummey case 
would not only countermine recent Congressional action to 
reduce, if not eliminate, ``death taxes,'' but would also 
seriously undermine at least one of the important reasons 
taxpayers use trusts for wealth transfer purposes.

Eliminate Dividends-Received Deduction for Certain Preferred 
Stock

    The Administration proposes to deny the dividends-received 
deduction for dividend payments on nonqualified preferred stock 
that is treated as taxable consideration in certain otherwise 
non-taxable corporate reorganizations. The Administration 
argues that such stock is sufficiently free from risk and from 
participation in corporate growth that it should be treated as 
debt for purposes of denial of the dividend received deduction. 
However, such nonqualified preferred stock is not treated as 
debt for all tax purposes.
    The ABA opposes this Administration proposal in that it 
would establish inconsistent tax policy and would amount to an 
inequitable tax increase. Certainly, items received in income 
and treated as debt to a recipient should, at minimum, be 
correspondingly deductible as interest expense to the payor. 
The instant proposal would create a ``lose-lose'' tax trap for 
corporate taxpayers.

                        Tax Incentive Proposals

    The Administration's budget proposal also contains several 
significant tax incentive provisions, which ABA fully supports.

Tax Credits for Holders of Qualified School Modernization Bonds 
and Qualified Zone Academy Bonds

    The ABA supports the provisions to expand qualified academy 
zone bonds and to establish school modernization bonds. Banks 
are very interested in Education Zone Academy Bonds because 
they could strengthen local communities and benefit the 
families that reside there. We also believe these bonds will 
attract investment in enterprise and poor communities by 
providing tax credits and Community Reinvestment Act credits.
    It is important for banks to be involved in all aspects of 
our local communities. The banking industry recognizes that 
education is a key component of that involvement and that there 
is an immediate need for improved infrastructure. We would urge 
you to include this proposal in the fiscal year 1999 budget 
legislation.

Educational Assistance

    The ABA supports the permanent extension of tax incentives 
for employer provided education. Many industries, including 
banking and financial services, are experiencing dramatic 
technological changes. The provision is an important benefit to 
many entry level employees and will assist in the retraining of 
employees to better face global competition. Employer provided 
educational assistance is a central component of the modern 
compensation package and is often used to recruit and retain 
vital employees.

Research and Experimentation Tax Credit Extended for One Year

    The ABA supports the permanent extension of the tax credit 
for research and experimentation. The banking industry is 
actively involved in the research and development of new 
intellectual products, services and technology in order to 
compete in an increasingly sophisticated and global 
marketplace. The banking industry has a vested interest in 
ensuring that the research and experimentation tax credit 
remains an appropriate incentive for banking institutions to 
improve efficiencies and remain competitive. Banking 
institutions increasingly engage in sophisticated and 
innovative research activities. These activities are currently 
being unreasonably scrutinized and questioned through narrowly 
defined Treasury regulations and audit positions, which we 
believe is inconsistent with Congressional intent. Along with 
the extension of the tax credit, continued availability of the 
research and experimentation tax credit in the financial 
services industry should be an encouraged and Congressionally 
supported incentive.

Contributions of Appreciated Stock to Private Foundations

    The ABA supports permanent extension of the full fair 
market value income tax deduction for gifts of publicly traded 
stock to private foundations. We agree that allowing donors to 
deduct the full value of such stock encourages taxpayers to 
donate the stock for charitable purposes.

Increase Low Income Housing Tax Credit Per Capita Cap

    The ABA supports the proposal to raise the $1.25 per capita 
cap and urges its inclusion in the fiscal year 1999 budget 
legislation.
Simplify the Foreign Tax Credit Limitation for Dividends from 
``10/50'' Companies

    The Administration proposal would, inter alia, simplify the 
application of the foreign tax credit limitation by applying 
the look-through approach immediately to all dividends paid by 
a 10/50 company, regardless of the year in which the earnings 
and profits out of which the dividend is paid were accumulated.
    The ABA supports legislative efforts to simplify 
application of the foreign tax credit. We also support 
proposals to increase the capacity for taxpayers to claim 
foreign credit for the taxes they actually pay. Further, we 
support legislative efforts in the foreign tax credit area that 
recognize efforts by a taxpayer to reduce foreign taxes.

Access to Payroll Deduction for Retirement Savings

    The ABA supports proposals to encourage and facilitate 
employee retirement savings. However, it is most important that 
providing expanded access to the payroll deduction remain at 
the employer's option. We are most concerned that such proposal 
could impose unreasonable and overly expensive administrative 
burdens on certain employers, which is contrary to recent 
Congressional efforts to reduce administrative tax burdens.

                               Conclusion

    We appreciate having this opportunity present our 
preliminary views on the tax proposals contained in the 
President's fiscal year 1999 budget. We look forward to working 
with you in the further development of the revenue proposals to 
be contained in the fiscal year 1999 budget.
      

                                

Statement of America's Community Bankers

    Mr. Chairman and Members of the Committee:
    America's Community Bankers appreciates this opportunity to 
submit testimony for the record of the hearing on the revenue 
raising provisions in the Administration's fiscal year 1999 
budget proposal. America's Community Bankers (ACB) is the 
national trade association for 2,000 savings and community 
financial institutions and related business firms. The industry 
has more than $1 trillion in assets, 250,000 employees and 
15,000 offices. ACB members have diverse business strategies 
based on consumer financial services, housing finance, and 
community development.
    ACB wishes to focus on two provisions included in the 
Administration's budget. We urge the Committee to reject the 
Administration's proposal to change the rules for business-
owned life insurance. On the other hand, we recommend that the 
Committee include in legislation, as soon as possible, the 
Administration's proposal to increase the low-income housing 
tax credit.

                       Bank-Owned Life Insurance

    ACB strongly disagrees with the Administration's proposal 
to disallow deductions for interest paid by corporations that 
purchase permanent life insurance on the lives of their 
officers, directors, and employees. This disallowance is 
retroactive in that it would occur with respect to life 
insurance contracts already in force. The Administration's 
proposal would revamp a statutory scheme enacted just last 
year. In 1997 Congress enacted a provision to disallow a 
proportional part of a business's interest-paid deductions on 
unrelated borrowings where the business purchases a life 
insurance policy on anyone and where the business is the direct 
or indirect beneficiary. Integral to this general rule, 
however, is an exception for business-owned life insurance 
covering employees, officers, directors, and 20 percent or more 
owners. The combination of the general rule and its exception 
implemented a sensible policy--that the benefits of permanent 
life insurance, where they are directly related to the needs of 
a business, should continue to be available to businesses
    The Administration is now proposing that the implicit 
agreement made last year be immediately broken by cutting back 
retroactively, for contracts issued after June 8, 1997, the 
exception to omit employees, officers, and directors. It would 
continue to apply to 20-percent owners. Thus, a portion of the 
interest-paid deductions of a business for a year would be 
disallowed according to the ratio of the average unborrowed 
policy cash values of life insurance, annuities, and endowment 
contracts to total assets. Insurance contracts would be 
included in this denominator to the extent of unborrowed cash 
values. (It also appears that a 1996 exception enacted would be 
repealed that permits an interest-paid deduction for borrowings 
against policies covering key employees.)
    The Administration's proposal would result in a 
significantly larger loss of deductions for a bank or thrift 
than a similar-sized commercial firm because financial 
institutions are much more leveraged than commercial firms.
    Financial institutions, because of their statutory capital 
requirements, have been under a special constraint to look to 
life insurance to fund retirement benefits after the issuance 
of FASB Statement 106 in December 1990. FASB 106, which was 
effective for 1992, requires most employers to give effect in 
their financial statements to an estimate of the future cost of 
providing retirees with health benefits. The impact of charging 
such an expense to the earnings of a company could be a 
significant reduction in capital. Many financial institutions 
were faced with the necessity of reneging on the commitments 
they had made to their employees or finding an alternative 
investment. Many of these institutions have chosen to fund 
their pension, as well as retiree health care benefits, using 
permanent life insurance.
    The banking regulators have permitted financial 
institutions to use life insurance to fund their employee 
benefit liabilities, but restricted the insurance policies that 
may be used to those that do not have a significant investment 
component and limited the insurance coverage to the risk of 
loss or the future liability. See e.g., the OCC's Banking 
Circular 249 (February 4, 1991) and the OTS's Thrift Activities 
Regulatory Handbook, Section 250.2. On September 20, 1996, the 
OCC issued Bulletin 96-51 which recognized the usefulness of 
permanent life insurance in the conduct of banking and granted 
banks increased flexibility to use it--consistent with safety 
and soundness considerations. The bulletin makes clear that the 
necessity to control a variety of risks created by life 
insurance ownership (liquidity, credit, interest rate, etc.) 
requires a bank to limit its purchases to specific business 
needs rather than for general investment purposes. In addition, 
bank purchases of life insurance will be limited by the need to 
maintain regulatory capital levels. (The other bank regulators 
are apparently in agreement with the OCC position and may 
shortly formalize similar positions.
    The Administration's proposed change in the current law 
treatment of business-owned life insurance would require many 
financial institutions, because of the extent of their loss of 
deductions, to terminate their policies. Policy surrender 
would, however, subject the banks to immediate tax on the cash 
value and possible cash-in penalties that would reduce capital.
    In most cases financial institutions have purchased life 
insurance to provide pension and retiree health benefits. If 
Congress were to make it uneconomical for businesses to 
purchase life insurance contracts, the employee benefits they 
fund would inevitably have to be reduced. For the 
Administration to make business-owned life insurance 
uneconomical, given its usefulness in providing employee 
benefits, is inconsistent with the other proposals in the 
Administration's budget proposal that would enhance pension an 
other retiree benefits.
    The Administration's argument that financial intermediaries 
are able to ``arbitrage'' their interest-paid deductions on 
unrelated borrowings where they own permanent life insurance is 
unconvincing. The leveraging of their capital by banks and 
thrifts to make loans is a vital component of a strong economy. 
The Administration's proposal would punish financial 
institutions, simply because they are inherently much more 
leveraged, to a much greater extent than similar-sized 
commercial firms for making what would otherwise be sound 
business decisions--to insure themselves against the death of 
key employees or to provide for the retirement health or 
security of their employees by means of life insurance.
    This is the third year in a row that legislation has been 
proposed to limit the business use of life insurance. This has 
now become unfair and unsound tax policy. It is disingenuous to 
say that the BOLI exception must now be eliminated because 
there may have been large recent policy purchases. If taxpayers 
have reason to believe that Congress is about to change its 
mind with respect to an exception and they rush to act before 
an opportunity is lost, as may have happened with BOLI, it is a 
case of blaming the victim to then say that the law is being 
changed because of taxpayer action. In fact, companies may have 
been motivated to act as they otherwise would not have, with 
respect to BOLI purchases, because of a perception that the tax 
legislative process is fickle. If taxpayers are to focus on 
long-term business benefits rather than short-term, tax-
motivated considerations, they must be confident that there is 
an implicit premise of consistency in the tax legislative 
process.
                     Low-Income Housing Tax Credit

    America's Community Bankers strongly supports the 
Administration's proposal to increase the per capita limit on 
the low-income housing tax credit from $1.25 to $1.75. As an 
important part of the thrift industry's commitment to housing, 
ACB's member institutions have been participants, as direct 
lenders and, through operating subsidiaries, as investors, in 
many low-income housing projects that were viable only because 
of the LIHTC. The ceiling on the annual allocation of the LIHTC 
has not been increased since the credit was created by the Tax 
Reform Act of 1986. Many members institutions have communicated 
to ACB that there are shortages of affordable rental housing in 
their communities and that, if the supply of LIHTCs were 
increased, such housing could be more efficiently be produced 
to address this shortage.
    The LIHTC was created in 1986 to replace a variety of 
housing subsidies whose efficiency had been called into 
question. Under Section 42 of the Internal Revenue Code, a 
comprehensive regime of allocation and oversight was created, 
requiring the involvement of both the IRS and state and local 
housing authorities, to assure that the LIHTC is targeted to 
increase the available rental units for low-income citizens. 
This statutory scheme has been revised in several subsequent 
tax acts to eliminate potential abuses.
    Every year since 1987, each state has been allocated a 
total amount of LIHTCs equal to $1.25 per resident. The annual 
per capita limit may be increased by a reallocation of the 
unused credits previously allocated to other states, as well as 
the state's unused LIHTC allocations from prior years. The 
annual allocation must be awarded within two years or returned 
for reallocation to other states. State and local housing 
authorities are authorized by state law or decree to award the 
state's allocation of LIHTCs to developers who apply by 
submitting proposals to develop qualified low-income housing 
projects.
    A ``qualified low-income project'' under Section 42(g) of 
the Code is one that satisfies the following conditions. (1) It 
must reserve at least 20 percent of its available units for 
households earning up to 50 percent of the area's median gross 
income, adjusted for family size, or at least 40 percent of the 
units must be reserved for households earning up to 60 percent 
of the area's median gross income, adjusted for family size. 
(2) The rents (including utility charges) must be restricted 
for tenants in the low-income units to 30 percent of an imputed 
income limitation based on the number of bedrooms in the unit. 
(3) During a compliance period, the project must meet 
habitability standards and operate under the above rent and 
income restrictions. The compliance period is 15 years for all 
projects placed in service before 1990. With substantial 
exceptions, an additional 15-year compliance period is imposed 
on projects placed in service subsequently.
    Putting together a qualifying proposal is only the first 
step, however, for a developer seeking an LIHTC award. The 
state or local housing agency is required to select from among 
all of the qualifying projects by means of a LIHTC allocation 
plan satisfying the requirements of Section 42(m). The 
allocation plan must set forth housing priorities appropriate 
to local conditions and preference must be given to projects 
that will serve the lowest-income tenants and will serve 
qualified tenants for the longest time.
    Section 42 effectively requires state and local housing 
agencies to create a bidding process among developers to ensure 
that the LIHTCs are allocated to meet housing needs 
efficiently. To this end the Code imposes a general limitation 
on the maximum LIHTC award that can be made to any one project. 
Under Section 42(b) the maximum award to any one project is 
limited to nine percent of the ``qualified basis'' (in general, 
development costs, excluding the cost of land, syndication, 
marketing, obtaining permanent financing, and rent reserves) of 
a newly constructed building. Qualified basis may be adjusted 
by up to 30 percent for projects in a qualified census tract or 
``difficult development area.'' For federally subsidized 
projects and substantial rehabilitations of existing buildings, 
the maximum annual credit is reduced to four percent. The nine 
and four percent annual credits are payable over 10 years and 
in 1987, the first year of the LIHTC, the 10-year stream of 
these credits was equivalent to a present value of 70 percent 
and 30 percent, respectively, of qualified basis. Since 1987, 
the Treasury has applied a statutory discount rate to the 
nominal annual credit percentages to maintain the 70 and 30 
percent rates.
    The LIHTC has to be taken over 10 years, but the period 
that the project must be in compliance with the habitability 
and rent and income restrictions is 15 years. This creates an 
additional complication. The portion of the LIHTC that should 
be theoretically be taken in years 11 through 15 is actually 
taken pro rata during the first 10 years. Where there is 
noncompliance with the project's low-income units during years 
11 through 15, the related portion of the LIHTC that was, in 
effect, paid in advance will be recaptured.
    Where federally subsidized loans are used to finance the 
new construction or substantial rehabilitation, the developer 
may elect to qualify for the 70 percent present value of the 
credit by reducing the qualified basis of the property. Where 
federal subsidies are subsequently obtained during the 15-year 
compliance period, the qualified basis must then be adjusted. 
On the other hand, certain federal subsidies do not affect the 
LIHTC amount, such as the Affordable Housing Program of the 
Federal Home Loan Banks, Community Development Block Grants, 
and HOME investment Partnership Act funds.
    The LIHTCs awarded to developers are, typically, offered to 
syndicators of limited partnerships. Because of the required 
rent restrictions on the project, the syndications attract 
investors who are more interested in the LIHTCs and other 
deductions the project will generate than the unlikely prospect 
of rental profit. The partners, who may be individuals or 
corporations, provide the equity for the project, while the 
developer's financial stake may be limited to providing the 
debt financing.
    The LIHTC is limited, however, in its tax shelter potential 
for the individual investor. Individuals are limited by the 
passive loss rules to offsetting no more than $25,000 of active 
income (wages and business profits) with credits and losses 
from rental real estate activities. For an individual in the 
28% bracket, for example, the benefit from the LIHTC would be 
limited to $7,000. It should also be borne in mind that such 
credits are unavailable against the alternative minimum tax 
liability of individuals and corporations.
    The Chairs of the Ways and Means Committee and its 
Subcommittee on Oversight recently requested the GAO to study 
the LIHTC program and, specifically, to evaluate: whether the 
LIHTC was being used to meet state priority housing needs; 
whether the costs were reasonable; and whether adequate 
oversight was being performed. The resulting GAO report was 
generally favorable. See Tax Credits: Opportunities to Improve 
Oversight of the Low-Income Housing Program (GAO/GGD/RCED-97-
55, March 28, 1997). The GAO found that the LIHTC has 
stimulated low-income housing development and that the 
allocation processes implemented by the states generally 
satisfy the requirements of the Code. In fact, the GAO found 
that the LIHTC was being targeted by the states to their very 
poorest citizens. The incomes of those for whom the credit was 
being used to provide housing were substantially lower than the 
maximum income limits set in the statute. While the GAO could 
find no actual abuses or fraud in the LIHTC program, it did 
determine that the procedures that some states use to review 
and implement project proposals need to be improved. The report 
also recommended a number of changes in the IRS regulations to 
ensure adequate monitoring and reporting so that the IRS can 
conduct its own verification of compliance with the law.
    The only increase in the total amount of LIHTCs since 1987 
has been through population growth, which has been only five 
percent nationwide over the 10-year period (floor statement of 
Senator Alphonse D'Amato, October 3, 1997). Had the $1.25 per 
capita limit been indexed for inflation since the inception of 
the LIHTC, as is commonly done in other Code provisions, it 
would be comparable to the $1.75 limit the Administration is 
proposing. According to the Joint Committee on Taxation, the 
Consumer Price Index measurement of cumulative inflation 
between 1986 and the third quarter of 1997 was approximately 47 
percent. Using this index to adjust the per capita limit, it 
would now be approximately $1.84. The GDP price deflator for 
residential fixed investment indicates 38.1 percent price 
inflation, which would have increased the per capita limit to 
approximately $1.73. (See Joint Committee on Taxation, 
Description of Revenue Provisions Contained in the President's 
Fiscal Year 1999 Budget Proposal (JCS-4-98), February 24, 1998)
    More affordable low-income housing is currently needed. 
``Nearly 100,000 low cost apartments are demolished, abandoned, 
or converted to market rate each year. Increasing the LIHTC 
would allow states to finance approximately 25,000 more 
critically needed low-income apartments each year'' (floor 
statement of Senator Alphonse D'Amato, October 3, 1997). ``In 
the state of Florida, for example, the LIHTC has used more than 
$187 million in tax credits to produce approximately 42,000 
affordable rental units valued at over $2.2 billion. Tax credit 
dollars are leveraged at an average of $18 to $1. Nevertheless, 
in 1996, nationwide demand for the housing credit greatly 
outpaced supply by a ratio of nearly 3 to 1. In Florida, 
credits are distributed based upon a competitive application 
process and many worthwhile projects are denied due to a lack 
of tax credit authority'' (floor statement of Senator Bob 
Graham, October 3, 1997). ``In 1996, states received 
applications requesting more than $1.2 billion in housing 
credits--far surpassing the $365 million in credit authority 
available to allocate that year. In New York, the New York 
Division of Housing and Community Renewal received applications 
requesting more than $104 million in housing credits in 1996--
nearly four times the $29 million in credit authority it 
already had available'' (floor statement of Senator Alphonse 
D'Amato, October 3, 1997).
    For all of the foregoing reasons, it seems clear to ACB 
that it is time to increase the LIHTC.
    Once again, Mr. Chairman, ACB is grateful to you and the 
other members of the Committee for the opportunity you have 
provided to make our views known on the Administration's tax 
proposals. If you have any questions or require additional 
information, please contact Jim O'Connor at 202-857-3125 or 
Brian Smith at 202-857-3118.
      

                                

Statement of The New York Clearing House Association, The Securities 
Industry Association, Independent Bankers Association of America, and 
America's Community Bankers

    The undersigned associations, which represent a broad range 
of financial institutions, including both large and small 
institutions, reiterate their strong opposition to the 
Administration's proposal to increase penalties for failure to 
file correct information returns.
    The proposed penalties are unwarranted and place an undue 
burden on already compliant taxpayers. It seems clear that 
most, if not all, of the revenue estimated to be raised from 
this proposal would stem from the imposition of higher 
penalties due to inadvertent errors rather than from enhanced 
compliance. The financial services community devotes an 
extraordinary amount of resources to comply with current 
information reporting and withholding rules and is not 
compensated by the U.S. government for these resources. The 
proposed penalties are particularly inappropriate in that (i) 
there is no evidence of significant current non-compliance and 
(ii) the proposed penalties would be imposed upon financial 
institutions while such institutions were acting as integral 
parts of the U.S. government's system of withholding taxes and 
obtaining taxpayer information. In addition, we believe the 
proposal is overly broad in that it applies to all types of 
information returns, including Forms 1099-INT, -DIV, -OID, -B, 
-C, and -MISC, as well as Form W-2.

                              The Proposal

    As included in the President's fiscal year 1999 budget, the 
proposal generally would increase the penalty for failure to 
file correct information returns on or before August 1 
following the prescribed filing date from $50 for each return 
to the greater of $50 or 5 percent of the amount required to be 
reported.\1\ The increased penalties would not apply if the 
aggregate amount that is timely and correctly rlendar year is 
at least 97 percent of the aggregate amount required to be 
reported for the calendar year. If the safe harbor applies, the 
present-law penalty of $50 for each return would continue to 
apply.
---------------------------------------------------------------------------
    \1\ A similar proposal was included in President Clinton's fiscal 
year 1997 and 1998 budgets.
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                    Current Penalties are Sufficient

    We believe the current penalty regime already provides 
ample incentives for filers to comply with information 
reporting requirements. In addition to penalties for 
inadvertent errors or omissions,\2\ severe sanctions are 
imposed for intentional reporting failures. In general, the 
current penalty structure is as follows:
---------------------------------------------------------------------------
    \2\ It is important to note that many of these errors occur as a 
result of incorrect information provided by the return recipients such 
as incorrect taxpayer identification numbers (TINs).
---------------------------------------------------------------------------
     The combined standard penalty for failing to file 
correct information returns and payee statements is $100 per 
failure, with a penalty cap of $350,000 per year.
     Significantly higher penalties--generally 20 
percent of the amount required to be reported (for information 
returns and payee statements), with no penalty caps--may be 
assessed in cases of intentional disregard.\3\
---------------------------------------------------------------------------
    \3\ The standard penalty for failing to file correct information 
returns is $50 per failure, subject to a $250,000 cap. Where a failure 
is due to intentional disregard, the penalty is the greater of $100 or 
10 percent of the amount required to be reported, with no cap on the 
amount of the penalty.
---------------------------------------------------------------------------
     Payors also may face liabilities for failure to 
apply 31 percent backup withholding when, for example, a payee 
has not provided its taxpayer identification number (TIN).
    There is no evidence that the financial services community 
has failed to comply with the current information reporting 
rules and, as noted above, there are ample incentives for 
compliance already in place.\4\ It seems, therefore, that most 
of the revenue raised by the proposal would result from higher 
penalty assessments for inadvertent errors, rather than from 
increased compliance with information reporting requirements. 
Thus, as a matter of tax compliance, there appears to be no 
justifiable policy reason to substantially increase these 
penalties.
---------------------------------------------------------------------------
    \4\ Also note that, in addition to the domestic and foreign 
information reporting and penalty regimes that are currently in place, 
for payments to foreign persons, an expanded reporting regime with the 
concomitant penalties is effective for payments made after December 31, 
1998. See TD 8734, published in the Federal Register on October 14, 
1997. The payor community is being required to dedicate extensive 
manpower and monetary resources to put these new requirements into 
practice. Accordingly, these already compliant and overburdened 
taxpayers should not have to contend with new punitive and unnecessary 
penalties.
---------------------------------------------------------------------------

            Penalties Should Not Be Imposed to Raise Revenue

    Any reliance on a penalty provision to raise revenue would 
represent a significant change in Congress' current policy on 
penalties. A 1989 IRS Task Force on Civil Penalties concluded 
that penalties ``should exist for the purpose of encouraging 
voluntary compliance and not for other purposes, such as 
raising of revenue.'' \5\ Congress endorsed the IRS Task 
Force's conclusions by specifically enumerating them in the 
Conference Report to the Omnibus Budget Reconciliation Act of 
1989.\6\ There is no justification for Congress to abandon its 
present policy on penalties, which is based on fairness, 
particularly in light of the high compliance rate among 
information return filers.
---------------------------------------------------------------------------
    \5\ Statement of former IRS Commissioner Gibbs before the House 
Subcommittee on Oversight (February 21, 1989, page 5).
    \6\ OBRA 1989 Conference Report at page 661.
---------------------------------------------------------------------------

                       Safe Harbor Not Sufficient

    Under the proposal, utilization of a 97 percent substantial 
compliance ``safe harbor'' is not sufficient to ensure that the 
higher proposed penalties apply only to relatively few filers. 
Although some information reporting rules are straightforward 
(e.g., interest paid on deposits), the requirements for certain 
new financial products, as well as new information reporting 
requirements,\7\ are often unclear, and inadvertent reporting 
errors for complex transactions may occur. Any reporting 
``errors'' resulting from such ambiguities could easily lead to 
a filer not satisfying the 97 percent safe harbor.
---------------------------------------------------------------------------
    \7\ For example, Form 1099-C, discharge of indebtedness reporting, 
or Form 1042-S, reporting for bank deposit interest paid to certain 
Canadian residents.
---------------------------------------------------------------------------

      Application of Penalty Cap to Each Payor Entity Inequitable

    We view the proposal as unduly harsh and unnecessary. The 
current-law $250,000 penalty cap for information returns is 
intended to protect the filing community from excessive 
penalties. However, while the $250,000 cap would continue to 
apply under the proposal, a filer would reach the penalty cap 
much faster than under current law. For institutions that file 
information returns for many different payor entities, the 
protection offered by the proposed penalty cap is substantially 
limited, as the $250,000 cap applies separately to each payor.
    In situations involving affiliated companies, multiple 
nominees and families of mutual funds, the protection afforded 
by the penalty cap is largely illusory because it applies 
separately to each legal entity. At the very least, any further 
consideration of the proposal should apply the penalty cap 
provisions on an aggregate basis. The following examples 
illustrate why aggregation in the application of the penalty 
cap provisions is critical.

                        Example I--Paying Agents

    A bank may act as paying agent for numerous issuers of 
stocks and bonds. In this capacity, a bank may file information 
returns as the issuers' agent but the issuers, and not the 
bank, generally are identified as the payors. Banks may use a 
limited number of information reporting systems (frequently 
just one overall system) to generate information returns on 
behalf of various issuers. If an error in programming the 
information reporting system causes erroneous amounts to be 
reported, potentially all of the information returns 
subsequently generated by that system could be affected. Thus, 
a single error could, under the proposal, subject each issuer 
for whom the bank filed information returns, to information 
reporting penalties because the penalties would be assessed on 
a taxpayer-by-taxpayer basis. In this instance, the penalty 
would be imposed on each issuer. However, the bank as paying 
agent may be required to indemnify the issuers for resulting 
penalties.

Recommendation:

    For the purposes of applying the penalty cap, the paying 
agent (not the issuer) should be treated as the payor.

                      Example II--Retirement Plans

    ABC Corporation, which services retirement plans, 
approaches the February 28th deadline for filing with the 
Internal Revenue Service the appropriate information returns 
(i.e., Forms 1099-R). ABC Corporation services 500 retirement 
plans and each plan must file over 1,000 Forms 1099-R. A 
systems operator, unaware of the penalties for filing late 
Forms 1099, attempts to contact the internal Corporate Tax 
Department to inform them that an extension of time to file is 
necessary to complete the preparation and filing of the 
magnetic media for the retirement plans. The systems operator 
is unable to reach the Corporate Tax Department by the February 
28th filing deadline and files the information returns the 
following week. This failure, under the proposal, could lead to 
substantial late filing penalties for each retirement plan that 
ABC Corporation services (in this example, up to $75,000 for 
each plan).\8\
---------------------------------------------------------------------------
    \8\ If the corrected returns were filed after August 1, the 
penalties would be capped at $250,000 per plan.

---------------------------------------------------------------------------
Recommendation:

    Retirement plan servicers (not each retirement plan) should 
be treated as the payor for purposes of applying the penalty 
cap.

                     Example III--Related Companies

    A bank or broker dealer generally is a member of an 
affiliated group of companies which offer different products 
and services. Each company that is a member of the group is 
treated as a separate payor for information reporting and 
penalty purposes. Information returns for all or most of the 
members of the group may be generated from a single information 
reporting system. One error (e.g., a systems programming error) 
could cause information returns generated from the system to 
contain errors on all subsequent information returns generated 
by the system. Under the proposal, the penalty cap would apply 
to each affiliated company for which the system(s) produces 
information returns.

Recommendation:

    Each affiliated group \9\ should be treated as a single 
payor for purposes of applying the penalty cap.
---------------------------------------------------------------------------
    \9\ A definition of ``affiliated group'' which may be used for this 
purpose may be found in Section 267(f) or, alternatively, Section 
1563(a).
---------------------------------------------------------------------------
    While these examples highlight the need to apply the type 
of penalty proposed by the Treasury on an aggregated basis, 
they also illustrate the indiscriminate and unnecessary nature 
of the proposal.

                               Conclusion

    The undersigned associations represent the preparers of a 
significant portion of the information returns that would be 
impacted by the proposal to increase penalties for failure to 
file correct information returns. In light of the current 
reporting burdens imposed on our industries and the significant 
level of industry compliance, we believe it is highly 
inappropriate to raise penalties. Thank you for your 
consideration of our views.
    The New York Clearing House Association
    The Securities Industry Association
    Independent Bankers Association of America
    America's Community Bankers
      

                                

       American Council for an Energy-Efficient Economy    
                                             Washington, DC
                                                      March 2, 1998

The Hon. Bill Archer
Chairman
Committee on Ways & Means
U. S. House of Representatives
Washington, DC 20515

    Dear Mr. Chairman:

    Please accept the attached position statement for the record of the 
February 25 hearing of the Committee on Ways & Means regarding the 
Administration's proposals and assumptions for Fiscal Year 1999. The 
Sustainable Energy Coalition is made up of more than 40 national 
business, environmental, consumer, and energy policy organizations that 
support a strong Federal role in research, development, and deployment 
of energy efficiency and renewable energy technologies.
    The Administration's proposals for $3.6 billion in tax incentives 
over 5 years for the purchase of energy-saving equipment, homes, and 
vehicles and renewable energy equipment has drawn a great deal of 
interest. Such measures can reduce energy costs for consumers while 
contributing to other important national goals, such as improved air 
quality, reduced energy imports, and improved competitiveness of 
American businesses. We urge the Committee to carefully consider these 
proposals in the weeks ahead, and look forward to discussing them 
further with you and your staff.
            Sincerely,
                                              Howard Geller
                                                 Executive Director

Attachment
cc: Hon. Charles B. Rangel, Ranking Minority Member
Members of the Committee on Ways & Means
      

                                

Statement of Sustainable Energy Coalition

    The undersigned members of the Sustainable Energy Coalition 
are expressing their support for the concept of providing tax 
incentives and other encouragement for a variety of advanced 
energy-saving and renewable energy technologies such as:
     superefficient cars and light trucks
     superefficient homes
     highly efficient heating and cooling systems
     highly efficient water heaters
     fuel cell cogeneration systems
     solar photovoltaic and water heating systems
     wind and biomass-based electricity generation
     combined heat and power systems
    Tax incentives along these lines will provide multiple 
benefits:
    1) They will stimulate technological innovation and reduce 
the risk that manufacturers face in introducing and marketing 
new technologies.
    2) They will save consumers billions of dollars by 
stimulating commercialization of cost-effective energy saving 
technologies.
    3) They will improve air quality, reduce public health 
hazards, and cut U.S. greenhouse gas emissions by promoting 
energy efficiency and clean energy sources.
    4) They will reduce oil imports, improve our balance of 
payments, and enhance national security by cutting gasoline 
use.
    5) They will help U.S. companies compete in what surely 
will be enormous worldwide markets in the next century.
    While the details of the Administration's tax proposals 
have not yet been announced, we urge policy makers to recognize 
that tax incentives for advanced energy efficiency and 
renewable energy technologies are a ``win-win-win'' strategy 
for manufacturers, consumers, and the environment. They are 
voluntary, market-based ``no regrets'' measures that will 
reduce the cost of energy services such as heating, cooling, 
and mobility. They are an economic development strategy as well 
as a climate technology strategy. Even those who may not 
support the Kyoto climate change agreement should find ample 
grounds to support tax incentives for innovative energy 
efficiency and renewable energy technologies.

Alliance to Save Energy, American Bioenergy Association, 
American Council for an Energy-Efficient Economy, American 
Green, American Public Power Association, American Wind Energy 
Association, Americans for Clean Energy, Business Council for 
Sustainable Energy, Cascade Associates, Center for a 
Sustainable Economy, Clean Fuels Foundation, Environmental & 
Energy Study Institute, Fuel Cells 2000, Global Biorefineries, 
Inc., International District Energy Association, National 
BioEnergy Industries Association, Public Citizen, Safe Energy 
Communication Council, Solar Energy Industries Association, 
Solar Unity Network, SUN DAY Campaign, Union of Concerned 
Scientists
      

                                

[GRAPHIC] [TIFF OMITTED] T1685.001

      

                                

Statement of American Petroleum Institute

    This testimony is submitted by the American Petroleum 
Institute (API) for the February 25, 1998 Ways and Means 
hearing on the tax provisions in the Administration's fy 1999 
budget proposal. API represents approximately 300 companies 
involved in all aspects of the oil and gas industry, including 
exploration, production, transportation, refining, and 
marketing. The U.S. oil and gas industry is the leader in 
exploring for and developing oil and gas reserves around the 
world.
    Our testimony will address the following proposals:
     modify rules relating to foreign oil and gas 
extraction income;
     prescribe regulatory authority to address tax 
avoidance through use of hybrids;
     reinstate excise taxes and the corporate 
environmental tax deposited in the Hazardous Substance 
Superfund Trust Fund.
     reinstate the oil spill excise tax;
     provide tax credits to promote energy efficiency 
and alternative energy sources

   I. Modify Rules Relating to Foreign Oil and Gas Extraction Income

    President Clinton's latest budget proposal includes some 
significant changes to the foreign tax credit (FTC) rules 
impacting companies with foreign oil and gas extraction income 
(FOGEI) as defined by Code Section 907(c)(1) and foreign oil 
related income (FORI) as defined by Code Section 907(c)(2). 
Specifically, the proposal includes the following provisions:
     In situations where taxpayers are subject to a 
foreign tax and also receive an economic benefit from the 
foreign country, taxpayers would only be able to claim a credit 
for such taxes under Code Section 901 if the country has a 
``generally applicable income tax'' that has ``substantial 
application'' to all types of taxpayers, and then only up to 
the level of taxation that would be imposed under the generally 
applicable income tax.
     Effective for taxable years beginning after the 
bill's enactment, new rules would be provided for all foreign 
oil and gas income (FOGI). FOGI would be trapped in a new 
separate FOGI basket under Code Section 904(d). FOGI would be 
defined to include both FOGEI and FORI.
     Despite these changes, U.S. treaty obligations 
that allow a credit for taxes paid or accrued on FOGI would 
continue to take precedence over this legislation (e.g., the 
so-called ``per country'' limitation situations.)

A. Introduction and Trade Arguments

    This proposal, aimed directly at the foreign source income 
of U.S. petroleum companies, seriously threatens the ability of 
those companies to remain competitive on a global scale, and 
API strongly opposes the proposal. It is particularly troubling 
that the Administration would attack the foreign operations of 
U.S. oil companies in this way, especially when the proposal 
conflicts with the Administration's announced trade policy and 
with Commerce and State Department initiatives encouraging 
those same companies to participate in exploration and 
production ventures in strategic areas around the world.
    The Administration has demonstrated an intention to 
subscribe to the integration of worldwide trade, with a 
continuing removal of trade barriers and promotion of 
international investment (e.g., the GATT and NAFTA agreements). 
Moreover, because of their political and strategic importance, 
foreign investments by U.S. oil companies have been welcomed by 
the U.S. government. For example, participation by U.S. oil 
companies in the development of the Tengiz oil field in 
Kazakhstan was praised as fostering the political independence 
of that newly formed nation, as well as securing new sources of 
oil to Western nations, which are still too heavily dependent 
on Middle Eastern imports. (See the April 28, 1996 Washington 
Post, at p. A-20).
    This proposed additional tax burden, like other barriers to 
foreign investments by U.S. firms, are based on several flawed 
premises. For example, there is the perception that foreign 
investment by U.S. business is responsible for reduced 
investment and employment in the U.S. These investments are 
perceived to be made primarily in low wage countries at the 
expense of U.S. labor with such foreign investments also 
including a shift of research and development (``R&D'') 
spending abroad. However, studies like the 1995 review by the 
Economic Strategy Institute (Multinational Corporations and the 
U.S. Economy [1995]) show these claims to be unfounded. Over a 
20-year period, capital outflows from the U.S. averaged less 
than 1% of U.S. nonresidential fixed investment, which is 
hardly sufficient to account for any serious deterioration in 
U.S. economic growth. Instead, affiliate earnings and foreign 
loans, not U.S. equity, have financed the bulk of direct 
foreign investment.
    Contrary to another perception, the principal reason for 
foreign investment is seldom cheap labor. Rather, the more 
common reasons are a search for new markets, quicker and easier 
response to local market requirements, elimination of tariff 
and transportation costs, faster generation of local good will, 
and other deep rooted host country policies. In this regard, 
the bulk of U.S. foreign investment is in Europe, where labor 
is expensive, rather than in Asia and Latin America, where 
wages are low. According to one study, almost two-thirds of 
employment by foreign subsidiaries of U.S. companies was in 
Canada, Japan, and Europe, all higher wage areas (Sullivan, 
From Lake Geneva to the Ganges; U.S. Multinational Employment 
Abroad, 71 Tax Notes 539 [4/22/96]. Although some R&D functions 
have been moved abroad, they make up only 15% of domestic R&D, 
and are primarily in areas aimed at tailoring products to local 
demands.
    In the case of natural resource extraction and production, 
the reason for foreign investment is obvious. If U.S. oil and 
gas concerns wish to stay in business, they must look overseas 
to replace their diminishing reserves, since the opportunity 
for domestic reserve replacement has been restricted by both 
federal and state government policy. A recent API study 
demonstrates that despite the fact that production outside the 
United States by U.S. companies increased by 300,000 barells/
day over the 10 years 1985-1995, that was not enough to offset 
the declines in U.S. production, so that U.S. companies' total 
global production over that period actually declined. Over that 
same period, production by similar sized oil companies other 
than those from OPEC countries expanded nearly 60%. These 
recent supply trends need not be permanent features of the U.S. 
companies' future role. The opening of Russia to foreign 
capital, the competition for investment by the countries 
bordering the Caspian Sea, the privatization of energy in 
portions of Latin America, Asia, and Africa--all offer the 
potential for unprecedented opportunity in meeting the 
challenges of supplying fuel to a rapidly growing world 
economy. In each of these frontiers U.S. companies are poised 
to participate actively. However, if U.S. companies can not 
economically compete, foreign resources will instead be 
produced by foreign competitors, with little or no benefit to 
the U.S. economy, U.S. companies, or American workers.
    The FTC principle of avoiding double taxation represents 
the foundation of U.S. taxation of foreign source income. The 
Administration's budget proposals would destroy this foundation 
on a selective basis for foreign oil and gas income only, in 
direct conflict with the U.S. trade policy of global 
integration, embraced by both Democratic and Republican 
Administrations.

B. The FTC Is Intended To Prevent Double Taxation

    Since the beginning of Federal income taxation, the U.S. 
has taxed the worldwide income of U.S. citizens and residents, 
including U.S. corporations. To avoid double taxation, the FTC 
was introduced in 1918. Although the U.S. cedes primary taxing 
jurisdiction for foreign income to the source country, the FTC 
operates by preventing the same income from being taxed twice, 
once by the U.S. and once by the source country. The FTC is 
designed to allow a dollar for dollar offset against U.S. 
income taxes for taxes paid to foreign taxing jurisdictions. 
Under this regime, foreign income of foreign subsidiaries is 
not immediately subject to U.S. taxation. Instead, the 
underlying earnings become subject to U.S. tax only when the 
U.S. shareholder receives a dividend (except for certain 
``passive'' or ``Subpart F'' income.) Any foreign taxes paid by 
the subsidiary on such earnings is deemed to have been paid by 
any U.S. shareholders owning at least 10% of the subsidiary, 
and can be claimed as FTCs against the U.S. tax on the foreign 
dividend income (the so-called ``indirect foreign tax 
credit'').

C. Basic Rules of the FTC

    The FTC is intended to offset only U.S. tax on foreign 
source income. Thus, an overall limitation on currently usable 
FTCs is computed by taking the ratio of foreign source income 
to worldwide taxable income, and multiplying this by the 
tentative U.S. tax on worldwide income. The excess of FTCs can 
be carried back 2 years and carried forward 5 years, to be 
claimed as credits in those years within the same respective 
overall limitations.
    The overall limitation is computed separately for various 
``separate limitation categories.'' Under present law, foreign 
oil and gas income falls into the general limitation category. 
Thus, for purposes of computing the overall limitation, FOGI is 
treated like any other foreign active business income. Separate 
special limitations still apply, however, for income: (1) whose 
foreign source can be easily changed; (2) which typically bears 
little or no foreign tax; or (3) which often bears a rate of 
foreign tax that is abnormally high or in excess of rates of 
other types of income. In these cases, a separate limitation is 
designed to prevent the use of foreign taxes imposed on one 
category to reduce U.S. tax on other categories of income.

D. FTC Limitations For Oil And Gas Income

    Congress and the Treasury have already imposed significant 
limitations on the use of foreign tax credits attributable to 
foreign oil and gas operations. In response to the development 
of high tax rate regimes by OPEC, taxes on foreign oil and gas 
income have become the subject of special limitations. For 
example, each year the amount of taxes on FOGEI may not exceed 
35% (the U.S. corporate tax rate) of such income. Any excess 
may be carried over like excess FTCs under the overall 
limitation. FOGEI is income derived from the extraction of oil 
and gas, or from the sale or exchange of assets used in 
extraction activities.
    In addition, the IRS has regulatory authority to determine 
that a foreign tax on FORI is not ``creditable'' to the extent 
that the foreign law imposing the tax is structured, or in fact 
operates, so that the tax that is generally imposed is 
materially greater than the amount of tax on income that is 
neither FORI or FOGEI. FORI is foreign source income from (1) 
processing oil and gas into primary products, (2) transporting 
oil and gas or their primary products, (3) distributing or 
selling such, or (4) disposing of assets used in the foregoing 
activities. Otherwise, the overall limitation (with its special 
categories discussed above) applies to FOGEI and FORI. Thus, as 
active business income, FOGEI and FORI would fall into the 
general limitation category. 

E. The Dual Capacity Taxpayer ``Safe Harbor'' Rule

    As distinguished from the rule in the U.S. and some 
Canadian provinces, mineral rights in other countries vest in 
the foreign sovereign, which then grants exploitation rights in 
various forms. This can be done either directly, or through a 
state owned enterprise (e.g., a license or a production sharing 
contract). Because the taxing sovereign is also the grantor of 
mineral rights, the high tax rates imposed on oil and gas 
profits have often been questioned as representing, in part, 
payment for the grant of ``a specific economic benefit'' from 
mineral exploitation rights. Thus, the dual nature of these 
payments to the sovereign have resulted in such taxpayers being 
referred to as ``dual capacity taxpayers.''
    To help resolve controversies surrounding the nature of tax 
payments by dual capacity taxpayers, the Treasury Department in 
1983 developed the ``dual capacity taxpayer rules'' of the FTC 
regulations. Under the facts and circumstances method of these 
regulations, the taxpayer must establish the amount of the 
intended tax payment that otherwise qualifies as an income tax 
payment but is not paid in return for a specific economic 
benefit. Any remainder is a deductible rather than creditable 
payment (and in the case of oil and gas producers, is 
considered a royalty). The regulations also include a safe 
harbor election (see Treas. Reg. 1.901-2A(e)(1)), whereby a 
formula is used to determine the tax portion of the payment to 
the foreign sovereign, which is basically the amount that the 
dual capacity taxpayer would pay under the foreign country's 
general income tax. Where there is no generally applicable 
income tax, the safe harbor rule of the regulation allows the 
use of the U.S. tax rate in a ``splitting'' computation (i.e., 
the U.S. tax rate is considered the country's generally 
applicable income tax rate).

F. The Proposal Limits FTCs Of Dual Capacity Taxpayers To the 
Host Country's Generally Applicable Income Tax

    If a host country that had an income tax on FOGI (i.e., 
FOGEI or FORI), but no generally applicable income tax were to 
ignore the effect that its tax regime had on the new FTC 
position of U.S. companies, the proposal would result in 
disallowing any FTCs on FOGI. This would result in inequitable 
and destructive double taxation of dual capacity taxpayers, 
contrary to the global trade policy advocated by the U.S.
    The additional U.S. tax on foreign investment in the 
petroleum industry would not only eliminate many new projects; 
it could also change the economics of past investments. In some 
cases, this would not only reduce the rate of return, but also 
preclude a return of the investment itself, leaving the U.S. 
business with an unexpected ``legislated'' loss. In addition, 
because of the uncertainties of the provision, it would also 
introduce more complexity and potential for litigation into the 
already muddled world of the FTC.
    The unfairness of the provision becomes even more obvious 
if one considers the situation where a U.S. based oil company 
and a U.S. based company other than an oil company are subject 
to an income tax in a country without a generally applicable 
income tax. Under the proposal, only the U.S. oil company would 
receive no foreign tax credit, while the other taxpayer would 
be entitled to the full tax credit for the very same tax.
    The proposal's concerns with the tax versus royalty 
distinction were resolved by Congress and the Treasury long ago 
with the special tax credit limitation on FOGEI enacted in 1975 
and the Splitting Regulations of 1983. These were then later 
reinforced in the 1986 Act by the fragmentation of foreign 
source income into a host of categories or baskets. The earlier 
resolution of the tax versus royalty dilemma recognized that 
(1) if payments to a foreign sovereign meet the criteria of an 
income tax, they should not be denied complete creditability 
against U.S. income tax on the underlying income; and (2) 
creditability of the perceived excessive tax payment is better 
controlled by reference to the U.S. tax burden, rather than 
being dependent on the foreign sovereign's fiscal choices.

G. The Proposal Limits FTCs To The Amount Which Would Be Paid 
Under the Generally Applicable Income Tax

    By elevating the regulatory safe harbor to the exclusive 
statutory rule, the proposal eliminates a dual capacity 
taxpayer's right to show, based on facts and circumstances, 
which portion of its payment to the foreign government was not 
made in exchange for the conferral of specific economic 
benefits and, therefore, qualifies as a creditable tax. 
Moreover, by eliminating the ``fall back'' to the U.S. tax rate 
in the safe harbor computation where the host country has no 
generally applicable income tax, the proposal denies the 
creditability of true income taxes paid by dual capacity 
taxpayers under a ``schedular'' type of business income tax 
regime (i.e., regimes which tax only certain categories of 
income, according to particular ``schedules''), merely because 
the foreign sovereign's fiscal policy does not include all 
types of business income.
    For emerging economies of lesser developed countries, as 
for post-industrial nations, it is not realistic to always 
demand the existence of a generally applicable income tax. Even 
if the political willingness exists to have a generally 
applicable income tax, such may not be possible because the 
ability to design and administer a generally applicable income 
tax depends on the structure of the host country's economy. The 
available tax regimes are defined by the country's economic 
maturity, business structure and accounting sophistication. The 
most difficult problems arise in the field of business 
taxation. Oftentimes, the absence of reliable accounting books 
will only allow a primitive presumptive measure of profits. 
Under such circumstances the effective administration of a 
general income tax is impossible. All this is exacerbated by 
phenomena which are typical for less developed economies: a 
high degree of self-employment, the small size of 
establishments, and low taxpayer compliance and enforcement. In 
such situations, the income tax will have to be limited to 
mature businesses, along with the oil and gas extraction 
business.

H. The Proposal Increases The Risk Of Double Taxation

    Adoption of the Administration's proposals would further 
tilt the playing field against overseas oil and gas operations 
by U.S. business, and increase the risk of double taxation of 
FOGI. This will severely hinder U.S. oil companies in their 
competition with foreign oil and gas concerns in the global oil 
and gas exploration, production, refining, and marketing arena, 
where the home countries of their foreign competition do not 
tax FOGI. This occurs where these countries either exempt 
foreign source income or have a foreign tax credit regime which 
truly prevents double taxation.
    To illustrate, assume foreign country X offers licenses for 
oil and gas exploitation and also has an 85% tax on oil and gas 
extraction income. In competitive bidding, the license will be 
granted to the bidder which assumes exploration and development 
obligations most favorable to country X. Country X has no 
generally applicable income tax. Unless a U.S. company is 
assured that it will not be taxed again on its after-tax profit 
from country X, it very likely will not be able to compete with 
another foreign oil company for such a license because of the 
different after tax returns.
[GRAPHIC] [TIFF OMITTED] T1685.002

    Because of the 35% additional U.S. tax, the U.S. company's 
after tax return will be more than one-third less than its 
foreign competitor's. Stated differently, if the foreign 
competitor is able to match the U.S. company's proficiency and 
effectiveness, the foreigner's return will be more than 50% 
greater than the U.S. company's return. This would surely harm 
the U.S. company in any competitive bidding. Only the 
continuing existence of the FTC, despite its many existing 
limitations, assures that there will be no further tilting of 
the playing field against U.S. companies' efforts in the global 
petroleum business.

I. Separate Limitation Category For FOGI

    To install a separate FTC limitation category for FOGI 
would single out the active business income of oil companies 
and separate it from the general limitation category or basket. 
There is no legitimate reason to carve out FOGI from the 
general limitation category or basket. The source of FOGEI and 
FORI is difficult to manipulate. For example, FORI is generally 
derived from the country where the processing or marketing of 
oil occurs. Moreover, Treasury has recently issued regulations 
addressing this sourcing issue. Also, any FORI that is earned 
in consuming countries and treated like other business income 
is very likely taxed currently, before distribution, under the 
anti-avoidance rules for undistributed earnings of foreign 
subsidiaries.
J. The FTC Proposals Are Bad Tax Policy

    Reduction of U.S. participation in foreign oil and gas 
development because of misguided tax provisions will adversely 
affect U.S. employment, and any additional tax burden may 
hinder U.S. companies in competition with foreign concerns. 
Although the host country resource will be developed, it will 
be done by foreign competition, with the adverse ripple effect 
of U.S. jobs losses and the loss of continuing evolution of 
U.S. technology. By contrast, foreign oil and gas development 
by U.S. companies increases utilization of U.S. supplies of 
hardware and technology. The loss of any major foreign project 
by a U.S. company will mean less employment in the U.S. by 
suppliers, and by the U.S. parent, in addition to fewer U.S. 
expatriates at foreign locations. Many of the jobs that support 
overseas operations of U.S. companies are located here in the 
United States--an estimated 350,000 according to analysts at 
Charles River Associates, a Cambridge, Massachusetts-based 
consulting firm. That figure consists of: 60,000 in jobs 
directly dependent on international operations of U.S. oil and 
gas companies; over 140,000 employed by U.S. suppliers to the 
oil and gas industry's foreign operations; and, an additional 
150,000 employed in the U.S. supporting the 200,000 who work 
directly for the oil companies and their suppliers.
    Thus, the questions to be answered are: Does the United 
States--for energy security and international trade reasons, 
among others--want a U.S. based petroleum industry to be 
competitive in the global quest for oil and gas reserves? If 
the answer is ``yes,'' then why would the U.S. government adopt 
a tax policy that is punitive in nature and lessens the 
competitiveness of the U.S. petroleum industry? The U.S. tax 
system already makes it extremely difficult for U.S. 
multinationals to compete against foreign-based entities. This 
is in direct contrast to the tax systems of our foreign-based 
competitors, which actually encourage those companies to be 
more competitive in winning foreign projects. What we need from 
Congress are improvements in our system that allow U.S. 
companies to compete more effectively, not further impediments 
that make it even more difficult and in some cases impossible 
to succeed in today's global oil and gas business environment. 
These improvements should include, among others, the repeal of 
the plethora of separate FTC baskets, the extension of the FTC 
carryback/carryover period for foreign tax credits, and the 
repeal of section 907.
    The Administration's fy 1998 budget included these same 
proposals which would have reduced the efficacy of the FTC for 
U.S. oil companies. Congress considered these proposals last 
year and rightfully rejected them. They should be rejected this 
year as well.

   II. Regulatory Directive to Address Tax Avoidance Through Use of 
                                Hybrids.

    A second fy 1999 budget proposal would adversely affect all 
U.S. multinationals' international operations. The 
Administration proposes that Congress grant the Treasury broad 
new regulatory authority to determine whether the tax 
consequences of cross border ``hybrid transactions'' are 
``appropriate'' and ``not inconsistent with the purposes of 
U.S. law.'' Treasury cites recently issued Notices 98-5 and 98-
11 (``the Notices'')--in which the IRS announced its intention 
to issue broad regulations that could significantly impact 
existing business arrangements' foreign tax credits and 
deferral--as examples of their use of the requested regulatory 
authority. The unfettered recognition of hybrid entities is 
essential to U.S. companies competing in foreign countries. 
Similarly, the utilization of foreign tax credits must not be 
subjected to new, unclear and confusing criteria. The Notices, 
along with the budget proposal, have already had a chilling 
effect on U.S. multinationals' ability to structure their 
foreign transactions in the ordinary course of business.
    The proposal would give the Treasury broad new authority to 
propound legislative regulations without further Congressional 
consideration. In developing U.S. international tax policy, 
Congress has attempted to balance the competing goals of 
capital export neutrality and U.S. international 
competitiveness. Treasury appears to be preparing to change 
that balance. API recommends that Congress conduct a study of 
the trade and tax policy issues associated with Notices 98-5 
and 98-11 and place a moratorium on further regulatory action 
by Treasury until specific legislative proposals are enacted.

III. Reinstatement of the Excise Taxes and the Corporate Environmental 
     Tax Deposited in the Hazardous Substance Superfund Trust Fund.

    The Administration's proposal would reinstate the Superfund 
excise taxes on petroleum and certain listed chemicals as well 
as the Corporate Environmental Tax through October 1, 2008. API 
opposes imposition of any Superfund taxes without substantial 
reform of the underlying Superfund program and the tax system 
supporting the fund. It is widely recognized that CERCLA is a 
broken program that requires major substantive and procedural 
changes. Furthermore, a restructured and improved CERCLA 
program can and should be funded through general revenues.
    Superfund sites are a broad societal problem, and taxes 
raised to remediate these sites should be broadly based rather 
than focused on a few specific industries. EPA has found wastes 
from all types of businesses at most hazardous waste sites. As 
consumers, as residents of municipalities, and as residents and 
taxpayers of a nation, our entire economy benefited in the pre-
1980 era from the lower cost of handling waste. To place 
responsibility for the additional costs resulting from 
retroactive CERCLA cleanup standards on the shoulders of a very 
few industries when previous economic benefits were widely 
shared is patently unfair.
    Petroleum-related businesses are estimated to be 
responsible for less than 10 percent of the contamination at 
Superfund sites; yet these businesses have historically paid 
over 50 percent of the taxes that support the Trust Fund. This 
inequity is of paramount concern to our industry and should be 
rectified. Congress should first substantially reform the 
program and then should fund the program through general 
revenues or some other broad-based funding source.

             IV. Reinstatement of the Oil Spill Excise Tax.

    The Administration proposes reinstating the five cents per 
barrel excise tax on domestic and imported crude oil dedicated 
to the Oil Spill Liability Trust Fund through October 1, 2008, 
and increasing the trust fund full funding limitation (the 
``cap'') from $1 billion to $5 billion.
    Collection of the Oil Spill Excise Tax was suspended for 
several months during 1994 because the Fund had exceeded its 
cap of $1 billion. It was subsequently allowed to expire 
December 31, 1994, because Congress perceived there was no need 
for additional taxes. Since that time, the balance in the Fund 
has remained above $1 billion, despite the fact that no 
additional tax has been collected. Clearly, the legislated 
purposes for the Fund have been accomplished without any need 
for additional revenues. The Administration's proposal to 
reinstate the tax and eliminate the fund cap is simply a poorly 
disguised effort to raise revenues to balance the budget. API 
opposes the proposal.

  V. Tax Credits to Promote Energy Efficiency and Alternative Energy 
                                Sources.

    The Administration's budget includes a number of tax and 
spending proposals related to the Kyoto global climate 
agreement. API would welcome the opportunity to meet with them 
to discuss the costs and benefits of possible approaches for 
reducing greenhouse gas emissions. However, we believe it is 
premature to present formal tax proposals to begin implementing 
the Kyoto agreement before there has been a thorough and open 
debate on its implications and before it has been acted on by 
the U.S. Senate.
    During the ratification process, the prioritization and 
implications of steps needed to reduce the growth in emissions 
can be clarified--and resulting governmental decisions can then 
be made after the views of all interested parties have been 
presented in public hearings. Any programs to expand research 
and development initiatives should maintain a level playing 
field for all energy sources and technology and should rely on 
market forces to bring new technology to consumers and 
business.
      

                                

            American Skandia Life Assurance Corporation    
                                       Shelton, Connecticut
                                                  February 27, 1998

The Honorable Congressman Bill Archer
Chairman
Committee on Ways and Means
C/O
A. L. Singleton
Chief of Staff
Committee on Ways and Means
U.S. House of Representatives
1102 Longworth House Office Building
Washington, D.C. 20515

    Dear Congressman Archer:

    We are writing on behalf of American Skandia Life Assurance 
Corporation (``American Skandia''). American Skandia, headquarted in 
Shelton Connecticut, is the 6th largest seller of variable annuities in 
the United States and has over 200,000 contract owners, with more than 
$12 billion in retirement annuities, who will be adversly impacted by 
the Administration's budget proposals. We currently employ over 650 
people and have an obligation to our employees, our annuity sellers 
and, most of all, our annuity customers to vigorously oppose this 
recent unwarranted attack on our industry in specific, and long-term 
retirement savings in general.
    The proposed changes to annuity taxation (deferred annuities, life 
insurance and immediate annuities would be affected) will directly harm 
the retirement plans of millions of Americans, including our 200,000 
plus annuity contract owners. These proposals are not the product of 
well thought out public policy, but rather ``quick fixes'' to find 
small or illusory amounts of money at the expense of hard-working, 
honest people saving for retirement. Tax deferral, one of the important 
features provided by annuities, has proven to be a powerful incentive 
to middle class Americans to take more responsibility for their 
retirement through long-term savings.
    It makes the most sense for us to focus our comments on the annuity 
proposals, so we will do so.
    1. The revenue numbers expected from these changes are illusory. 
These proposals are designed to kill the deferred annuity industry in 
general and the variable annuity industry in particular. If passed, 
they will do just that. There are two key incentives Congress has 
provided for long-term savings that have been in place for decades--tax 
deferral and tax-free reallocation among funding vehicles. The 
Administration's budget proposals attack both.
    The first part of the attack--reducing the tax basis of non-
qualified annuities by an imputed insurance expense--will make the 
product economically uncompetitive against investments with the benefit 
of capital gains treatment and a stepped-up basis at death. This 
proposal is also an insult to both market forces and state regulation 
of insurance. Market forces have been driving down the expenses within 
variable annuities below the proposed 1.25% imputed cost. This proposal 
would eliminate any continued incentive to lower costs. It is also a 
heavy-handed attempt at Federal rate regulation of products that are 
regulated by the states. Lowering the cost basis of any investment 
product essentially converts after-tax capital into income or gain, 
once again taxable by the government. Under the Administration's 
current proposal, the longer the capital is set aside for retirement, 
the more it will be taxed again. This sort of double taxation, 
particularly of retirement savings, is a questionable approach to 
encouraging Americans to save.
    The second part of the attack--taxing transfers between investment 
options within variable annuities, as well as exchanges between annuity 
products--destroys key values for savers. Insurers have gone to great 
lengths to provide an array of investment options, build systems 
support for asset allocation programs and teach the public about the 
wisdom of diversification among investment objectives, investment 
styles and investment managers. This type of diversification is prudent 
for persons in 401(k) plans, tax-sheltered annuities and IRAs and is 
equally smart for persons in tax-deferred annuities. All tax deferred 
programs provide value on this basis alone, since customers can engage 
in such diversification and risk reduction strategies without incurring 
taxes every time money is transferred between investment vehicles. 
Another key value for savers is the opportunity to change their 
providers. Any provider of tax-deferred saving vehicle knows that if 
their performance or service is poor, the customer can go elsewhere 
without tax penalty. This puts strong pressure on us to perform well, 
consistently. We, as a company, have thrived on this pressure. It has 
forced innovation and a constant focus on improving service. This 
leverage versus big, sophisticated insurers, mutual funds, brokerage 
houses and banks is good for consumers. Why in the world should it be 
taken away in the context of variable annuities?
    If this two pronged attack is successful, new variable annuity 
sales will stop, transfers and exchanges will not occur and the 
projected revenues will not come in. We as a country have learned the 
hard way that we need to ``pay as we go'' for the services we want from 
government. We do not need to go back to budgetary make-believe, 
spending revenues that will not really appear.
    2. These tax proposals are a bad idea because long-term savings 
must be encouraged, not hampered, and because this proposal 
discriminates against many working people. Congress tightened up the 
tax rules for annuities four times in the 1980's. Those changes made 
annuities a good retirement savings vehicle for two main purposes: (a) 
supplemental long term savings over and above employer-sponsored plans; 
and (b) easy access to tax deferral over and above the IRA contribution 
limits for people who were never or are no longer employed by firms 
with retirement plans. The Administration's proposals would kill the 
product, so it could no longer serve these important purposes. We are 
particularly perturbed that with the impact of this proposal on working 
people once a working family gets the mortgage paid off and the kids 
through school. If a working family gets the mortgage paid off and the 
kids through school, the parents or parent now need to put away more 
than the inadequate $2,000 a year permitted in an IRA for retirement. 
They would not be able to get the benefit of tax deferral on that extra 
savings unless their employer provided a plan. Deferred annuities are 
an important savings vehicle for middle class Americans. These 
proposals are just plain unfair to the people who need this break the 
most.
    The annuity business is threatened now by the cloud that has been 
created by these proposals. I hope the House Committee on Ways and 
Means will work to remove that cloud quickly, forcefully and sensibly. 
The annuity product is an excellent retirement savings tool for many 
Americans. The current tax rules assure that the annuity is not a tax 
dodge for the rich. It is an important long-term savings product for 
many middle-class Americans, especially those who are not covered by an 
employer sponsored retirement plan and need to use these products to 
save for their retirement. On behalf of American Skandia, we thank you 
for your consideration of our input on this very important matter.

            Sincerely,
                                   Wade Dokken
                                           Deputy Chief Executive 
                                               Officer
                                           American Skandia Marketing, 
                                               Inc.

                                   Gordon C. Boronow
                                            Deputy Chief Executive 
                                               Officer
                                           American Skandia Life 
                                               Assurance Corporation
      

                                

Statement of Jaime Steve, Legislative Director, American Wind Energy 
Association

    The American Wind Energy Association,\1\ or AWEA, 
respectfully submits this written testimony in support of a 
five-year extension of the existing 1.5 cent per kilowatt-hour 
production tax credit (PTC) for electricity produced using wind 
energy resources. An immediate extension of this provision is 
crucial if we are to see significant growth in the domestic 
wind energy industry. We are grateful for the opportunity to 
participate in the deliberations of the House Ways and Means 
Committee as it considers this important issue.
---------------------------------------------------------------------------
    \1\ The American Wind Energy Association, or AWEA, was formed in 
1974 and has nearly 700 members from 48 states. AWEA represents 
virtually every facet of the wind energy industry, including turbine 
manufacturers, project developers, utilities, academicians, and 
interested individuals.
---------------------------------------------------------------------------
     The Energy Policy Act of 1992 (EPAct) enacted the PTC as 
Section 45 of the Internal Revenue Code of 1986. The credit is 
phased out if the price of wind generated electricity is 
sufficiently high. In report language accompanying EPAct (H. 
Rpt. 102-474, Part 6, p. 42), the Ways and Means Committee 
stated, ``The Credit is intended to enhance the development of 
technology to utilize the specified renewable energy sources 
and to promote competition between renewable energy sources and 
conventional energy sources.''
    Since its inception, the PTC has supported wind energy 
development and production. In the 1980's, electricity 
generated with wind could cost as much as 25 cents/kilowatt-
hour. Since then wind energy has reduced its cost by a 
remarkable 80% to the current levelized cost of between 4 and 5 
cents per kilowatt hour.
    The 1.5 cent/kilowatt-hour credit enables the industry to 
compete with other generating sources being sold at 3 cents/
kilowatt-hour. The extension of the credit will enable the 
industry to continue to develop and improve its technology to 
drive costs down even further and provide Americans with 
significantly more clean, emissions-free electricity 
generation. Indeed, experts predict the cost of wind equipment 
alone can be reduced by another 40% from current levels, with 
an appropriate commitment of resources to research and 
development and from manufacturing economies of scale.
    Current Provision: The Production Tax Credit (PTC) provides 
a 1.5 cents per kilowatt-hour credit (adjusted for inflation) 
for electricity produced from a facility placed in service 
after December 31, 1993 and before July 1, 1999 for the first 
ten years of the facility's existence. The credit is only 
available if the wind energy equipment is located in the United 
State and electricity is sold to an unrelated party. Under 
current law, the tax credit qualification date would expire on 
July 1, 1999. A five-year extension would create a new sunset 
date of July 1, 2004.
    Status: A five-year extension of this provision--through 
July 1, 2004--was introduced in the House (H.R. 1401) by Rep. 
Bill Thomas (R-CA). H.R. 1401 has been cosponsored by Ways and 
Means Committee members Reps. Jim Nussle (R-IA), Jennifer Dunn 
(R-WA), Robert Matsui (D-CA), Jim McDermott (D-WA), John Lewis 
(D-GA) and Karen Thurman (D-FL).
    As similar bill (S. 1459) has been introduced in the Senate 
by Senators Chuck Grassley (R-IA) and James M. Jeffords (R-VT) 
joined by Sens. Frank Murkowski (R-AK), Kent Conrad (D-ND) and 
Bob Kerrey (D-NE), all members of the Finance Committee. A 
five-year extension of the wind tax credit also is contained 
within the Clinton Administration's FY 1999 budget proposal. At 
present, H.R. 1401 has 20 co-sponsors and S. 1459 has 10 co-
sponsors.
    Contributions of Wind Power: Wind is a clean, renewable 
energy source which helps to protect public health, secure a 
cleaner environment, enhance America's national security 
through increased energy independence, and reduce pollution. In 
fact, reducing air pollutants in the United States will 
necessitate the promotion of clean, environmentally-friendly 
sources of renewable energy such as wind energy. Further, 
renewable energy technologies such as wind power should play an 
important role in a deregulated electrical generation market.
    Wind power alone has the potential to generate power to 
provide the electric energy needs of as many as 10 million 
homes by the end of the next decade. The extension of the PTC 
will not only assure the continued availability of wind power 
as a clean energy option, but also it will help the wind energy 
industry secure its position in the restructured electricity 
market as a fully competitive, renewable source of electricity.
    Significant Economic Growth Potential of Wind Power: The 
global wind energy market has been growing at a remarkable rate 
over the last several years and is the world's fastest growing 
energy technology. The growth of the market offers significant 
export opportunities for U.S. wind turbine and component 
manufacturers.
    The World Energy Council has estimated that new wind 
capacity worldwide will amount to $150 to $400 billion worth of 
new business over the next twenty years. Experts estimate that 
as many as 157,000 new jobs could be created if U.S. wind 
energy equipment manufacturers are able to capture just 25% of 
the global wind equipment market over the next ten years. Only 
by supporting its domestic wind energy production through the 
extension of the PTC can the U.S. hope to develop the 
technology and capability to effectively compete in this 
rapidly growing international market.
    Finally, we must stress that the immediate extension of the 
PTC is critical to the continued development of the wind energy 
industry. Since the PTC is a production credit available only 
for energy actually produced from wind facilities, the credit 
is conditioned on permitting, financing and construction of the 
facilities. The financing and permitting requirements for a new 
wind facility often require two to three years of lead time. 
With the credit due, wind energy developers and investors are 
reluctant to commit to new projects without the assurance of 
the continued availability of the PTC. Moreover, if the credit 
is not extended this year, it is extremely unlikely that 
Congress will be able to address an extension of the PTC before 
its expiration in 1999.
    The American Wind Energy Association appreciates the 
opportunity to submit written testimony on this matter. We 
stand ready to assist the Committee in any way regarding the 
five-year extension of the wind energy Production Tax Credit.
    Thank you.
      

                                

Statement of Bond Market Association

    The Bond Market Association is pleased to comment on 
several of the revenue-raising provisions in the Clinton 
Administration's FY 1999 budget. The Association's membership 
consists of securities firms and banks that underwrite, trade, 
and sell fixed-income securities in the U.S. and international 
markets, including nearly all dealers of municipal and 
corporate bonds. We take an active interest in tax policy 
issues that affect the ability of corporations and governments 
to raise capital to finance new investment. As such, we are 
pleased that the deficit has finally been eliminated, and we 
commend the leadership of Chairman Archer and other members of 
the committee in bringing about a balanced federal budget.
    Eliminating the deficit has already borne economic fruit. 
Interest rates are at historic lows, due at least in part to a 
reduction in federal borrowing brought about by eliminating the 
deficit. Indeed, one of the most important benefits of 
balancing the budget is that it leads to lower interest rates 
and encourages more capital investment. We are dismayed and 
disappointed, however, that the administration has persisted in 
advocating tax increases which would have the opposite effect. 
Several tax increases in the administration's budget would 
raise capital costs for states, localities and corporations and 
discourage new capital investment.
    In our testimony before this committee last year, we argued 
against several of the tax provisions which have been re-
proposed by the administration. In addition, throughout 1996 
and 1997, Congress heard from countless state and local 
officials, corporate CEOs, public interest groups, and others 
about the negative effect the administration's proposals would 
have on borrowing costs and new capital investment. In the end, 
Congress wisely rejected the administration's tax increases 
which were targeted at capital investment. Indeed, even the 
administration itself has retreated from some of the proposed 
tax increases aimed at capital investment by corporations. 
However, other proposals are back, along with a new proposed 
tax increase which would have a particularly negative effect on 
state and local government borrowing. Since we have repeatedly 
commented on older administration proposals, our comments today 
will focus primarily on new aspects of the revenue provisions, 
although we will also discuss the others. We urge this 
committee and the entire Congress to once again reject these 
ill-conceived tax increases.
    The proposals we oppose, as described in the ``Summary of 
Tax Provisions in President Clinton's FY 1999 Budget'' prepared 
by the Ways and Means Committee staff, include:
     Increase proration percentage for property and 
casualty companies.
     Extend pro rata disallowance of tax-exempt 
interest expense to financial intermediaries.
     Defer original issue discount on convertible debt.
     Deny DRD for preferred stock with certain non-
stock characteristics.

   Increase proration percentage for property and casualty companies

    The administration's proposal to increase the proration 
percentage for property and casualty companies appears to be 
targeted at the insurance industry. In reality, however, a 
significant portion of the new tax would be borne by states and 
localities in the form of higher borrowing costs.
    The three largest groups of investors in the tax-exempt 
bond market, together accounting for over 90 percent of 
outstanding bonds, are households, mutual funds and property 
and casualty insurance companies (P&Cs). As of September 30, 
1997, P&Cs held approximately $180 billion in municipal 
securities, or about 14 percent of outstanding tax-exempt 
bonds. That significant figure belies their true influence in 
the municipal market, however. In the years 1994 through 1996, 
households decreased their holdings of municipal bonds by $145 
billion. Mutual fund holdings increased by $2 billion. Over the 
same period of time, net new investment in municipal securities 
by P&Cs increased by $29 billion. Indeed, over the past several 
years, P&Cs have been the only major source of new demand for 
state and local government bonds. If not for P&C participation 
in the municipal market, interest rates faced by states and 
localities would be significantly higher than they are today.
[GRAPHIC] [TIFF OMITTED] T1685.003


    P&Cs are particularly important in certain sectors of the 
municipal market. They tend to invest in medium- to long-term 
municipals of relatively high credit quality with maturities of 
12-20 years. These bonds are issued for a variety of purposes, 
from financing new public school construction to building 
roads, bridges, water and sewer systems, airports and a variety 
of other traditional government uses. In many cases, 
substantial portions of new municipal bond issues are sold to 
P&Cs. They often represent the primary factor in determining 
the pricing of new issues. Between 1991 and 1997, P&Cs went 
from holding 10 percent of all outstanding municipal securities 
to 14 percent. A table outlining P&C holdings of municipal 
bonds by state of the issuer is included as an appendix to this 
statement.
    For most investors, interest earned on state and local 
government bonds is exempt from federal income taxation, but 
that is not entirely so for P&Cs. A P&C is permitted a 
deduction for contributions to its reserves for losses. That 
deduction is reduced by an amount equal to 15 percent of its 
``proration'' income, which includes tax-exempt bond interest, 
the deductible portion of dividends earned, and tax-exempt or 
tax-deferred income from certain life insurance products. The 
application of the deduction disallowance is in effect a 5.25 
percent tax on the P&C's ``tax-exempt'' interest income (15 
percent disallowance multiplied by a 35 percent marginal tax 
rate), known as a ``haircut.'' In addition, 100 percent of 
``private-activity'' bond interest and 75 percent of other 
municipal bond interest earned by P&Cs is subject to the 
corporate alternative minimum tax (AMT). For AMT payers, then, 
non-private-activity municipal bond interest is subject to a 
15.75 percent tax (75 percent times the 20 percent AMT rate 
plus the effect of the ``haircut'').
    The administration has proposed raising the loss reserve 
deduction disallowance from 15 percent of proration income to 
30 percent, thereby doubling the tax rate P&Cs pay on municipal 
bond interest from 5.25 percent to 10.5 percent. Under current 
market conditions, interest rates on tax-exempt securities 
would not be sufficient to continue to attract P&Cs to the 
municipal market. Unfortunately, in the market sectors where 
P&Cs are most active, there are few other ready buyers at 
current interest rates. It is likely that if the 
administration's proposal were enacted, once municipal bond 
yields rose to fully reflect the proposal's effects, P&Cs would 
remain active as municipal market investors. However, interest 
rates paid by state and local governments on their borrowing 
would be higher than if the proposal had not been enacted. P&Cs 
will simply be compensated for their additional tax liability 
through higher returns on their municipal bond portfolios. The 
effect for state and local governments would be higher 
borrowing costs. An analysis by one member firm suggests that 
municipal borrowing costs would increase by 10-15 basis points 
(0.10-0.15 percentage point) as a result of this proposal. 
Implicitly, approximately 40-60 percent--perhaps up to 75 
percent--of the tax would be borne not by P&Cs but by state and 
local governments in the form of higher borrowing costs.
    On a typical $200 million tax-exempt bond issue with an 
average maturity of 15 years, the administration's proposal 
would cost the state or local issuer $2-3 million in additional 
interest expense in present value terms over the life of the 
issue. If the administration's proposal had been in place when 
the approximately $207 billion in tax-exempt securities were 
issued in 1997, it would have cost state and local governments 
$2-3 billion in additional interest expense over the life of 
their issues, assuming an average maturity of 15 years. This 
additional cost would have been related to just one year of 
borrowing.
    The administration has offered little justification for its 
proposal. The arguments in the Treasury Department's ``Green 
Book'' \1\ assert only that current law ``still enables 
property and casualty insurance companies to fund a substantial 
portion of their deductible reserves with tax-exempt or tax-
deferred income.'' The administration's answer, however, simply 
raising the tax on municipal bond interest earned by P&Cs, is 
an inappropriate response. First, there is no direct connection 
between contributions to loss reserves and the amount of 
municipal bond interest earned. Second, a deduction 
disallowance of 30 percent, as the administration proposes, is 
an unjustified, arbitrary figure. Third, as already stated, a 
substantial portion of this tax would be borne not by P&Cs but 
by state and local governments.
---------------------------------------------------------------------------
    \1\ Department of the Treasury, General Explanations of the 
Administration's Revenue Proposals, February 1998, page 113
---------------------------------------------------------------------------
    We urge the committee to consider the negative effects this 
proposal would have on states and localities and to reject the 
provision.

    Extend pro rata disallowance of tax-exempt interest expense to 
                        financial intermediaries

    Another proposed tax increase in the administration's 
budget, while it would nominally apply to corporations, would 
again in reality be borne by state and local governments in the 
form of higher financing costs. Rather than closing a ``tax 
loophole'' for corporations, the proposal would make it more 
expensive for state and local governments to finance vital 
public services. Taken together with the provision related to 
P&Cs, these two proposals represent a significant attack on the 
ability of states and localities to finance new investment at 
the lowest possible cost.
    Under current law, investors, including corporations, are 
not permitted to deduct the interest expense associated with 
borrowing to finance purchases of tax-exempt securities. 
Financial institutions that earn non-qualified tax-exempt 
interest are automatically disallowed a portion of their 
interest expense deduction in proportion to the ratio of 
municipal bond holdings to total assets. Securities firms are 
generally bound to the same rules as banks. However, securities 
firms are not required to apply the pro rata disallowance to 
interest expense which is explicitly traceable to activities 
other than buying or holding municipal bonds. Non-bank 
corporations that earn tax-exempt interest, in order to avoid a 
loss of interest-expense deduction, must demonstrate that they 
did not borrow to finance their purchases. Under an IRS 
procedure in place since 1972, as long as a corporation's tax-
exempt bond portfolio does not exceed two percent of its total 
assets, the IRS does not attempt to determine whether the 
corporation borrowed to finance its municipal bond holdings.\2\ 
This is the so-called ``two-percent de minimis rule.'' The 
administration's proposal would effectively repeal this safe 
harbor for ``financial intermediaries'' and apply to them the 
same rules that now apply to banks.
---------------------------------------------------------------------------
    \2\ Internal Revenue Service, Revenue Procedure 72-18.
---------------------------------------------------------------------------
    This provision is similar to one proposed by the 
administration in last year's budget request. Last year's pro 
rata disallowance proposal would have applied to non-bank 
corporations generally, while this year's version is limited to 
financial intermediaries. Although the term ``financial 
intermediaries'' has yet to be formally defined, it is likely 
to include securities firms, finance companies and certain 
government-sponsored corporations, among others. The proposal 
would have three distinct effects on municipal market 
participants.

Securities firms' activities

    Securities firms borrow in a very unique way. Securities 
firms, including the securities subsidiaries of commercial bank 
holding companies, carry large positions in a variety of 
securities for various lengths of time. For large firms, the 
value of these positions is often in the tens of billions of 
dollars. No firm is able to finance such large positions from 
its own capital, so all securities firms borrow to finance 
their holdings. In most cases, this borrowing is secured by the 
securities being held by the firm. This activity is related to 
securities firms' unique role as ``market-makers.'' In order to 
be prepared to buy or sell securities from or to customers at 
any time, firms must be able to efficiently finance their 
positions.
    For example, in a typical transaction, a securities firm 
may buy U.S. Treasury bonds from a customer. Unless the firm is 
able to immediately resell the securities to another customer, 
it must finance its position. For government securities, this 
is most often accomplished through repurchase agreements, 
essentially a form of secured borrowing.\3\ Because the 
interest paid on a repurchase agreement is directly traceable 
to financing the firm's position in Treasury securities, the 
interest is not subject to the pro rata deduction disallowance 
that applies to all general, non-traceable interest of the 
firm. The justification for this treatment is that the interest 
expense which is traceable to some specific activity other than 
buying or holding municipal securities should not be subject to 
a rule designed to prevent interest deductions for borrowing to 
finance tax-exempt assets. The same reasoning applies with 
respect to other traceable interest expense, such as interest 
paid on margin loans. Indeed, given the unique nature of 
securities firms' borrowing in many cases, a great deal of 
interest expense is traceable and hence not subject to the pro 
rata disallowance.
---------------------------------------------------------------------------
    \3\ Technically, a repurchase agreement is not a loan but a 
contract to sell a security and to subsequently repurchase it in the 
future at a price agreed upon at the time the contract is executed. The 
difference between the sale and purchase price is the interest paid by 
the ``borrower'' to the ``lender.'' Repurchase agreements are 
recognized as a form of secured lending for virtually all tax purposes.
---------------------------------------------------------------------------
    The administration's proposal would change the way in which 
the pro rata disallowance is applied to securities firms by 
applying it to all interest expense, even that which is 
directly traceable to activities other than buying municipal 
securities. In doing so, the proposal would significantly 
increase the cost for securities firms of financing positions 
in tax-exempt securities--firms' ``cost of carry'' for 
municipal bonds--since under the proposal, tax-exempt bonds 
held by a securities dealer would trigger a much larger 
interest expense disallowance than under current law. Because 
securities firms are highly leveraged companies, i.e., they 
have a very high ratio of debt to total capitalization, they 
would be hard-hit by the proposal. Estimates of the effects of 
the proposal on dealer's costs of carrying municipal bonds in 
inventory range from 40 basis points (0.4 percentage point) to 
well over a percentage point, depending on the amount of a 
dealer's interest which under current law is traceable and not 
subject to the pro rata disallowance.
    Because the administration's proposal would raise a 
dealer's cost of carry for municipal bond inventories, there 
would be inevitable consequences for state and local bond 
issuers and investors. Much of the increased cost associated 
with acting as a market-maker in the municipal market would be 
reflected in higher costs of dealer services. For example, 
securities firms that underwrite new issues of municipal 
securities often carry the bonds in inventory for a period of 
time. The administration's proposal would increase the cost 
associated with that activity. These costs would likely be 
reflected in higher fees paid by states and localities for 
underwriting services. The proposal would increase costs for 
dealers of buying bonds in the secondary municipal market, 
where bonds are bought and sold after they are initially placed 
with investors, and could affect market liquidity. These 
effects would be particularly profound in the market for 
shorter term municipal bonds, where dealers already face a 
negative cost of carry and where dealers are particularly 
important in providing liquidity under certain market 
conditions. Individual investors would likely face higher 
transaction costs associated with buying and selling 
securities. In short, a significant portion of the new tax 
imposed on municipal securities dealers would ultimately be 
borne by state and local governments and municipal market 
investors.

Housing and student loan bonds

    The housing and student loan sectors of the municipal 
market would also be negatively affected by the 
administration's proposal. State and local governments issue 
bonds to finance home mortgage loans for low- and moderate-
income families as well as loans for low-income, multi-family 
rental projects. Both these programs provide limited, targeted, 
below-market financing for housing. Over the past several 
decades, state and local housing bonds have provided tens of 
billions of dollars in rental housing for low-income families 
and have made home ownership available to families who may not 
have been able to finance a home through any other source. 
Student loan bonds are issued to finance below-market loans to 
college students who may not otherwise be able to obtain 
tuition financing.
    Together, Fannie Mae, Freddie Mac, Sallie Mae and other 
government-sponsored corporations and agencies hold about $9 
billion of outstanding municipals. These entities invest 
primarily in state and local housing bonds (Fannie Mae and 
Freddie Mac) and student loan bonds (Sallie Mae). Indeed, it is 
a condition of Fannie Mae's and Freddie Mac's statutory 
charters that they help support the market for low- and middle-
income housing, and investing in state and local housing bonds 
is one of the ways in which these agencies carry out that 
obligation. Under the administration's proposal, these 
organizations would simply stop buying municipals. As a result, 
the cost of mortgage financing provided through state and local 
governments would increase substantially.

Municipal leasing transactions

    The proposal would also have profound effects on municipal 
leasing. States and localities routinely lease assets and 
equipment, such as school buses, police cars, and computers. If 
the administration's proposal were adopted, equipment lessors 
estimate that their cost of financing for state and local 
governments would increase dramatically. After originating 
municipal lease transactions, most lessors generally sell their 
financing contracts to private funding sources to generate the 
capital they need to continue to operate their business. Those 
who invest in tax-exempt leasing include corporations, 
commercial banks and investment banks. Individuals and mutual 
funds, through certificates of participation, also purchase 
tax-exempt leases. Although last year's version of the 
administration's proposal would not have applied ``to certain 
non-salable tax-exempt bonds acquired by a corporation in the 
ordinary course of business in payment for goods and services 
sold to a state or local government,'' this intended relief was 
illusory. The vast majority of equipment manufacturers who sell 
to state and local governments prefer not to hold municipal 
leases because they do not want to tie up their capital. These 
companies generally sell their financing contracts to third 
party investors. The administration's proposal would discourage 
vendor financing of capital equipment leased to states and 
localities. As a direct result, the cost of new capital 
investment by state and local governments would rise 
substantially.
    Because the new taxes imposed by the proposal would be 
borne to a significant degree by states and localities, we urge 
that the proposal be rejected.

           Defer original issue discount on convertible debt

    The administration has proposed to change the tax treatment 
of original issue discount (OID) on convertible debt 
securities. OID occurs when the stated coupon of a debt 
instrument is below the yield demanded by investors. The most 
common case is a zero-coupon bond, where all the interest 
income earned by investors is in the form of accrued OID. Under 
current law, corporations that issue debt with OID may deduct 
the interest accrual while bonds are outstanding. In addition, 
taxable OID investors must recognize the accrual of OID as 
interest income. Under the administration's proposal, for OID 
instruments which are convertible to stock, issuers would be 
required to defer their deduction for accrued OID until payment 
was made to investors in cash. For convertible OID debt where 
the conversion option is exercised and the debt is paid in 
stock, issuers would lose the accrued OID deduction altogether. 
Investors would still be required to recognize the accrual of 
OID on convertible debt as interest income, regardless of 
whether issuers took deductions.
    The administration's proposal is objectionable on several 
grounds. First, convertible zero-coupon debt has efficiently 
provided corporations with billions of dollars in capital 
financing. The change the administration proposes would 
significantly raise the cost of issuing convertible zero-coupon 
bonds, and in doing so would discourage corporate capital 
investment. Second, the administration's presumptions for the 
proposal are flawed. The administration has argued that ``the 
issuance of convertible debt instrument[s] is viewed by market 
participants as a de facto issuance of equity.'' \4\ However, 
performance does not bear out this claim. In fact, of the 
convertible zero-coupon debt retired since 1985, approximately 
70 percent has been retired in cash, and only 30 percent has 
been converted to stock. Indeed, the market treats convertible 
zero-coupon bonds more as debt than as equity.
---------------------------------------------------------------------------
    \4\ Department of the Treasury, page 97.
---------------------------------------------------------------------------
    Third, and perhaps most important, the administration's 
proposal violates the basic tenet of tax symmetry, the notion 
that the recognition of income by one party should be 
associated with a deduction by a counterparty. This fundamental 
principle exists to help ensure that income is taxed only once. 
Under the proposal, investors would be taxed fully on the 
accrual of OID on convertible zero-coupon debt, but issuers' 
deductions would be deferred or denied. The proposal would 
compound problems associated with the multiple taxation of 
investment income, thereby raising the cost of corporate 
capital.
    Because the proposal would exacerbate problems of multiple 
taxation of corporate income and because it would raise the 
cost of corporate capital investment, we urge the rejection of 
the administration's proposal.

  Deny DRD for preferred stock with certain non-stock characteristics

    Under current law, corporate taxpayers that earn dividends 
on investments in other corporations are permitted a tax 
deduction equal to at least 70 percent of those earnings. The 
deduction is designed to mitigate the negative economic effects 
associated with multiple taxation of corporate earnings. The 
administration has proposed eliminating the dividends-received 
deduction (DRD) for preferred stock with certain 
characteristics. This proposal would increase the taxation of 
corporate earnings and discourage capital investment.
    The DRD is important because it reduces the effects of 
multiple taxation of corporate earnings. When dividends are 
paid to a taxable person or entity, those funds are taxed 
twice, once at the corporate level and once at the level of the 
taxpayer to whom the dividends are paid. These multiple levels 
of taxation raise financing costs for corporations, create 
global competitiveness problems, and generally reduce 
incentives for capital formation. The DRD was specifically 
designed to reduce the burden of one layer of taxation by 
making dividends largely non-taxable to the corporate owner.
    The administration has argued that certain types of 
preferred stock, such as variable-rate and auction-set 
preferred, ``economically perform as debt instruments and have 
debt-like characteristics.'' \5\ However, the administration 
has not proposed that such instruments be formally 
characterized as debt eligible for interest payment and accrual 
deductions. The administration has sought to characterize 
certain preferred stock in such a way as to maximize tax 
revenue; it would be ineligible for both the DRD and the 
interest expense deduction.
---------------------------------------------------------------------------
    \5\ Ibid., page 99
---------------------------------------------------------------------------
    Eliminating the DRD for these instruments would exacerbate 
the effects of multiple taxation. The change would be 
tantamount to a tax increase on corporate earnings since the 
minimum deduction available to certain investors would fall. 
This tax increase would flow directly to issuers of preferred 
stock affected by the proposal who would face higher financing 
costs as investors demanded higher pre-tax yields. Amplifying 
the competitive disadvantages of multiple taxation of American 
corporate earnings would be the fact that many of our largest 
economic competitors have already adopted tax systems under 
which inter-corporate dividends are largely or completely 
untaxed. Eliminating the DRD for preferred stock with certain 
characteristics would cut U.S. corporations off from an 
efficient source of financing, thereby discouraging capital 
investment.

                                Summary

    Government fiscal policy, especially tax policy, can have a 
profound effect on the ability of governments and corporations 
to undertake capital investment. Tax proposals as seemingly 
arcane, technical and focused as ``increasing the proration 
percentage for property and casualty companies'' or ``extending 
the pro rata interest expense disallowance to financial 
intermediaries'' would have effects far beyond what is 
apparent. By affecting the choices and preferences of 
investors, these proposals would also have a significant 
negative effect on the ability of borrowers to finance capital 
investments at the lowest possible cost. We share the belief of 
many members of this committee that our tax system ought to 
encourage and facilitate capital investment. The 
administration's proposals outlined above would have the 
opposite effect. We urge you to oppose these provisions.
    We appreciate the opportunity to present our statement, and 
we look forward to working with Ways and Means members and 
staff as the budget debate progresses.
      

                                
Appendix

 Municipal Holdings of U.S. Property & Casualty Insurance Companies By State of Issuer As of September 30, 1997
----------------------------------------------------------------------------------------------------------------
                     State                          ($000s)                   State                   ($000s)
----------------------------------------------------------------------------------------------------------------
 Alabama......................................       2,059,021  Nebraska........................       1,126,823
Alaska........................................       1,306,692  Nevada..........................       2,939,837
Arizona.......................................       4,446,074  New Hampshire...................         674,534
Arkansas......................................         432,179  New Jersey......................       4,495,815
California....................................      10,349,389  New Mexico......................         951,091
Colorado......................................       3,323,768  New York........................      10,633,565
Connecticut...................................       3,538,421  North Carolina..................       2,532,793
Delaware......................................         784,556  North Dakota....................         346,563
District of Columbia..........................         839,432  Ohio............................       4,190,349
Florida.......................................       9,657,937  Oklahoma........................       1,157,219
Georgia.......................................       5,804,654  Oregon..........................       1,493,789
Hawaii........................................       2,016,090  Pennsylvania....................       6,585,177
Idaho.........................................         336,904  Puerto Rico.....................         754,917
Illinois......................................      11,641,432  Rhode Island....................         950,926
Iowa..........................................       4,333,908  South Carolina..................       2,200,217
Kansas........................................         787,849  South Dakota....................         752,454
Kentucky......................................       1,250,188  Tennessee.......................       2,594,871
Louisiana.....................................       2,108,269  Texas...........................      23,244,490
Maine.........................................       2,291,331  Utah............................       2,910,860
Maryland......................................         653,460  Vermont.........................         293,421
Massachusetts.................................       3,699,884  Virginia........................       4,709,072
Michigan......................................       6,085,316  Washington......................       9,888,956
Minnesota.....................................       5,187,175  West Virginia...................         953,235
Mississippi...................................       3,080,033  Wisconsin.......................       4,568,021
Missouri......................................       1,243,470  Wyoming.........................         433,659
                                                                                                 ---------------
Montana.......................................       1,534,822  Total...........................     180,405,996
----------------------------------------------------------------------------------------------------------------


      

                                

Statement of Business Insurance Coalition


Business Insurance Coalition Members

AIG Life Companies (U.S.)
American Council of Life Insurance
American General Corporation
America's Community Bankers
Association for Advanced Life Underwriting
Clarke/Bardes, Inc.
Great West Life and Annuity Insurance Company
Harris, Crouch, Long, Scott, Miller Inc.
The Hartford Financial Services Group
Massachusetts Mutual Life Insurance Company
MetLife
The Mutual of Omaha Companies
National Association of Life Underwriters
National Institute for Community Banking
New York Life Insurance Company
The Newport Group
Pacific Life
Schoenke & Associates
Zurich Centre Group LLC

    The Business Insurance Coalition, which is comprised of the 
above-listed purchasers, issuers, and sellers of business-use 
life insurance, submits this statement opposing the 
Administration's FY'99 budget proposal to impose new taxes on 
businesses that own or benefit from permanent life insurance.
    American businesses, large and small, have for many decades 
used life insurance to assure business continuation, provide 
employee benefits and attract and retain key employees. There 
is no justification for discouraging or eliminating these 
traditional business uses of life insurance, and we urge 
Members of the Ways and Means Committee to reject the 
Administration's efforts to impose a tax penalty that would 
strongly discourage the vast majority of employers from 
utilizing this important product.

  Life Insurance Allows Business Continuation, Protects Employees and 
                 Funds Vital Employee Benefit Programs

    Permanent life insurance protects businesses against the 
economic losses which could occur after the death of an owner 
or employee. Life insurance death benefits provide liquid cash 
to pay estate taxes when a business owner dies, to buy out 
heirs of a deceased owner or to meet payroll and other ongoing 
expenses when an income-producing worker dies, terminates or 
retires.
    Permanent life insurance purchased with after-tax dollars 
smoothes the transition during difficult times, allowing the 
business--and its employees--to continue working by preventing 
or mitigating losses associated with these disruptions. 
Anecdotal evidence of this abounds; every Representative and 
Senator will hear from constituents whose jobs still exist 
because their employers were protected from financial loss by 
life insurance.
    Many businesses, both large and small, also use permanent 
life insurance to finance employee benefit programs, thus 
enabling them to attract and retain their most important asset: 
skilled, experienced employees. Insurance-financed benefit 
programs are as diverse as the companies that use them, ranging 
from those which provide broad-based health coverage for 
retirees to individual split-dollar arrangements to non-
qualified pensions and savings benefits.

The Proposal Reverses Recent Congressional Action by Imposing New Taxes 
                     on Business-Use Life Insurance

    The Administration's FY'99 budget proposal would severely 
impact all of the aforementioned business uses of life 
insurance. Under the proposal, any business with any debt 
whatsoever would be forced to reduce its deduction for interest 
paid on that debt by an amount in relation to the net 
unborrowed cash values in policies owned by, or for the benefit 
of, the business, unless the policy was on the life of a 20 
percent owner. This would impose an indirect tax on 
accumulating cash values--as unborrowed cash values increase, 
the business' interest deduction disallowance would 
correspondingly increase.
    The Administration proposal would repeal specific 
exceptions to a 1997 rule enacted by Congress which generally 
disallows a portion of a business' deduction for interest paid 
on unrelated borrowing where the business directly or 
indirectly benefits from insurance covering the lives of anyone 
but an employee, officer, director or 20 percent or greater 
owner. The pending proposal would remove all exceptions except 
that applicable to 20 percent owners.
    In addition, the proposal apparently would repeal the 1996 
rule that allows a limited interest deduction for interest paid 
on loans against the life insurance policy itself when that 
policy covers a key employee.
    The Administration proposal therefore seeks to overturn 
current law, which was developed after two years of 
Congressional examination into appropriate business uses of 
life insurance. It asks Congress to reconsider its August 1997 
determination that there is no inappropriate interrelationship 
between owning (or benefiting from) life insurance on 
employees, officers and directors and general, unrelated 
borrowing decisions. More broadly, the proposal seeks to repeal 
long-standing tax policy which confers on corporations the 
right to enjoy the same important insurance tax benefits that 
are available to individuals.

The Administration Proposal Would Severely Impact Businesses That Rely 
                           on Life Insurance

    Enactment of the Administration proposal would make it 
significantly--in most cases, prohibitively--more expensive for 
businesses to own permanent life insurance. This would increase 
the number of inadequately protected businesses, which would, 
in turn, cause more businesses to fail when their owners and/or 
key workers die (a result directly at odds with the effort to 
save family-owned businesses as ongoing entities in the estate 
tax debate).
    The Administration proposal also would stifle business 
expansion and job creation by placing a completely arbitrary 
tax on normal corporate indebtedness of companies that own life 
insurance. The net effect would be to increase the cost of 
business expansion and discourage business growth, which is 
both bad economic and tax policy.
    If enacted, the Administration proposal also would make it 
more difficult, perhaps impossible, for many businesses to use 
life insurance to finance broad-based employee and retiree 
benefits. It would lower the level of retirement income benefit 
provided by companies to key workers. It would make it more 
difficult for businesses to attract and retain quality 
employees.
    Finally, the Administration proposal would impose a double 
tax penalty on certain business policyholders forced to 
surrender or sell their life insurance policies. The first tax 
penalty would be paid through reduced interest deductions on 
the business' unrelated borrowing. The second tax penalty would 
occur upon surrender of the policy, when the business would 
again be required to pay tax on the gain generated inside the 
policy. Plainly, there is no justification for imposing two 
taxes (a proration tax and a tax on policy surrender) with 
respect to the same item of income (life insurance inside 
build-up).

   The Administration's ``Arbitrage'' Justification Is Without Merit

    The Administration asserts that tax legislation is needed 
to prohibit ``arbitrage'' with respect to cash value life 
insurance. This is not the case. Current law (IRC section 264) 
disallows the deduction of interest on ``policy indebtedness'' 
and has always applied to direct borrowing (policy loans) and 
indirect borrowing (third party debt) where the debt is 
traceable to the decision to ``purchase or carry'' life 
insurance.
    What remains outside of section 264, then, is solely debt 
that is unrelated to a business' decision to ``purchase or 
carry'' life insurance, such as a manufacturer's mortgage to 
purchase a new plant or a travel agency's loan to buy a new 
copy machine. Under the Administration's proposal, these 
businesses would be penalized for protecting themselves against 
the premature death of key persons or funding retiree health 
benefits through life insurance, even if they have neither 
borrowed funds to purchase the policies nor taken out loans 
against the policies.
    Current tax law is designed to capture situations involving 
arbitrage with respect to cash value life insurance. The 
Administration's attempt to characterize any form of debt as 
leverage which renders a business' purchase of life insurance 
tax ``arbitrage'' is nothing but smoke and mirrors designed to 
hide its true purpose: the imposition of new taxes on business-
use life insurance.

  Tax Policy Should Encourage Appropriate Business-Use Life Insurance 
                                Programs

    At the heart of the debate over the Administration's 
proposal is the issue of whether business uses of life 
insurance should be encouraged or discouraged. The Business 
Insurance Coalition fundamentally disagrees with the 
Administration's position, which threatens all present and 
future uses of life insurance by businesses, and its members 
firmly believe that business-use life insurance falls clearly 
within the policy purposes supporting the tax benefits 
presently accorded to life insurance products.
    Tax policy applicable to business-use life insurance should 
encourage appropriate use of business life insurance by 
embodying the following principles:
     Businesses, in their use of life insurance, should 
have the benefit of consistent tax laws in order to facilitate 
reliable and effective long-range planning.
     All businesses, regardless of size or structure, 
should be able to use life insurance to provide benefits for 
their workers. Life insurance is an appropriate method of 
facilitating provision of retirement income, medical and 
survivorship benefits.
     Businesses must be able to use life insurance as 
an important part of their financial protection plans, and the 
insurance industry should respond to new business needs.
     Businesses, like individuals, should be able to 
use all products which qualify as life insurance under 
applicable federal and state law.
     Businesses should use life insurance products in 
ways consistent with the public interest and the intent of the 
tax laws.
     Businesses should be able to use life insurance to 
protect against the financial loss of the insured's death, or 
to meet other financial needs or objectives, including but not 
limited to:
    --successful continuation of business operations following 
the death of an insured key employee;
    --purchase of a business interest, thereby enabling the 
insured's family to obtain a fair value for its business 
interest and permitting the orderly continuation of the 
business by new owners;
    --redemption of stock to satisfy estate taxes and transfer 
costs of an insured stockholder's estate;
    --creation of funds to facilitate benefits programs for 
long-term current and retired employees, such as programs 
addressing needs for retirement income, post-retirement medical 
benefits, disability income, long-term care, or similar needs; 
and
    --payment of life insurance or survivor benefits to 
families or other beneficiaries of insured employees.
     Employers should be able to facilitate employee 
ownership of and benefit from permanent life insurance death 
and retirement income protection through split dollar insurance 
arrangements.

   Businesses Need Reliable and Predictable Tax Rules to Guide Their 
                          Financial Decisions

    Life insurance is a long-term commitment. It spreads its 
protection--and premium obligations--over life spans, often 40 
or 50 years. Its value base is predicated on the lifetime 
income-producing potential of the person insured. Thus, the 
process of selecting, using and paying for permanent insurance 
is one that contemplates decades of financial planning 
implications.
    Accordingly, the rules governing the choices inherent in 
constructing a business-use life insurance program must be 
clear and reliable. Certainty of rules that drive the 
configuration of decades-long financial commitments is crucial. 
There must be a stable environment that acknowledges long-
established practices.
    This need is even more acute today because of the 
Congressional actions of 1996 and 1997, which created a virtual 
``road map'' for businesses to follow in designing and 
implementing their business-use life insurance programs. The 
two years of debate addressed business-use life insurance 
practices in substantial detail, settling all of the issues 
raised by the pending Administration proposal. Thus, businesses 
reasonably thought they could proceed with some certainty under 
the rules enacted in 1996 and then further refined in 1997. To 
reopen these issues--which were addressed and settled just six 
months ago--and then to change them would be unconscionably 
unfair.

 Conclusion: The Administration's Business-Use Life Insurance Proposal 
 Unfairly and Adversely Affects Every Business with Current or Future 
                                  Debt

    The Business Insurance Coalition strongly opposes the 
Administration's FY'99 budget proposal on business-use life 
insurance, which unfairly and adversely affects every business 
that has current or future debt unrelated to its ownership of 
life insurance. The Business Insurance Coalition has 
demonstrated the appropriateness of the current rules governing 
business-use life insurance, which underpins business 
continuation and employee protection.
    Life insurance that protects businesses against the loss of 
key personnel and/or facilitates the provision of employee 
benefits should not be subject to further changes in applicable 
tax law. The question before Congress should be: Do current 
uses of business life insurance serve legitimate policy 
purposes justifying the tax benefits accorded life insurance 
generally? We believe that this question should be answered 
with an emphatic ``YES,'' and urge the Committee to reject the 
Administration's proposal to impose new taxes on business-use 
life insurance.

            Submitted by:
                                              John F. Jonas
                                               Patton Boggs, L.L.P.
                        Counsel to the Business Insurance Coalition
      

                                

Statement of Committee of Annuity Insurers

    The Committee of Annuity Insurers is composed of forty-four 
life insurance companies that issue annuity contracts. Our 
member companies represent almost two-thirds of the annuity 
business in the United States. The Committee of Annuity 
Insurers was formed in 1981 to address Federal legislative and 
regulatory issues confronting the annuity industry and to 
participate in the development of Federal tax policy regarding 
annuities. A list of the member companies is attached at the 
end of this statement. We thank you for the opportunity to 
submit this statement for the record.
    The Committee of Annuity Insurers believes that all of the 
Administration's proposals relating to the taxation of life 
insurance companies and their products are fundamentally 
flawed, but the focus of this statement is the Administration's 
proposals relating to the taxation of annuities. We believe 
that the Administration's proposals relating to the taxation of 
annuities represent unsound tax policy, and, if enacted, would 
have a substantial, adverse effect on private retirement 
savings in America. The Administration evidently does not 
understand the important role that annuities play in assuring 
Americans that they will have adequate resources during 
retirement. We hope that the following will help you come to 
the conclusion that the Administration's proposals involving 
annuities should be rejected.
    Annuities are widely owned by Americans. At the end of 
1996, there were approximately 32 million individual annuity 
contracts outstanding, an increase from approximately 13 
million just ten years before. The premiums paid into 
individual annuities, i.e., the amounts saved by Americans, 
grew from approximately $26 billion in 1986 to $84 billion in 
1996, an increase of 222 percent.
    Annuities have unique characteristics that make them 
particularly well-suited to accumulate retirement savings and 
provide retirement income. Annuities protect individuals 
against the risk of outliving their savings by guaranteeing 
income payments that will continue as long as the owner lives. 
Deferred annuities also guarantee a death benefit if the owner 
dies before annuity payments begin.
    Non-qualified annuities are a retirement savings product 
used primarily by middle-income Americans. According to a 
Gallup survey conducted in February 1997, most owners of non-
qualified annuities have moderate annual household incomes. 
More than 80 percent have total annual household incomes under 
$75,000. Owners of non-qualified variable annuities have 
slightly higher household incomes than do fixed annuity owners, 
but 74 percent of variable annuity owners have household 
incomes under $75,000. Eight in ten owners of non-qualified 
annuities state that they plan to use their annuity savings for 
retirement income (85%) or to avoid being a financial burden on 
their children (84%).
    The tax rules established for annuities have been 
successful in increasing retirement savings. Eighty-four 
percent of owners of non-qualified annuities surveyed by Gallup 
in 1997 reported that they have saved more money than they 
would have if the tax advantages of an annuity contract had not 
been available. Ninety-one percent reported that they try not 
to withdraw any money from their annuity before they retire 
because they would have to pay tax on the money withdrawn. In 
fact, only 15 percent of owners who are not receiving regular 
payouts from their annuity contracts reported having withdrawn 
money from their annuity contract.
    While the tax treatment of annuities is well-targeted to 
encourage people to save for retirement, this same tax 
treatment makes annuities significantly less attractive than 
other investment options for shorter term savings. For 
instance, savings invested in annuities are allowed to build on 
a tax-deferred basis, but when those savings are used, i.e., 
when the owner receives cash from the annuity contract, all 
gains will be subject to tax at ordinary income rates, not 
capital gains rates. If an individual invests money in an 
annuity for a substantial period, the deferral of tax will be a 
very powerful savings tool which can compare favorably to 
investments which give rise to long-term capital gain. A recent 
study by the Economic Policy Consulting Group of Price 
Waterhouse LLP, Variable Annuities After the 1997 Tax Act: 
Still Attractive For Retirement Savings, concluded that 
variable annuities can be attractive investments for long-term 
savers relative to mutual funds. A monograph by Dr. James 
Poterba, an economics professor at the Massachusetts Institute 
of Technology, that was published in September, 1997, The 
History of Annuities in the United States, reached a similar 
conclusion.
    If an individual takes money out of an annuity before age 
59, not only is the amount taxable on an ``income-first'' 
basis, but it also is subject to an early withdrawal penalty of 
10 percent. If an individual wants to borrow from an annuity, 
or pledge it as security for a loan, any amount received is 
treated as a distribution which is subject to ordinary income 
tax, plus the early withdrawal penalty if before age 59. There 
are several additional tax rules that make annuities attractive 
only as a funding vehicle for long-term savings, but the 
essential point is simply that the annuity tax rules have been 
carefully crafted by Congress to assure that annuities will be 
used for retirement income.
    The proposals contained in the Administration's FY 1999 
budget greatly upset this carefully balanced set of tax rules 
and jeopardize the continued existence of annuities as a method 
to save for retirement. The balance of this statement will 
address the specific proposals.

1. Proposal to Tax Exchanges of Variable Annuities and Reallocations of 
                    Assets Within Variable Annuities

    This proposal applies to ``variable'' annuities. A variable 
annuity is a type of annuity where premiums are placed in a 
``separate account'' of a life insurance company, and the funds 
are invested by the life insurance company in various stocks 
and bonds. Variable annuities typically offer the owner a 
choice among several diversified investment options with 
different, broad investment strategies. These investment 
options may include, for example, a domestic equity fund, a 
government bond fund, and a balanced fund. Most variable 
annuities offer a fixed account investment option as well. The 
value of a variable annuity contract is not guaranteed. 
Instead, its value will vary according to the performance of 
the investment options that the owner has chosen. This allows 
the annuity owner to benefit over the long term from the higher 
rates of return historically provided by the stock market.
    Variable annuity contracts typically provide that owners 
may allocate their premium payments among the several different 
investment options provided under their contracts. Owners may 
also periodically reallocate their account values among these 
investment options. Under present law, these reallocations do 
not cause the owner to incur a tax so long as the investment 
remains in the annuity. This flexibility provides an important 
incentive to encourage people to keep their savings in their 
annuities to provide for their retirement. Of course, the 
earnings in the contract are taxed when the owner takes funds 
out of his or her annuity, typically during retirement.
    The Administration would reverse over 40 years of sound tax 
policy by taxing people before they take money out of their 
annuity if they reallocate their annuity savings among the 
available investment options or if they exchange their variable 
annuity for an annuity issued by another insurer.
    There are a number of reasons why Congress should reject 
this proposal.
    Perhaps the most important is that it ds to retirement 
savings merely because their savings needs have changed. 
Variable annuities are used for long-term savings. They offer 
investment options based on diversified pools of stocks and/or 
bonds, just as section 401(k) plans and IRAs do, although no 
deduction is ever allowed for a contribution to a non-qualified 
variable annuity. All retirement savers periodically need to 
shift their savings among different options as they grow older 
and in response to changes in the financial markets. Under the 
Administration's proposal, annuity owners who, as a result of 
growing older or due to concerns over market performance and 
the security of their retirement savings, shift their savings 
from a stock fund to a government bond fund within a variable 
annuity would be immediately taxed.
    Second, the Administration's proposal would tax individuals 
even though they do not have the proceeds from which to pay the 
tax. An individual who reallocates his or her retirement 
savings within an annuity contract has not withdrawn any part 
of it for current consumption. In fact, it would appear that 
such an individual would be forced to incur the 10 percent 
penalty tax for early withdrawal if he or she needed to use 
part of the amounts invested in a variable annuity to pay this 
new tax.
    Third, the proposal is a disguised tax increase on retired, 
middle income savers. Five consecutive Gallup surveys conducted 
since 1992 have shown that more than 80 percent of the owners 
of non-qualified annuities have total household incomes under 
$75,000. Moreover, the 1997 Survey shows that the average age 
of an owner of a non-qualified annuity is 66 and about 60 
percent of owners are now retired.
    Finally, the proposal undoubtedly would discourage private 
retirement savings. Congress in recent years has become ever 
more focused on the declining savings rate in America and on 
ways to encourage savings and retirement savings in particular. 
The variable annuity is a well-designed product that is 
successful in encouraging Americans to commit funds to 
retirement. As described above, Americans have been saving more 
and more in annuities, which alone among non-pension retirement 
investments can provide the owner with a guarantee of an income 
that will last as long as the owner lives. Taxing annuity 
owners when they reallocate their savings among different 
investment options will inevitably reduce private savings.

2. Proposal to Reduce the ``Investment in the Contract'' for Mortality 
                    and Expense Charges of Annuities

    When the Administration refers to the ``investment in the 
contract'' of an annuity contract, it actually is referring to 
the tax basis that an individual has in the contract. This 
basis generally equals the premiums paid for the contract. 
Amounts paid for insurance and other mortality risk and expense 
charges are included in the contract's tax basis.
    The Administration's budget proposal would reduce a 
policyholder's tax basis in a deferred annuity contract for the 
mortality and expense charges under the contract. Under the 
proposal, these charges are deemed to equal 1.25 percent of the 
contract's average cash value each year (regardless of what is 
actually paid). Lost basis would be restored only if the 
policyholder elected to receive annuity payments for life and 
only if the policyholder used the annuitization rates 
guaranteed under the contract--even if the insurance company 
was currently offering annuitization rates that would give the 
policyholder larger annuity income payments.
    Again, there are several very good reasons why Congress 
should reject this proposal.
    First, this proposal is inconsistent with longstanding tax 
rules which are based on essential fairness and economic 
reality. Generally, under the Federal income tax, if an 
individual incurs expenses related to the purchase of an asset, 
those expenses are included in the basis of the asset for tax 
purposes. For instance, if sales commissions are charged when 
an individual buys a share of stock in a company, the 
commissions are included in the basis of the asset. When the 
asset is sold, the gain realized does not include the costs 
incurred to purchase the asset.
    Similarly, the tax basis of an asset (e.g., a home or a 
car) is not reduced by any personal consumption element 
attributable to the asset (e.g., nondeductible depreciation). 
The Administration's proposal is equivalent to reducing a 
taxpayer's basis in his or her car or home by the annual rental 
value of those assets. It is true that the taxpayer has 
obtained a benefit from ownership of the car or home, but the 
tax that the owner pays on a subsequent sale is not increased 
because of that benefit.
    The proposal also would increase the tax burden on 
retirement savers and create a disincentive to use the valuable 
protection provided by annuity contracts.
    Annuity contracts are designed to accomplish two important, 
and related, purposes: to accumulate retirement savings, and to 
insure against mortality-related risks that individuals face 
(i.e., outliving one's assets). The insurance features are an 
intrinsic and important part of these contracts. Taxes on 
income from savings should not be increased just because those 
savings are accumulated in annuity contracts, which provide 
insurance protection to the owner and his or her family. Such 
tax increases would discourage savings by the middle-class 
Americans who are the predominant purchasers of non-qualified 
annuities.
    In addition, the proposal would substantially increase 
administrative and compliance costs for little revenue. Under 
the proposal, life insurance companies would be required to 
calculate and keep track of two different basis amounts for 
each annuity contract. One set of basis records would be used 
in the event that the policyholder annuitized his or her 
contract for life at the guaranteed rates under the annuity and 
the other set of basis records would be used if the 
policyholder took a distribution in any other form from the 
annuity. These calculations would have to be made and 
maintained for many years because annuity contracts are used 
for long-term savings. The increased costs of designing 
computer and administrative systems to implement this proposal 
is disproportionate to any revenue gain from what is in all 
events a proposal that is contrary to generally applicable tax 
rules.

  3. Proposal to Deny a Reserve Deduction for Certain Annuity Benefits

    Life insurance companies are required by state insurance 
law to establish reserves in order to fund the benefits 
promised to policyholders under annuity contracts. These 
policyholder benefits include the guarantee of an income stream 
extending over the annuitant's life, a death benefit if the 
annuitant dies prematurely, and a cash surrender value. In 
recent years, annuity contract benefits have been expanding and 
many contracts now offer larger death benefits, incentives for 
annuitization (such as higher interest credits), and 
withdrawals without surrender charges if certain conditions 
exist (e.g., disability or confinement in a nursing home).
    Life insurance companies include in their income all of the 
premiums they receive and the investment income they earn, but 
are allowed a deduction for their reserve obligations in 
recognition of the fact that a substantial part of the premiums 
and investment income will be used to pay policyholder 
benefits. The reserve for an annuity contract simply represents 
the present value of all the future benefits guaranteed to the 
policyholder. Under current law, the deduction is allowed for 
the greater of (1) the contract's net surrender value, and (2) 
a Federal tax reserve computed using a Federally prescribed 
interest rate, a prescribed mortality table, and a reserve 
method known as the ``Commissioners' Annuity Reserve Valuation 
Method'' or ``CARVM.'' CARVM was developed by the National 
Association of Insurance Commissioners (NAIC), which is the 
association of state officials responsible for regulating 
insurance companies. In all events, the deduction is limited to 
the reserves required under state law.
    The Administration's budget proposal would limit the 
deduction for reserves to the lesser of (1) the contract's net 
surrender value (plus a small additional percentage that phases 
out over seven years), and (2) the Federal tax reserve 
describproposal is based on its belief that the new NAIC 
actuarial guidelines on CARVM issued in 1997 will result in 
annuity reserves being increased ``substantially'' and that 
annuity reserves will be ``excessive.''
    There are several reasons why Congress should reject this 
proposal.
    First, the proposal is based on a basic misunderstanding by 
the Treasury Department of the new NAIC guidelines. The new 
NAIC guidelines did not change the definition of CARVM and did 
not require any ``substantial'' increase in annuity reserves. 
Rather, the new NAIC guidelines simply clarified the meaning of 
a long-standing reserve method. For most companies, the new 
NAIC guidelines will have no material effect on their annuity 
reserves--most companies already have been calculating their 
annuity reserves in the manner described in the new NAIC 
guidelines. For those companies whose reserves are affected by 
the new NAIC guidelines, the guidelines simply assure that a 
company's reserves accurately reflect its liabilities for the 
types of benefits guaranteed to its policyholders.
    Second, the Administration's proposal would increase the 
cost, and thus reduce the availability, of important 
policyholder benefits offered under annuity contracts. The 
effect of the Administration's proposal is to deny a reserve 
deduction for many of these benefits. Without this deduction, 
those benefits (which include death benefits, enhanced annuity 
payments, and the right to make withdrawals free of surrender 
charges) would be more costly to provide to consumers. Yet 
those benefits are the very ones being demanded by consumers in 
the retirement savings marketplace.
    In addition, annuity benefits beyond the ability to take a 
lump-sum cash payment represent true liabilities for which a 
deduction has been, and should continue to be, allowed. The 
Administration's proposal seems to be based on the premise that 
a life insurance company's obligations for the insurance 
benefits guaranteed under an annuity contract are not true 
liabilities. That premise is clearly erroneous. It is beyond 
dispute that a life insurance company has a liability to the 
purchaser of an immediate life annuity--even though such an 
annuity typically has no cash value--an obligation to make 
payments to the annuitant for as long as he or she lives. 
Likewise, a life insurance company has a liability to provide a 
purchaser of a deferred annuity all the benefits promised--not 
just the benefit of taking a lump-sum cash payment.
    In conclusion, the Committee of Annuity Insurers urges that 
the Administration's tax increases involving annuities be 
rejected. These tax increases have no basis in good tax policy 
and will discourage Americans from taking the initiative to 
save for their own retirement.
      

                                

The Committee of Annuity Insurers

Aetna Inc., Hartford, CT
Allmerica Financial Company, Worcester, MA
Allstate Life Insurance Company, Northbrook, IL
American General Corporation, Houston, TX
American International Group, Inc., Wilmington, DE
American Investors Life Insurance Company, Inc., Topeka, KS
American Skandia Life Assurance Corporation, Shelton, CT
Charter National Life Insurance Company, St. Louis, MO
Commonwealth General Corporation, Louisville, KY
Conseco, Inc., Carmel, IN
COVA Financial Services Life Insurance Co., Oakbrook Terrace, IL
Delta Life and Annuity, Memphis, TN
Equitable Life Assurance Society of the United States, New York, NY
Equitable of Iowa Companies, Des Moines, IA
F & G Life Insurance, Baltimore, MD
Fidelity Investments Life Insurance Company, Boston, MA
Great American Life Insurance Co., Cincinnati, OH
GE Financial Assurance, Richmond, VA
Hartford Life Insurance Company, Hartford, CT
IDS Life Insurance Company, Minneapolis, MN
Integrity Life Insurance Company, Louisville, KY
Jackson National Life Insurance Company, Lansing, MI
Keyport Life Insurance Company, Boston, MA
Life Insurance Company of the Southwest, Dallas, TX
Lincoln National Corporation, Fort Wayne, IN
ManuLife Insurance Company, Boston, MA
Merrill Lynch Life Insurance Company, Princeton, NJ
Metropolitan Life Insurance Company, New York, NY
Minnesota Mutual Life Insurance Company, St. Paul, MN
Mutual of Omaha Companies, Omaha, NE
Nationwide Life Insurance Companies, Columbus, OH
New England Life Insurance Company, Boston, MA
New York Life Insurance Company, New York, NY
Ohio National Financial Services, Cincinnati, OH
Pacific Life Insurance Company, Newport Beach, CA
Phoenix Home Mutual Life Insurance Company, Hartford, CT
Protective Life Insurance Company, Birmingham, AL
ReliaStar Financial Corporation, Seattle, WA
Security First Group, Los Angeles, CA
SunAmerica, Inc., Los Angeles, CA
Sun Life of Canada, Wellesley Hills, MA
Teachers Insurance & Annuity Association of America--College Retirement
Equities Fund (TIAA-CREF), New York, NY
Travelers Insurance Companies, Hartford, CT
Zurich Kemper Life Insurance Companies, Chicago, IL
      

                                

Statement of Corporate Property Investors

First Union Real Estate Investments

Meditrust

Patriot American Hospitality

Starwood Hotels & Resorts

                              Introduction

    This testimony outlines the concerns of the five 
grandfathered paired-share real estate investment trusts 
(REITs) over the Administration's FY 1999 Budget proposal that 
would ``freeze'' the status of paired-share REITs. Each of the 
grandfathered entities strongly opposes the Administration's 
proposal. The concerns about this proposal go beyond its harm 
to these companies' shareholders, each of whom reasonably 
relied on existing law when their investments were made. The 
Administration's proposal also would unfairly (i) reverse 
Congress' historic efforts to encourage utilization of REITs to 
allow all kinds of investors to own real estate, and (ii) 
impose unnecessary complexity to the Internal Revenue Code, 
without raising any significant revenue or resolving any of the 
issues raised by those opposing the existing grandfather rule.

                   Description of a Paired-Share REIT

    Each grandfathered paired-share REIT consists of two 
companies, the stock of which are ``paired'' or ``stapled'' 
together, such that the shares trade as a single investment 
unit and are owned by the same shareholders. One of the paired 
companies is a REIT, essentially a pass-through entity subject 
to the Internal Revenue Code's numerous requirements, including 
distributing 95 percent of its taxable income to shareholders 
on an annual basis. The other paired company is an operating 
company that is subject to the regular corporate federal income 
tax, found in subchapter C of the Internal Revenue Code (``C 
corporation'').
    The paired-share structure is typically used to own and 
operate certain types of real property, like hotels and medical 
facilities, that cannot be operated by a REIT under the 
existing Internal Revenue Code. The paired REIT owns the 
properties and leases such assets to its paired operating C 
corporation, which operates and manages the properties.

               Analysis of the Administration's Proposal

I. The 1960 legislation establishing REITs implemented Congressional 
interest in providing all kinds of investors with the same opportunity 
to invest in real estate as wealthy investors.

    The 1960 legislation establishing REITs (P.L. 86-779) used the 
Internal Revenue Code rules for regulated investment companies (RICs) 
as a model for the new REIT structure. The legislative history 
indicates that Congress wanted to give small investors an opportunity 
to invest in professionally managed portfolios of real estate, in the 
same manner as permitted for investments in stocks through the RIC 
rules. H.R. Rep. No. 2020, 86th Cong., 2d Sess. (1960), 1960-2 C.B. 
819, 820.
    The Committee report accompanying the 1960 Act drew parallels 
between the RIC and REIT investment strategies and noted their common 
purpose and structure. Id. In particular, the Report clarified that 
both arrangements enable small investors to secure advantages normally 
available only to those with greater monetary resources. Such 
advantages include: (1) risk spreading through greater diversification 
of investments secured through pooling; (2) opportunities to secure the 
benefits of expert management advice; and (3) means of collectively 
financing projects that individual investors would be unable to 
undertake. Id.
    During the House Floor debate on the bill, the Chairman of the 
House Ways and Means Committee, Wilbur Mills, explained the purpose of 
the REIT legislation. In his statement, Chairman Mills indicated that 
the bill would not only ``provide equitable treatment of existing real 
estate investment trusts but it would provide a reasonable machinery 
whereby a large number of small investors would be able to make real 
estate investment without incurring the penalty of additional income 
tax at the corporate level.'' 106 Cong. Rec. H15017 (daily ed. June 29, 
1960).

II. The paired-share structure fulfills the policy goals underlying the 
basis for establishment of REITs in 1960.

    Congress' 1960 REIT policy is preserved in the paired-share 
structure that was sanctioned by the Internal Revenue Service (IRS) in 
the 1970s and early 1980s. In those years, the formation and operation 
of paired-share REITs were approved by the IRS through the issuance of 
several broadly written private letter rulings. See e.g., PLR 8002026 
(Oct. 16, 1979); PLR 8013039 (Jan. 4, 1980); PLR 8120107 (Feb. 20, 
1981).
    The structure, as sanctioned by these rulings, was designed to 
ensure that non-REIT, active income is subject to taxable C corporation 
treatment. The REIT must operate as a REIT, and the operating C 
corporation is treated just like any other taxable C corporation. At 
the same time, the paired-share REIT structure has a sound business 
purpose unrelated to any tax savings. The structure achieves a better 
investment result for the public shareholders of a REIT by allowing the 
shareholders to retain the economic benefits of both the lease payments 
received by the REIT and the after-tax operating profits realized by 
the operating C corporation.
    The nature of the business advantage to the paired-share structure 
can be understood in part by considering the problems that exist in 
management-intensive real estate activities. In the absence of a paired 
operating company, where the operating entity and the real estate are 
under separate control, the REIT that owns assets such as a hotel is 
required to lease such property to an unaffiliated property operator. 
This structure presents at least two basic problems.
    First, in reaching an agreement on the lease terms between the REIT 
and the operating company, the profitability of the operations may be 
difficult to determine. In such cases, neither party might wish to 
undertake the risk of a long-term contract. Further, each party is 
potentially exposed to the risk of agreeing to lease terms too 
favorable to the other party. Under a long-term contract, the owner of 
the real estate may have an insufficient incentive to undertake 
investments that maintain the profitability of the property, unless the 
owner believes it is fully compensated for these investments by the 
terms of the lease agreement.
    Second, in the absence of a long-term contract, the operating 
entity may have a reduced incentive to undertake investments that 
enhance the long-term value of the operation. The operating entity may 
not be assured that it will be the actual beneficiary of these 
investments. These investments may take the form of advertising, 
capital improvements, and efforts to reward long-term customer loyalty 
to the operations. If the operating company decides to undertake these 
investments and is successful in enhancing the profitability of the 
operation, upon expiration of the initial lease, the real estate owner 
(REIT) could capture all of the benefits achieved by the operator by 
increasing the rental payments required under the terms of the lease.
    Faced with these structural constraints, the paired-share REIT 
structure was developed to preserve shareholder value, by eliminating 
potential conflicts of interest between the owner of the property (the 
REIT) and the tax-paying entity that operates and manages the REIT's 
property. Non-paired REITs have responded to these economic and 
conflict issues in similar ways, through affiliation with taxable C 
corporations using ``preferred stock subsidiary'' and ``paper clipped 
REIT'' structures.
    Further, the changes made by Congress to the Internal Revenue 
Code's REIT provisions have consistently reflected (i) Congress' 1960 
policy of providing small investors with access to real estate 
ownership via a pass-through entity and (ii) Congress' desire to 
improve the operation of the REIT rules through the integration of 
ownership and management of real estate. In other words, when the 
statute was passed in 1960 based on the RIC paradigm, application of 
this model to real estate ownership was not fully appreciated. The REIT 
provisions have been amended nine times since 1960, each time to fine 
tune this structure for use in the real estate context.
    Changes to the REIT rules made over the years indicate that the 
Congressional tax writers recognized that the value in real estate, 
unlike stock, is inextricably intertwined with the management of the 
properties. Without a greater alignment of the owner's and operator's 
interests in the real estate, the value of such real estate interests 
cannot be maximized as originally envisioned. In particular, the 1986 
and 1997 amendments significantly liberalized the extent to which 
operational income could be earned by a REIT. See Pub. L. No. 99-514, 
Sec. 663 (allowing certain customary management functions and 
services); Pub. L. No. 105-34, Sec. 1255 (allowing a small amount of 
prohibited services not to taint rental income). Thus, Congress 
indicated that it understood how essential it is for REIT owners to 
control the management and operations of the properties they own.
    In contrast, the 1984 amendment, adding IRC section 269B to limit 
future paired-share REITs, ignored the need for certain REIT owners to 
control the management and operations of the properties they own. The 
provision did not amend the REIT provisions in the Internal Revenue 
Code, but was instead part of an effort primarily focused on foreign 
corporations stapled to domestic corporations. It therefore was 
included in the foreign tax section of the Deficit Reduction Act of 
1984. Pub. L. No. 98-369, Sec. 136. When Congress addressed the paired 
or stapled structure in this statutory provision, it recognized that 
the IRS had sanctioned this structure. H.R. Conf. Rep. No. 432, 98th 
Cong., 2d Sess., 1545 (1984). Accordingly, unlike the language 
providing relief for the foreign-domestic paired entity, which was 
limited to about 2.5 years, the grandfather rule for the paired-share 
REITs in existence on the date of introduction of the bill first 
imposing these limits (June 30, 1983), was unrestricted. The conference 
report for the Act states that the IRS guidance was the rationale for 
the unqualified grandfather rule. Id.

III. The paired-share REIT structure meets Congress' expectations, even 
when analyzed under concerns raised by others.

    A. The paired-share structure does not represent an abuse of the 
federal tax laws.--Use of the paired share structure is simply a way to 
align ownership and operation of real estate consistently with the 
limitations on the kinds of income that a REIT may earn. Most REITs 
face economic and investor pressure not to permit third parties to 
divert operational income to themselves. REITs use many approaches, 
including affiliation with taxable C corporations, to remove the 
potential conflict inherent in third party management. The paired share 
structure is only one form of C corporation affiliation. The most 
prominent alternative forms are use of a ``preferred stock 
subsidiary,'' which is a taxable subsidiary of a REIT that uses 
multiple classes of stock to comply with REIT rules, and a ``paper 
clipped REIT,'' which involves a C corporation that is affiliated with 
the REIT through common directors, common managers, contractual 
relationships and substantially the same shareholders.
    Existing rules applicable to all REITs ensure that transactions 
between the paired REIT and an affiliated C corporation are conducted 
on an arm's-length basis. These rules, and the low Joint Tax Committee 
revenue estimate ($34 million over 5 years/$217 million over 10 years), 
demonstrate that the paired-share REIT structure is not abusive.
    A study conducted by Price Waterhouse analyzing transfer pricing 
risks found no evidence of transfer pricing abuses by paired-share 
REITs. See Price Waterhouse LLP, ``Federal Income Tax Effects of the 
Paired-Share REIT Structure of Starwood Lodging,'' (Nov. 7, 1997). The 
study tested the returns of Starwood, the largest paired-share REIT, to 
the compensation ratios of non-paired hotel REITs for the 1995 and 1996 
periods. The results of the study indicate that the compensation ratio 
from leasing hotel properties to the paired operating C corporation is 
no greater than that of non-paired hotel REITs.
    REIT provisions defining non-qualifying income also prevent 
taxpayers from manipulating the allocation of costs between entities. 
IRC Sec. 856(c)(2); Treas. Reg. 1.856-4(b)(3). As a consequence, REITs 
are strongly discouraged from taking aggressive tax positions. 
Moreover, current law imposes a penalty involving the loss of REIT 
status and onerous restrictions on reentry into REIT status. IRC 
Sec. 856(g); Treas. Reg. Sec. 1.856-8.
    B. The structure does not contribute to ``disincorporation.''--
Historical evidence shows that the existence of the paired-share REIT 
structure does not encourage the ``disincorporation'' of U.S. 
businesses. Significantly, none of the existing paired-share REIT 
companies began as C corporations. Each began its business as a stand-
alone REIT that later added the C corporation management function to 
maximize shareholder value, avoid conflicts of interest and incorporate 
an ability to manage the properties owned by the REIT.
    Disincorporation is discouraged by Internal Revenue Code rules that 
impose penalties on conversions of C corporations into REITs. IRS 
Notice 88-19, 1988-1 C.B. 486. In particular, these rules impose tax on 
the sale of real estate assets to a REIT.
    Furthermore, where services and other non-real estate income 
provide the greater share of an enterprise's value, a C corporation 
would not benefit from the establishment of a REIT. Splitting such a 
business's value between its real estate and other operations would 
bifurcate important aspects of the business, unless it had a strong 
real property component. The mandatory dividend rules applicable to 
REITs would prevent the company from reinvesting a substantial portion 
of its cash flow, resulting in either cash flow problems or a 
substantial change in the capital requirements for that type of 
business operation.
    C. The paired-share structure does not give an unfair business 
advantage.--The tax advantage of paired-share REITs is the same one 
enjoyed by every other REIT, namely, that the REIT's taxable income is 
taxed once, not twice. However, the corporate level tax on real estate 
ownership income, is not unique to the REIT structure. Corporations 
taxed under Subchapter C of the Internal Revenue Code often achieve the 
substantive equivalent of one layer of taxation on their real estate. 
For instance, C corporations have opportunities to reduce double 
taxation and otherwise lower the cost of capital by incurring higher 
debt and by using depreciation and other business deductions. REITs, on 
the other hand, tend to be less leveraged than C corporations to help 
ensure sufficient earnings for the payment of required dividend 
distributions to shareholders.
    Additionally, stock prices, measured as a multiple of earnings, can 
be similar for C corporations and non-paired REITs. Such figures 
reflect shareholder expectations of growth in the future, including an 
assessment of management expertise, superior workforce, name 
recognition, infrastructure, customer base, location, as well as any 
combination of these or other factors.
    Historical evidence reflecting on the successes and failures 
between paired-share REITs and other companies without this structure 
for acquisitions also demonstrate that such REITs do not have unfair 
business advantages over C corporations. One company can have a number 
of advantages over another company, regardless of the REIT or non-REIT 
structure. For example, two paired-share REITs unsuccessfully bid 
against Marriott, a C corporation, last year for the Renaissance hotel 
chain; and this year against Bass PLC, a foreign-based lodging and 
spirits company, for the Inter-Continental Hotels and Resorts chain.

IV. The Administration's proposal is a totally inappropriate 
``solution'' to the concerns relating to paired-share REITs.

    The Administration's proposal attempts to ``freeze'' the 
grandfathered status of the existing paired-share REITs. Under the 
proposal, for purposes of determining whether any grandfathered entity 
is a REIT, the paired entity would be treated as one entity with 
respect to properties acquired on or after the date of first action by 
a Congressional committee, and with respect to activities or services 
relating to such properties that are undertaken or performed by one of 
the paired entities on or after such date. The proposal would 
effectively mean that future acquisitions of certain types of property 
by paired-share REITs would generate ``bad income'' under the 95 
percent gross income test, if the paired-share REIT were to operate 
such property. As a result, enactment of this proposal would severely 
limit the ability of paired-share REITs to operate properties that they 
traditionally have operated, if such properties are acquired after the 
proposed effective date of the proposal.
    The Administration proposal is not projected to raise significant 
revenue. It represents just one-half of one percent of its overall 
revenue package, and fails to take into account factors which suggest 
that paired-share REITs may, in fact, be revenue enhancing. First, 
since the paired operating C corporation is fully subject to tax, and 
the REIT must pay out 95 percent of its taxable income to its 
shareholders as dividends (which are than taxable as current, ordinary 
income), it is difficult to see how tax revenue is decreased through 
the paired-share structure. In fact, because individual tax rates are 
higher than corporate tax rates, and as a result of differences in how 
REIT dividends are taxed, the profits earned by a REIT may be taxed at 
higher effective rates than the profits of a regular C corporation. 
Second, paired-share REITs typically have lower levels of debt than C 
corporations, which often use interest deductions and depreciation to 
minimize Federal taxes, and generally distribute far less than 95 
percent of their net earnings to shareholders. Thus, any proposal which 
marginally increases real estate holdings in C corporations, while 
simultaneously decreasing the level of such assets held by REITs, could 
result in a loss of Federal tax revenues. A preliminary analysis by 
Price Waterhouse LLP suggests the possibility of this conclusion; a 
more thorough study, which is now underway, likely will demonstrate 
that paired-share REITs are net contributors to the U.S. Treasury.
    The Administration's proposal also would increase the complexity of 
the Code, as outlined by the Joint Tax Committee pamphlet. Description 
of Revenue Provisions Contained in the President's Fiscal Year 1999 
Budget Proposal, JCS-4-98, at 209 (1998). The pamphlet raises a number 
of concerns, particularly relating to how a paired-share REIT would be 
able to determine when a ``new'' acquisition has occurred and how the 
proposal would be applied.
    For example, the proposal's use of the term ``property'' is 
unclear. Does the term apply to improvements or renovations to existing 
properties? If a new roof were placed on a building, the taxpayer 
typically would depreciate it as a separate property. If a new item of 
property were acquired as part of an existing business operation (e.g., 
a new bed is purchased for a hospital), would the paired-share REIT 
have to determine the revenues allocable to the bed? If so, how?
    The application of the income tests to the acquisition of a new 
property also is unclear. For example, if a new hotel were acquired, 
how would revenues and expenses be allocated? In particular, would 
there be assumed allocations of overhead, and how would internal 
management and franchise fees be treated? Would the rent be treated as 
``good'' income or would the entire gross revenue of the property be 
treated as ``bad'' income? For purposes of determining the taxable 
income and distribution requirements of the REIT, would the net income 
from the property be included in the REIT's income (with a 
corresponding deduction to the C corporation) or would the single 
entity treatment only apply for purposes of the REIT qualification 
tests?
    These and many other interpretive issues would have to be settled 
before the Administration's proposal could be considered. In any event, 
any adjustment in the treatment of paired-share REIT entities must be 
clear and unambiguous. Clarity is particularly important because REITs 
are subject to an all or nothing status test. IRC 856(g). Investors 
must be able to determine with a high level of certainty whether REIT 
status could be maintained by a paired-share REIT, and the extent to 
which the C corporation's operations would be affected.

                               Conclusion

    The Administration's proposal with respect to paired-share 
REITs is inconsistent with Congress' historic support for 
business structures that allow public investors to own a 
diversified portfolio of real estate. Charges that the 
structure permits abuse or unfair advantage are simply wrong. 
The existing paired-share REITs are prepared to support and 
work with Committee staff to develop proposals directly 
addressing any actual transfer pricing or other problems 
involving transactions between the two paired entities, or to 
expand the opportunities for other REITs to operate as paired-
share REITs.
      

                                

Statement of Employer-Owned Life Insurance Coalition

    This statement presents the views of the Employer-Owned 
Life Insurance Coalition, a broad coalition of employers 
concerned by the provisions in the Administration's fiscal year 
1999 budget that would increase taxes on life insurance 
policyholders.

  Congress Should Reject the Administration's Life Insurance Proposals

    The Administration's fiscal year 1999 budget proposal would 
increase taxes on life insurance policyholders in three major 
respects:
     Businesses that purchase insurance on the lives of 
their employees would be denied a portion of the deduction to 
which they are otherwise entitled for ordinary and necessary 
interest expenses unrelated to the purchase of life insurance.
     Businesses (and individuals) that exchange 
policies or reallocate policy investments would be taxed on the 
unrealized appreciation--the inside buildup--because such 
exchange or reallocation would be treated as a taxable event.
     Taxable gains associated with permanent life 
insurance and annuity contracts would be artificially inflated 
by denying basis for the portion of the policy premium that 
reflects certain mortality charges and expenses.
    For the reasons set forth below, we urge the Congress to 
reject each of these ill-conceived proposals.

                         Summary of Opposition

    The Administration's proposals drive at the very heart of 
traditional permanent life insurance, the so-called ``inside 
buildup'' of credits (or cash value) within these policies that 
permits policyholders to pay level premiums over the lives of 
covered individuals. Each of the proposals would in one way or 
another effectively tax inside buildup. This would change the 
fundamental tax treatment of level-premium life insurance that 
has been in place since the federal tax code was first enacted 
in 1913. We believe that the historical tax treatment of these 
policies is grounded in sound policy and should not be altered.
    This is particularly true in light of the efforts by 
Congress and the Administration over the past two decades to 
develop strict statutory and regulatory standards designed to 
ensure that permanent life insurance policies cannot be used to 
cloak inappropriate investments. Policies that are unable to 
meet these standards are not eligible for tax treatment as life 
insurance under current law. To the extent the buildup of cash 
values is permitted under current standards, this 
``investment'' feature should if anything be encouraged, not 
penalized.
    With respect to the proposal to deny a portion of a 
policyholder's deduction for unrelated interest expenses, we 
find it particularly difficult to comprehend how an otherwise 
ordinary and necessary business expense loses its status as 
such merely because a business purchases life insurance on its 
employees. If the Administration's concern is with the inside 
buildup in insurance policies, it should say so--and it should 
address the issue directly. The proposed ``tax by proxy'' is 
poorly targeted--it would have widely-varying impacts on 
similarly-situated taxpayers with identical life insurance 
policies. More importantly, it would circumvent Congress's 
steadfast refusal for more than 80 years to permit current 
taxation of inside buildup.

 Disguised Attack on Historical Treatment of Traditional Life Insurance

    The Administration's proposals drive at the heart of 
permanent life insurance. Although the Treasury Department has 
characterized the proposals as targeting certain ``collateral'' 
uses of life insurance unrelated to its core purpose, in fact, 
the proposals go to the very essence of traditional permanent 
life insurance: the accumulated cash values inherent in such 
policies, commonly referred to as inside buildup. Each of the 
Administration's proposals would impose new taxes on 
policyholders based on the cash value of their life insurance 
policies.
    For example, the most pernicious of the Administration's 
proposals would deny a portion of a business's otherwise 
allowable interest expense deductions based on the cash value 
of insurance purchased by the business on the lives of its 
employees. Though thinly disguised as a limitation on interest 
expenses deductions, the proposal generally would have the same 
effect as a tax on inside buildup. Similar to a tax on inside 
buildup, the interest disallowance would be measured by 
reference to the cash values of the business's insurance 
policies--as the cash values increase, the disallowance would 
increase, resulting in additional tax.\1\ So while not a direct 
tax on inside buildup, the effect would be similar--accumulate 
cash value in a life insurance policy, pay an additional tax.
---------------------------------------------------------------------------
    \1\ As this Committee, to its credit, has recently brought to light 
in connection with its examination of individual tax rates, a deduction 
disallowance is a tax increase by another name.
---------------------------------------------------------------------------
    The Administration's other insurance proposals are more 
direct in their taxation of cash value. One would tax 
accumulated cash values in insurance company variable life and 
annuity contracts every time the contract is exchanged or 
policy investments reallocated. The other would increase the 
taxes due on accumulated cash values upon disposition.

     Historical Tax Treatment of Permanent Life Insurance is Sound

    The Administration's proposals would change the fundamental 
tax treatment of traditional life insurance that has been in 
place since the federal tax code was first enacted in 1913. 
Congress has on a number of occasions considered, and each time 
rejected, proposals to alter this treatment. Nothing has 
changed that would alter the considered judgment of prior 
Congresses that the historical tax treatment of traditional 
life insurance is grounded in sound policy and should not be 
modified.
    Among the reasons we believe that these latest attacks on 
life insurance are particularly unjustified, unnecessary and 
unwise are--

Cash Value is Incidental to Life Insurance Protection

    The cash value of life insurance is merely an incident of 
the basic plan called ``permanent life insurance'' whereby 
premiums to provide protection against the risk of premature 
death are paid on a level basis for the insured's lifetime or 
some other extended period of years. In the early years of the 
policy, premiums necessarily exceed the cost of comparable term 
insurance. These excess premiums are reflected in the ``cash 
value'' of the policy. As fairness would dictate, the insurance 
company credits interest to the accumulated cash value, which 
helps finance the cost of coverage in later years, reducing 
aggregate premium costs.
    Thus, while a permanent life insurance policy in a sense 
has an investment component, this feature is incidental to the 
underlying purpose of the policy. The essential nature of the 
arrangement is always protection against the risk of premature 
death.

The Tax Code Already Strictly Limits Cash Value Accumulations

    The Administration's proposals ignore the major overhauls 
of life insurance taxation made by Congress over the past 20 
years. These reforms have resulted in a set of stringent 
standards that ensure that life insurance policies cannot be 
used to cloak inappropriate investments.
    The most significant reforms occurred in the 1980's, when 
Congress and the Treasury undertook a thorough study of life 
insurance. It was recognized that while all life insurance 
policies provided protection in the event of death, some 
policies were so heavily investment oriented that their 
investment aspects outweighed the protection element. After 
much study, Congress established stringent statutory 
guidelines, approved by the Administration, that limit life 
insurance tax benefits at both the company and policyholder 
levels to those policies whose predominant purpose is the 
provision of life insurance protection.
     In 1982, Congress first applied temporary 
``guideline premium'' limitations to certain flexible premium 
insurance contracts;
     In 1984, Congress revised and tightened these 
limitations and extended them to all life insurance products;
     In 1986, the Congress again reviewed these 
definitional guidelines, making additional technical and 
clarifying changes;
     Finally, in 1988, the Congress again addressed 
these issues, developing still more restrictive rules for 
certain modified endowment contracts and modifying the rules 
applicable to life insurance contracts to require that premiums 
applicable to mortality charges be reasonable, as defined by 
Treasury regulation.
    As currently applied to life insurance policies, these 
guidelines (set forth in sections 7702 and 7702A of the 
Internal Revenue Code) significantly limit the investment 
element of any policy by requiring specific relationships 
between death benefits and policy accumulations under 
complicated technical rules (the so-called cash value test or 
the guideline premium/cash value corridor tests). Policies that 
cannot meet these limitations were deemed ``investment 
oriented'' in the judgment of Congress and are not eligible for 
tax treatment as life insurance.
    On the other hand, Congress and the Administration clearly 
intended that inside buildup within policies satisfying the new 
criteria would not be subject to taxation. In fact, 
policymakers concluded that with the tightening of the 
definition of life insurance and the placing of narrower limits 
on the investment orientation of policies, there was all the 
more reason for continuing an exemption for inside buildup. 
Buck Chapoton, then Assistant Secretary of the Treasury for Tax 
Policy testified on this point before a Ways & Means 
subcommittee in 1983, explaining that: the treatment of [inside 
buildup bears] an important relationship to the definition of 
life insurance; that is, to the extent the definition of life 
insurance is tightened, thereby placing narrower limits on the 
investment orientation of a life insurance policy, there is 
more reason for allowing favorable tax treatment to the [inside 
buildup] under policies that fall under a tighter definition. 
[Tax Treatment of Life Insurance; Hearings Before the 
Subcommittee on Select Revenue Measures of the House Committee 
on Ways and Means, May 10, 1983, 98th Cong., 1st Sess. 16 
(1983).]
    Congress proceeded on this basis and, as noted above, in 
1984 established a tighter and narrower definition of life 
insurance.
    In addition to blessing the continuation of tax benefits 
for inside buildup within life insurance contracts when it 
considered these issues in the 1982, 1984, 1986 and 1988 
legislation described above, Congress did so on numerous other 
occasions by failing to enact treasury proposals to tax inside 
buildup. For example, notwithstanding Treasury proposals to tax 
inside buildup contained in the 1978 Blueprints for Tax Reform, 
the November, 1984 Treasury Tax Reform proposals, the 1985 Tax 
Reform Proposals and various budget proposals in the 90's, 
Congress consistently refused to tax inside buildup within life 
insurance policies.
    Moreover, the Congress implicitly endorsed continuation of 
inside buildup in 1996 when it considered and addressed certain 
perceived problems with policy loans (repealing the deduction 
for interest on policy loans) and in 1997, when it became 
concerned that Fannie Mae intended to use its quasi-federal 
status and preferred borrowing position to purchase coverage 
for its customers (denying a portion of Fannie Mae's otherwise 
applicable interest deductions). On both occasions, 
conventional life insurance policies were unaffected; tax 
preferences for inside buildup were retained.
    The 1997 experience is of particular relevance. When 
drafting the interest disallowance for Fannie Mae, Congress 
distinguished its concerns regarding what was considered to be 
Fannie Mae's inappropriate efforts to exploit its preferred 
borrowing position from the typical situation involving 
employer-owned policies, providing a clear exemption for 
policies purchased by a business on employees, officers, 
directors and 20-percent owners. In late 1997, Congress further 
demonstrated its commitment to preserving tax-favored status 
for employer policies by proposing additional technical 
corrections to clarify the scope of this intended relief (e.g. 
to cover former employees, group contracts, etc.). Those 
technical corrections, adopted by the House and attached to the 
IRS restructuring bill last fall, are now awaiting Senate 
consideration.
    Given the detailed 1996-97 review of life insurance 
policies, which triggered narrow reforms rather than any 
cutback of the core tax benefits afforded with respect to 
inside buildup, individuals and employers reasonably relied on 
the continued availability of inside buildup with respect to 
the policies they previously held, as well as subsequent 
purchases. Similarly, carriers reasonably relied on the 
continued availability of inside buildup in developing and 
marketing insurance policies. Treasury's attempt to reverse 
that Congressional decision and undercut policyholder and 
carrier reliance through these thinly disguised attacks on 
inside buildup is unconscionable and should, consistent with 
every prior Congressional decision on this issue, AGAIN be 
summarily rejected.

             Appreciation in Cash Value Should Not Be Taxed

Long-Term Investment Should be Encouraged, Not Penalized

    Permanent life insurance provides significant amounts of long-term 
funds for investment in the U.S. economy. These funds are attributable 
to permitted levels of policy investment, a portion of which represents 
the ``prepayment'' element needed to permit level premium policies 
which remain affordable as covered individuals age. Without this 
prepayment/investment feature premium costs would increase rapidly with 
age, making insurance unaffordable when it is most needed.
    The incidental investment element inherent in permanent life 
insurance should, if anything, be encouraged, not penalized. Congress 
and the Administration have repeatedly emphasized the need to increase 
U.S. savings, especially long term and retirement savings. Recent 
efforts have used the tax code to encourage savings, not penalize them. 
Consider, for example, the recent expansion of IRAs, the introduction 
of Roth IRAs and education IRAs, as well as small employer savings 
vehicles like the SIMPLE. Given these savings goals, the Administration 
proposal to significantly reduce or eliminate savings through life 
insurance appears especially misguided.

Unrealized Appreciation Should Not be Taxed

    There is another, more fundamental, reason why the incidental 
investment inherent in permanent life insurance should not be taxed 
currently: accumulating cash values represent unrealized appreciation. 
Taxing a policyholder currently on the increase in the cash value of a 
life insurance policy would be like taxing a homeowner each year on the 
appreciation in value of the home even though the home has not been 
sold. This would be inconsistent with historical and fundamental 
concepts of the federal income tax and contrary to the traditional 
principle that the government should not tax unrealized amounts which 
taxpayers cannot receive without giving up important rights and 
benefits. Taxing life insurance policyholders on accumulating cash 
values would single out life insurance by withdrawing the protection 
generally provided against taxation of an amount the receipt of which 
is subject to substantial restrictions. Given that much of this 
``investment'' actually reflects a prepayment of premiums designed to 
spread costs levelly over the insured's life, this would be especially 
inappropriate.

     Ordinary and Necessary Interest Expenses Should be Deductible

    The Administration's proposal to disallow otherwise 
deductible interest expenses is inconsistent with fundamental 
income tax principles.

Interest Payments are an Ordinary and Necessary Business 
Expense

    It is difficult to comprehend how an otherwise ordinary and 
necessary business expense loses its status as such solely 
because a business purchases life insurance on its employees. 
For example, few would argue that if Acme Computer borrows 
funds to help finance the cost of a new supercomputer assembly 
plant, the interest Acme pays on the debt is a legitimate 
business expense that is properly deductible. How can it be 
that if Acme decides it is prudent to purchase life insurance 
on the leader of the team that developed the supercomputer--to 
help offset the inevitable transition costs that would follow 
the team leader's unexpected death--that a portion of the 
interest payments is suddenly no longer considered a legitimate 
business expense? This is precisely the effect of the 
Administration's proposal.
    To fully appreciate this provision, apply the underlying 
rationale to an individual taxpayer: Should any homeowner who 
purchases or holds life insurance be denied a portion of the 
otherwise applicable deduction for mortgage interest? Or, 
carrying the analogy a bit further, should any homebuyer who 
contributes to an IRA or a section 401(k) plan (thereby 
receiving the tax benefits of tax deferral or, in the case of a 
Roth IRA, tax exemption) be denied a portion of the otherwise 
applicable deduction for mortgage interest?
    The Treasury Department asserts that the deduction denial 
would prevent tax arbitrage in connection with cash value 
policies. However, the proposal does not apply to debt directly 
or even indirectly secured by cash values; interest on such 
amounts is nondeductible under current law. Section 264 of the 
Internal Revenue Code disallows a deduction for interest on 
policy loans from the insurer as well as on loans from third 
parties to the extent the debt is traceable to the decision to 
purchase or maintain a policy. Thus, the only interest 
deductions that would be affected by the proposal would be 
those attributable to unrelated business debt--loans secured 
byThe arbitrage concern is a red herring; the real target is 
inside buildup.
    If the Administration has concerns about the insurance 
policy purchased on the life of the team leader, then it should 
say so--and it should address the issue directly. It is 
inappropriate to deny instead a legitimate business expense 
deduction as an indirect means of taxing inside buildup. 
Congress, for sound policy reasons, has steadfastly refused to 
enact proposals that more directly attack inside buildup; it 
should similarly refuse to enact this proposal.

Disproportionate Impact on Similar Businesses

    The Administration's proposal to impose a tax penalty on 
businesses that purchase life insurance on their employees 
would have a disproportionate impact on highly-leveraged 
businesses. This is inconsistent with a fundamental tenet of 
the tax laws that, to the extent possible, taxation should be 
neutral with respect to core business decisions such as the 
appropriate degree of debt. It is also patently unfair and 
without policy justification.
    To illustrate the disproportionate burden on highly-
leveraged businesses, take the following example: Assume two 
competing companies, each with $50 million in assets. Company A 
has $2 million in outstanding debt, with an annual interest 
expense of $150,000. Company B has $20 million in outstanding 
debt, with an annual interest expense of $1.8 million.
     If Company A purchases an insurance policy on the 
life of its resident genius, Company A would be required to 
forego a portion of the interest expense on its outstanding 
debt. For example, if the cash value of the policy is $5 
million, one-tenth of the annual interest expense, or $15,000, 
would not be deductible.
     If Company B buys the same policy for its resident 
genius, it too would be required to forego one-tenth of its 
interest expense deduction. However, for Company B, this 
amounts to a foregone deduction of $180,000--12 times the 
amount foregone by Company A.
    The deduction disallowances illustrated above would occur 
each year, compounding the disproportionate impact on Company 
B. Over a span of 30 years, Company B could lose interest 
deductions in excess of $5.4 million--while Company A might 
lose closer to $450,000.
    Whatever one's beliefs about the proper tax treatment of 
life insurance policies, what possible justification exists for 
imposing a tax penalty associated with the purchase of such a 
policy that varies with the level of a company's outstanding 
debt?

                               Conclusion

    For the reasons explained above, we believe the Congress, 
consistent with its long-standing interest in preserving tax 
benefits for inside buildup within life insurance contracts, 
should reject the Administration's insurance proposals, which 
would effectively subject inside buildup to current taxation.

            Submitted by:
                                            Kenneth J. Kies
                                               Price Waterhouse LLP
      

                                

Statement of Kenneth C. Karas, Chairman and CEO, Enron Wind Corp.

    My name is Ken Karas, and I am the Chairman and Chief 
Executive Officer of Enron Wind Corp., a subsidiary of Enron 
Renewable Energy Corporation. Enron Wind Corp., one of the 
largest producers in the U.S. wind energy industry, offers a 
fully integrated range of services including wind assessment, 
project siting, engineering, project finance, turbine 
production, construction, and operation and maintenance of wind 
energy facilities. Among the projects currently under 
development by Enron Wind Corp. are a 112.5 megawatt project in 
Iowa and a 107 megawatt project in Minnesota. Upon completion, 
these projects will be operated by Enron Wind Corp. and the 
power produced will be sold to MidAmerican Energy Company and 
Northern States Power Company, respectively. As a committed 
member of the wind energy industry, Enron Wind Corp. strongly 
endorses the Administration's proposal to extend the Wind 
Energy Production Tax Credit (``PTC'') by five years.
    The current Wind Energy PTC, first enacted under the Energy 
Policy Act of 1992, provides a 1.5-cent-per-kilowatt-hour tax 
credit, adjusted for inflation after 1992, for electricity 
produced from wind or ``closed-loop'' biomass. The credit is 
available for wind energy production facilities placed in 
service prior to July 1, 1999, and applies to wind energy 
produced for the first ten years after the facilities are 
brought on line. The revenue impact of the Administration's 
proposal to extend the credit is projected by the Office of 
Management and Budget to be only $191 million between fiscal 
years 1999 and 2003. The Joint Committee on Taxation has 
projected an even lower cost of $144 million over the same 
period.
    The Administration's proposal is identical in substance to 
H.R. 1401 introduced by Representative Bill Thomas (R-CA) in 
this Committee in 1997. H.R. 1401 currently has eighteen 
cosponsors including Representatives Dunn, Nussle, Matsui, 
Ehlers, Fazio, McDermott, Minge, Lewis, Rivers, Schaefer, 
Bartlett, Thurman, Shaw, Tauscher, Klug, Skaggs, Woolsey and 
Pallone.
    Wind energy has made phenomenal advances in the last 
fifteen years achieving improvements in reliability, 
efficiency, and cost per kilowatt hour. The world market for 
wind power continues to grow rapidly having had a $1.3 billion 
year in 1996 and a $1.5 billion year in 1997 as new wind power 
capacity continued to be installed. However, the U.S. wind 
energy industry has seen very little growth in recent years due 
in part to uncertainty surrounding deregulation of the electric 
power industry. The failure to extend the Wind Energy PTC, 
which is now scheduled to expire in little more than a year, 
will only add to this uncertainty. As most wind energy projects 
require a minimum of two years to develop, extension of the 
Wind Energy PTC is critical now to ensure the availability of 
long-term, low-cost financing for wind energy projects. Despite 
these difficulties, close to 800 megawatts will be installed in 
1998 and the first half of 1999, prior to the June 30, 1999 
date for expiration of the credit.
    Extension of the Wind Energy PTC is a targeted investment 
in renewable energy that will provide significant returns to 
the country, including:
     Continuing to Reduce the Cost of Wind Power: 
Dramatic advances have been made in the cost of wind power with 
some current projects currently based upon a cost of below 5 
cents per kilowatt hour. Stimulating investment through the 
Wind Energy PTC will continue to bring these costs down as wind 
energy begins to achieve economies of scale;
     Achieving Reduced CO2 Emissions: The 
Department of Energy has cited wind power as one of the 
emerging electricity supply technologies needed to reduce the 
emissions of carbon dioxide (CO2) caused by burning 
fossil fuels; and
     Creating Jobs and Export Revenues: A healthy 
domestic wind energy industry creates the momentum to continue 
developing wind energy technologies for export abroad into the 
booming world market for renewable power, which in turn creates 
more jobs at home.
    We at Enron Wind Corp. are excited to be at the forefront 
of one of the most promising renewable energy technologies 
available, and believe that the Wind Energy PTC represents a 
sound investment in the American economy, renewable energy and 
our environment. I urge your support for this important and 
cost-effective initiative.
      

                                

Statement of Export Source Coalition

    The Export Source Coalition is a group of US companies and 
associations concerned about the ability of the United States 
to compete in world markets. The Coalition includes both large 
and small US exporters. A list of our members is attached 
hereto as Exhibit #1.
    The President has once again proposed changing the export 
source rule to an ``activities based rule'' as part of his FY 
1999 budget submission to the Congress. Such a change would 
effectively repeal this rule which has been in effective for 
more than 75 years, and we urge the Committee to reject this 
proposal as it did last year.
    In March of last year the Committee heard testimony from 
two members of the Export Source Coalition, Douglas Oberhelman, 
Chief Financial Officer and Vice President of Caterpillar Inc., 
and William C. Barrett, Director of Tax, Export and Customs for 
Applied Materials, Inc., who explained in detail how this rule 
helps reduce the double taxation companies face competing 
overseas, thereby increasing their ability to produce in the US 
for export markets. Two noted economists, Gary Hufbauer and 
Dean DeRosa, also presented testimony before the Committee 
supporting these conclusions and giving specific estimates on 
the costs and benefits of the export source rule over the next 
five years. A copy of that study is attached hereto as Exhibit 
#2.
    Increasing exports is vital to the health of the US economy 
and fundamental to our future standard of living. There is 
virtually no dispute among economists that jobs in export 
industries pay approximately 15% higher wages. The Hufbauer-
DeRosa study estimates that for the year 1999 alone, the export 
source rule will account for an additional $30.8 billion in 
exports, support 360,000 jobs, and add $1.7 billion to worker 
payrolls as a result of the export related wage premium cited 
above.
    The complex rules by which the US taxes its companies doing 
business in foreign jurisdictions put them at a disadvantage 
when competing abroad. The export source rule is one of the few 
favorable tax rules which mitigate the harm done by other 
distortive US tax rules that cause many US multinationals to 
suffer significant double taxation on income earned from their 
international operations.
    Increasing exports is a bipartisan goal. Given the dangers 
posed to our exports by the current crisis in Asia, repeal of a 
rule, such as the export source rule, which clearly helps 
increase exports would be even more unwise and 
counterproductive than it was last year.

                        Description of the Rule

    The export source rule is a technical tax rule which has 
been in operation for approximately 75 years. Since 1922, 
regulations under IRC section 863(b) and its predecessors have 
contained a rule which allows the income from goods that are 
manufactured in the U.S. and sold abroad (with title passing 
outside the U.S.) to be treated as 50% U.S. source income and 
50% foreign source income. This export source rule (sometimes 
referred to as the ``title passage'' rule) has been beneficial 
to companies who manufacture in the U.S. and export because it 
increases their foreign source income and thereby increases 
their ability to utilize foreign tax credits more effectively. 
Because the U.S. tax law restricts the ability of companies to 
get credit for the foreign taxes which they pay, many 
multinational companies face double taxation on their overseas 
operations, i.e. taxation by both the U.S. and the foreign 
jurisdiction. The export source rule helps alleviate this 
double taxation burden and thereby encourages U.S.-based 
manufacturing by multinational exporters.

                        Administration Proposal

    The President's FY1999 Budget proposal would eliminate the 
50/50 rule and replace it with an ``activities based'' test 
which would require exporters to allocate income from exports 
to foreign or domestic sources based upon how much of the 
activity producing the income takes place in the U.S. and how 
much takes place abroad. The justification given for 
eliminating the rule is essentially that it provides U.S. 
multinational exporters that also operate in high tax foreign 
countries a competitive advantage over U.S. exporters that 
conduct all their business activities in the U.S. The 
Administration also notes that the U.S. tax treaty network 
protects export sales from foreign taxation in countries with 
which we have treaties, thereby reducing the need for the 
export source rule. As discussed below, both these arguments 
are seriously flawed.

     The Export Source Rule Serves As An Effective Export Incentive

    The export source rule, by alleviating double taxation, 
encourages companies to produce goods in the U.S. and export, 
which is precisely the tax policy needed to support the goal of 
increasing exports. The effectiveness of the rule as an export 
incentive was examined by the Treasury Department in 1993, as a 
result of a directive in the 1986 Tax Reform Act. The Treasury 
study found that if the rule had been replaced by an activity-
based rule in 1992, goods manufactured in the U.S. for export 
would have declined by a substantial amount. The most recent 
study of the costs and benefits of the rule by Gary Hufbauer 
and Dean DeRosa estimates that for the year 1999 alone, the 
export source rule will account for an additional $30.8 billion 
in exports, support 360,000 jobs, and add $1.7 billion to 
worker payrolls in the form of export-related wage premiums. 
The Hufbauer-DeRosa study concludes that the export source rule 
furthers the goal of achieving an outward-oriented economy, 
with more exports and better paying jobs.

     Increasing Exports Is Vital To The Health Of The U.S. Economy

    Exports are fundamental to our economic growth and our 
future standard of living. Although the U.S. is still the 
largest economy in the world, it is a slow-growing and mature 
market. As such, U.S. employers must export in order to expand 
the U.S. economy by taking full advantage of the opportunities 
in overseas markets. The U.S. is continuing to run a trade 
deficit (i.e. our imports exceed our exports) of over $100 
billion per year. Increasing exports helps to reduce this 
deficit.
    In 1996, exports of manufactured goods reached a record 
level of $653 billion. In recent years, exports have accounted 
for about one-third of total U.S. economic growth. Today, 96% 
of U.S. firms' potential customers are outside the U.S. 
borders, and in the 1990's 86% of the gains in worldwide 
economic activity occurred outside the U.S.

                Exports Support Better Jobs In The U.S.

    According to the Commerce Department, exports are creating 
high paying, stable jobs in the U.S. In fact, jobs in export 
industries pay 13-18 percent more and provide 11 percent higher 
benefits than jobs in non-exporting industries. Exporting firms 
also have higher average labor productivity. In 1992, value-
added per employee, one measure of productivity, was almost 16% 
higher in exporting firms than in comparable non-exporting 
firms.
    Over the last several years more than one million new jobs 
were created as a direct result of increased exports. In 1995, 
11 million jobs were supported by exports. This is equivalent 
to one out of every twelve jobs in the U.S. Between 1986 and 
1994, U.S. jobs supported by exports rose 63%, four times 
faster than overall private job growth. Since the late 1980s, 
exporting firms have experienced almost 20% faster employment 
growth than those which never exported, and exporting firms 
were 9% less likely to go out of business in an average year.

             Export Source Rule Alleviates Double Taxation

    In theory, companies receive a credit for foreign taxes 
paid, but the credit is not simply a dollar for dollar 
calculation. Rather it is severely limited by numerous 
restrictions in the U.S. tax laws. As a result, multinational 
companies often find themselves with ``excess'' foreign tax 
credits and facing ``double'' taxation, i.e. taxation by both 
the U.S. and the foreign country. How much credit a company can 
receive for foreign taxes paid depends not only on the tax 
rates in the foreign country, but also on the amount of income 
designated as ``foreign source'' under U.S. tax law.
    For example, for purposes of U.S. foreign tax credit rules, 
a portion of U.S. interest expense, as well as research and 
development costs, must be deducted from foreign source income 
(even though no deduction is actually allowed for these amounts 
in the foreign country). On the other hand, if the company 
incurs a loss from its domestic operations in a year, it is 
restricted from ever using foreign source earnings in that year 
to claim foreign tax credits.
    These restrictions in the U.S. tax law, which reduce or 
eliminate a company's foreign source income, result in 
unutilized or ``excess'' foreign tax credits. The export source 
rule, by treating approximately half of the income from exports 
as ``foreign source,'' increases the amount of income 
designated ``foreign source'' thereby enabling companies to 
utilize more of these excess foreign tax credits, thus reducing 
double taxation.

        Export Source Rule Helps to ``Level the Playing Field''

    The export source rule does not provide a competitive 
advantage to multinational exporters vis-a-vis exporters with 
``domestic-only'' operations. Exporters with only domestic 
operations never incur foreign taxes and thus, are not even 
subjected to the onerous penalty of double taxation. Also, 
domestic-only exporters are able to claim the full benefit of 
deductions for U.S. tax purposes for all their U.S. expenses, 
e.g., interest on borrowings and R&D costs because they do not 
have to allocate any of those expenses against foreign source 
income. Thus, the export source rule does not create a 
competitive advantage, rather it helps to ``level the playing 
field'' for U.S.-based multinational exporters.

  Export Source Rule Affects Decision to Locate Production in the U.S.

    Just as labor, materials, and transportation are among the 
costs factored into a production location decision, so is the 
overall tax burden. The export source rule, by alleviating 
double taxation, helps reduce this tax cost, thereby making it 
more cost efficient to manufacture in the U.S. For example, for 
one coalition member, the export source rule was the 
determining factor in deciding to fill a German customer order 
from a U.S. rather than a European facility making the 
identical product. By allowing half the income from the sale to 
be considered ``foreign source,'' thereby helping the company 
utilize foreign tax credits, the export source rule outweighed 
other cost advantages such as transportation, and American 
workers filled the customer's order.

  FSC Regime and Treaty Network Not Substitutes for Export Source Rule

    If the export source rule is eliminated, the FSC regime 
will not be a sufficient remedy for companies facing double 
taxation because of excess foreign tax credits. Instead of 
using a FSC, many of these companies may decide to shift 
production to their foreign facilities in order to increase 
foreign source income. Since more and more U.S. companies are 
finding that they must have production facilities around the 
globe to compete effectively, this situation is likely to 
become more and more common. The risk that these companies 
(which by definition are facing double taxation because they 
already have facilities overseas) would shift production abroad 
if the rule is repealed is significant and not worth taking.
    Our tax treaty network is certainly no substitute for the 
export source rule since it is not income from export sales but 
rather US restrictions on their ability to credit foreign taxes 
paid on their overseas operations, which are the main cause of 
the double taxation described above. To the extent the treaty 
system lowers foreign taxation, it can help to alleviate the 
double tax problem, but only with countries with which we have 
treaties, which tend to be the most highly industrialized 
nations of the world.
    The US treaty network is limited to less than 60 countries, 
leaving many more countries (approximately 170) without 
treaties with the US. Moreover, many of the countries without 
treaties are developing countries, which are frequently high 
growth markets for American exports. For example, the US has no 
treaty with any Central or South American country.

                               Conclusion

    While this technical tax rule was not originally intended 
as an export incentive, it has evolved into one of the few WTO-
consistent export incentives remaining in our tax code. It is 
also justified on the basis of administrative convenience. This 
50/50 sourcing rule is working as originally intended to avoid 
endless disputes and problems which would inevitably arise in 
administering an activity-based rule.
    Given the acknowledged role of exports in sustaining growth 
in the U.S. economy and supporting higher paying U.S. jobs, and 
the effectiveness of this tax rule in encouraging exports, any 
attempt to reduce or eliminate the rule is counterproductive 
and unwise. We urge you to strenuously oppose the provision 
contained in the President's FY 1999 budget which would 
effectively repeal the export source rule.

                                Sources:

    Fourth Annual Report of the Trade Promotion Coordinating Committee 
(TPCC) on the National Export Strategy: ``Toward the Next Century: A 
U.S. Strategic Response to Foreign Competitive Practices,'' October 
1996, U.S. Department of Commerce, ISBN 0-16-048825-7;
    U.S. Department of Commerce, Economics and Statistics 
Administration, Office of the Chief Economist.
    Gary C. Hufbauer and Dean A. DeRosa, ``Costs and Benefits of the 
Export Source Rule, 1996-2000,'' February 1997.
    James R. Hines, Jr., ``Tax Policy and The Activities of 
Multinational Corporations,'' NBER Working Paper 5589, May 1996.
    John Mutti and Harry Grubert, ``The Significance of International 
Tax Rules for Sourcing Income: The Relationship Between Income Taxes 
and Trade Taxes,'' NBER Working Paper 5526, April 1996.
    J. David Richardson and Karin Rindal, ``Why Exports Matter: 
More!,'' Institute for International Economics and the Manufacturing 
Institute, Washington, DC, February 1996.
      

                                
[GRAPHIC] [TIFF OMITTED] T1685.004

      

                                

Exhibit 2

Costs and Benefits of the Export Source Rule, 1998-2002 \1\ by Gary C. 
Hufbauer and Dean A. DeRosa

    The Export Source Rule of the Internal Revenue Code of 1986 
provides U.S. companies, both large and small, with a mechanism 
for apportioning their net income from exports between domestic 
and foreign sources. Broadly, it permits them to attribute 
about 50 percent of their net export income to foreign sources. 
Firms that have excess foreign tax credits can utilize the 
Export Source Rule to ``absorb'' part of those excess credits, 
thereby alleviating the double taxation of foreign income.
---------------------------------------------------------------------------
    \1\ This report was prepared for the Export Source Coalition, a 
group of U.S. companies and associations concerned about the ability of 
the United States to compete in world markets.
---------------------------------------------------------------------------
    This report presents our assessment of the costs and 
benefits of the Export Source Rule for 1998, with projections 
over the 5-year period 1998-2002. As seen in the accompanying 
table, our projections indicate that the Export Source Rule 
supports significant additional U.S. exports and worker 
earnings--all at costs to the U.S. Treasury that are lower than 
usually estimated. For example, in 1999, for an adjusted net 
tax revenue cost of $1.1 billion, the United States will ship 
an additional $30.8 billion of exports and add $1.7 billion to 
worker payrolls in the form of the export earnings premium. The 
additional exports will support 360 thousand workers in export-
related jobs who in a full employment economy would otherwise 
be working in lower paid sectors of the U.S. economy.

 Projected Export and Revenue Impact of the Export Source Rule, 1998-2002 (Central projections based on Kemsley
                                              data and parameters)
----------------------------------------------------------------------------------------------------------------
                                                              1998       1999       2000       2001       2002
----------------------------------------------------------------------------------------------------------------
Benefits to U.S. Economy
    Additional U.S. exports ($ millions).................     28,223     30,763     33,532     36,550     39,839
    Jobs supported by additional exports.................    343,779    360,093    377,182    395,081    413,831
    Additional wages and salaries ($ millions)...........      1,572      1,708      1,857      2,018      2,194
Costs to U.S. Treasury ($ millions)
    Tax revenue forecasts................................        891      1,474      1,555      1,750      1,855
    Revenue offsets (arising from wage and salary               n.a.        367        399        434        472
     premiums)...........................................
    Adjusted tax revenue forecasts.......................       n.a.      1,107      1,156      1,316      1,383
----------------------------------------------------------------------------------------------------------------
Sources and Notes: See Tables 1 and 4 of the report.


    The revenue cost estimates are based on the current U.S. 
Treasury forecasts of the tax revenue gains associated with 
repeal of the Export Source Rule. The Treasury estimates 
reflect the likelihood that, if the Export Source Rule is 
repealed, erstwhile users of the Export Source Rule among U.S. 
firms would instead turn to a Foreign Sales Corporation. Under 
the Foreign Sales Corporation legislation, a U.S. exporter can 
exclude up to 15 percent of its net export income from U.S. 
taxation. Unlike the Treasury estimates, our adjusted revenue 
cost estimates also reflect additional tax receipts derived 
from individual workers who enjoy premium earnings in export-
related jobs supported by the Export Source Rule.
    The benefits of the Export Source Rule are measured in 
terms of additional exports, the jobs supported by additional 
exports, and the premium on worker earnings in export-related 
jobs. These benefits are assessed using three different 
analytical approaches from two recent econometric studies, and 
one older, more traditional, quantitative study. In all cases, 
we assume that, in the absence of the Export Source Rule and 
its 50-50 division of export profits between foreign and 
domestic source income, U.S. firms would instead sell their 
exports through a Foreign Sales Corporation and exclude up to 
15 percent of their export profits from U.S. taxation.
    Our findings demonstrate that the Export Source Rule 
furthers the goal of achieving an outward-oriented economy, 
with more exports and better-paying jobs. One key to these 
broad conclusions is the fact that export-oriented industries 
and jobs are highly productive, partly because U.S. producers 
and workers engaged in export production face the considerable 
discipline of highly competitive international markets for 
traded goods and services. A second key is the sensitivity of 
plant location to the tax environment. Not right away perhaps, 
but over a period of years a country that penalizes export 
production with high taxes will forfeit first investment and 
then export sales.
    This second point deserves amplification. Recent empirical 
research by several scholars--Grubert and Mutti, Hines, 
Kemsley, and Wei--indicates far higher response rates of 
investment decisions to tax rates than previously believed. The 
new evidence is summarized in our report. A one percentage 
point increase in the corporate tax rate (e.g., from 18 percent 
to 19 percent) apparently induces a decline of 1.5 percent (and 
perhaps as much as 3 or 5 percent) in investment committed to 
export and import-competing production. The consequent impact, 
in terms of lost exports (or higher imports), is much larger 
than previously believed. The policy implications of the new 
scholarship extend well beyond the Export Source Rule. 
Countries that impose high corporate tax rates will 
significantly erode their competitive position in the world 
economy.

              1. U. S. Exports and the Export Source Rule

    Continued robust exports by U.S. firms in a wide variety of 
manufactures and especially advanced technological products--
such as sophisticated computing and electronic products and 
cutting-edge pharmaceuticals--are critical for maintaining 
satisfactory rates of GDP growth and the international 
competitiveness of the U.S. economy. Indeed, it is widely 
acknowledged that strong export performance ranks among the 
primary forces behind the economic well-being that U.S. workers 
and their families enjoy today, and expect to continue to enjoy 
in the years ahead.
    The Export Source Rule (Section 863(b) of the Internal 
Revenue Code of 1986) plays an important role in supporting 
U.S. exports of manufactures and other merchandise, above 
levels that would otherwise occur. The rule provides U.S. 
companies, both large and small, with a mechanism for 
apportioning their net income from exports between domestic and 
foreign sources. Under the Export Source Rule, U.S. companies 
attribute about 50 percent of their net export income to 
foreign sources. Firms that have excess foreign tax credits 
utilize the Export Source Rule to enlarge their foreign source 
income and ``absorb'' part of those excess foreign tax credits, 
thereby alleviating the double taxation of foreign income.\2\ 
Under such circumstances, the U.S. exporter will pay no 
additional U.S. tax on the foreign source portion of its export 
earnings. Moreover, as a general rule, foreign countries do not 
tax the export earnings of U.S. firms, so long as the 
production and distribution activity does not take place within 
the foreign territory. Of course, the U.S. firm will pay U.S. 
tax at the normal 35 percent rate on the domestic source 
portion of its export earnings. The net result, for U.S. firms 
with excess foreign tax credits that use the Export Source 
Rule, is to pay a ``blended'' tax rate of 17.5 percent on their 
export earnings--zero percent on half and 35 percent on half.
---------------------------------------------------------------------------
    \2\ Excess foreign tax credits can arise from various 
circumstances: higher rates of corporate taxation abroad than in the 
United States; U.S. interest, and research and experimentation 
allocation rules that attribute a share of these expenses to foreign 
source income; U.S. rules that effectively recharacterize domestic 
losses as foreign source losses in some circumstances; U.S. rules that 
create hermetic ``baskets of income'' so that foreign taxes on one type 
of foreign income cannot be attributed to another type of foreign 
income; etc.
---------------------------------------------------------------------------
    Those U.S. firms that export can also utilize another 
provision of the Internal Revenue Code, Section 862(a)(6) 
enacted under the Deficit Reduction Act of 1984, which allows 
companies to establish a Foreign Sales Corporation (FSC). The 
FSC is a successor to the former Domestic International Sales 
Corporation (DISC). Under the FSC provisions, U.S. firms can 
conduct their export sales through a Foreign Sales Corporation 
and exclude a maximum of 15 percent of their net export 
earnings from U.S. taxation. In this case, the ``blended'' rate 
is 29.75 percent--zero percent on 15 percent of export earnings 
and 35 percent on 85 percent of export earnings.
    This report assesses the costs and benefits of the Export 
Source Rule for 1998, with projections over the 5-year period 
1998-2002.\3\ The revenue cost estimates are based on the 
current U.S. Treasury forecasts of the tax revenues associated 
with the Export Source Rule. (The Joint Committee on Taxation 
(JCT) has published very similar revenue forecasts.) These 
revenue cost estimates reflect likely changes in corporate 
operations in response to a change in the tax laws. Hence, they 
assume that, if the Export Source Rule is repealed, erstwhile 
users among U.S. exporters would instead turn to the Foreign 
Sales Corporation. Our ``adjusted'' revenue cost estimates go 
one important step further. Namely, they take into account the 
revenues that would be lost to the U.S. Treasury owing to the 
loss of premium earnings by manufacturing workers in export-
related jobs supported by the Export Source Rule.
---------------------------------------------------------------------------
    \3\ Our projections of costs and benefits are made on a calendar 
year basis, even though, strictly speaking, our projections of tax 
revenue costs refer to U.S. fiscal years.
---------------------------------------------------------------------------
    We measure the benefits of the Export Source Rule in terms 
of additional exports, the jobs supported by additional 
exports, and the premium on worker earnings. We assess these 
benefits using three very different analytical approaches. In 
all cases, we assume that, in the absence of the Export Source 
Rule and its 50-50 division of export profits between foreign 
and domestic source income, U.S. firms would instead sell their 
exports through a Foreign Sales Corporation, and that, to an 
important extent, they would export less and produce more 
abroad.

               2. Three Approaches to Estimating Benefits

    U.S. exports and jobs supported by the Export Source Rule 
are estimated using three different analytical approaches, 
first for a base year (1992) and, subsequently, for the 5-year 
period 1998-2002. The three approaches to estimating benefits 
of the Export Source Rule are based on the findings of two 
recent econometric studies of U.S. export levels and investment 
location behavior in response to tax rates (Kemsley 1997; 
Grubert and Mutti 1996), and a much older study of the former 
Domestic International Sales Corporation (DISC) provisions of 
the U.S. tax law, carried out by the U.S. Department of the 
Treasury (1983).

Direct Estimates Based on Kemsley Parameters

    The first approach to estimating the benefits of the Export 
Source Rule is based on the findings of Kemsley (1997). The 
Kemsley sample data, which are compiled from the financial 
statements of U.S. multinational firms, consist of information 
on the worldwide assets, U.S. exports, foreign sales, and U.S. 
and foreign tax rates of 276 U.S. firms during the 9-year 
period 1984-92. As seen in the upper panel of Table 1, these 
data may be divided into two sub-samples: data for the 
companies with ``binding FTC positions'' and data for the 
companies with ``nonbinding FTC positions.'' The companies with 
binding foreign tax credit (FTC) positions are companies with 
excess foreign tax credits. These corporations are assumed to 
use the Export Source Rule. Under the Export Source Rule, half 
the profits are characterized as foreign source income, and can 
be used to absorb excess foreign tax credits, thereby reducing 
the ``blended'' U.S. tax rate on their export profits to 17.5 
percent.\4\ The companies in nonbinding FTC positions (i.e., 
without excess foreign tax credits) are assumed to exclude 15 
percent of their export profits from U.S. taxation by using a 
Foreign Sales Corporation (FSC), thereby reducing the 
``blended'' U.S. tax rate on their export profits to 29.75 
percent.\5\
---------------------------------------------------------------------------
    \4\ A company could be in a ``partially binding FTC position''--
i.e., the company could have excess FTCs, but in an amount less than 
the additional FTC ``capacity'' generated by the Export Source Rule. In 
those cases, the blended effective tax rate would be higher than 17.5 
percent. Our study does not take such intermediate case into account.
    \5\ This assumption probably overstates the tax benefits of the 
FSC, since many companies are not able to exclude the full 15 percent 
of export profits.
---------------------------------------------------------------------------
    Kemsley investigated the amount of export sales per company 
associated with U.S. export tax rules using an econometric 
equation that includes the ``marginal export tax incentive'' 
facing companies with binding FTC positions and companies with 
nonbinding FTC positions as separate explanatory variables. By 
the design of his econometric analysis, coupled with his 
assignment of companies predominantly utilizing a Foreign Sales 
Corporation to the sub-sample of companies with nonbinding FTC 
positions, Kemsley associated the estimated coefficient on the 
marginal export tax incentive variable for firms with binding 
FTC positions with the impact of the Export Source Rule. Based 
on Kemsley's coefficients, it can be calculated that the Export 
Source Rule supports $42 million additional exports per company 
for 140 companies in a binding FTC position.\6\
---------------------------------------------------------------------------
    \6\ To make this calculation, we assume that the ``blended'' U.S. 
tax rate component of the marginal export tax incentive (METI) variable 
for firms with binding FTC positions rises from an average value of 
17.5 percent with the Export Source Rule to an average value of 29.75 
percent without the Export Source Rule. The hypothetical increase in 
U.S. taxation of export earnings, 12.25 percentage points, or 0.1225, 
is multiplied by the average ratio of foreign pre-tax income to foreign 
sales (ES in Kemsley's notation), or 0.106 for firms with binding FTC 
positions, to obtain the relevant value for Kemsley's METI variable, 
namely 0.013. This value of METI is multiplied by the estimated 
coefficient for the regression variable FTCBIND*METI, 2.437, and also 
multiplied by mean foreign sales for firms in a binding FTC position, 
$1,332 million, to obtain an estimate of additional exports resulting 
from the Export Source Rule, namely $42 million (0.0130  2.437 
 $1,332 = $42). The methodology is spelled out in footnote 23 
of Kemsley's paper.
---------------------------------------------------------------------------
    However, this figure is an understatement for an important 
reason recognized by Kemsley. His data on exports only count 
exports to unaffiliated foreign buyers. According to a survey 
by the U.S. Department of Commerce (1996c), exports by U.S. 
multinational firms to their foreign affiliates accounted for 
38 percent of the total exports of these firms in the year 1994 
(this proportion has remained practically constant since 1989). 
Assuming that exports to affiliated foreign firms are impacted 
to the same extent as exports to unaffiliated firms, the impact 
per U.S. parent firm can be calculated at $68 million ($42 
million divided by 0.62).
    Kemsley's figure of 140 companies in a binding FTC position 
represents an average for the entire period 1984-92. However, 
for the period after the Tax Reform Act of 1986, Kemsley found 
that the Export Source Rule had a stronger positive impact on 
exports. The reason is that, with a lower U.S. corporate tax 
rate, and with the adoption of various rules that block U.S. 
firms from crediting foreign taxes, more companies found 
themselves in an excess foreign tax credit position, and thus 
more firms made use of the Export Source Rule. Kemsley's data 
indicate that 74 of his sample firms had a binding FTC position 
before the Tax Reform Act of 1986, and 173 firms had a binding 
FTC position after the Act. Even this figure understates the 
number of firms that rely on the Export Source Rule. Kemsley 
estimates that his sample firms may account for only 70 percent 
of all firms that utilize the Export Source Rule. In other 
words, the ``true'' average number of impacted firms, during 
the period 1987-92, could be about 247 companies (173 divided 
by 0.70). Thus, as reported in Table 1, for 1992, the total 
value of U.S. exports supported by the Export Source Rule can 
be estimated, based on Kemsley's econometric findings, at $16.8 
billion ($68 million per company for 247 U.S. firms).
    Using a rate of 15.5 thousand jobs supported in the U.S. 
economy per $1 billion of goods exported in 1992, as estimated 
by the U.S. Department of Commerce (1996b), the number of U.S. 
jobs supported by the Export Source Rule can be calculated at 
260 thousand jobs for 1992. These jobs might not represent 
additional employment in the current circumstances of the U.S. 
economy, where the unemployment rate is relatively low. 
Instead, additional exports may draw already employed workers 
from other jobs, rather than from the ranks of unemployed 
workers. Under this assumption--which is usually made by JCT 
and Treasury analysts when evaluating tax changes--the Export 
Source Rule may not be attributed with creating new jobs.
    However, the Export Source Rule does shift the composition 
of output--towards more output for export markets and less 
output for domestic use. The shift of output towards exports 
can be expected to benefit U.S. workers. There is significant 
evidence, such as that reported recently by Richardson and 
Rindall (1996), that both blue collar and white collar workers 
in exporting firms enjoyed earnings that were about 15 percent 
higher on average in 1992 than similar workers in non-exporting 
firms. The U.S. Department of Commerce (1996b) reports an 
earnings advantage of 12 percent for manufacturing workers 
supported directly and indirectly by exports in 1994. Hence, a 
change in the composition of output can be expected to improve 
the earnings of workers, even if they are drawn from other 
sectors and not from the ranks of the unemployed. Based on the 
Department of Commerce earnings premium of 12 percent, and 
average annual earnings of manufactures workers of just over 
$30,500 in 1992, the wage and salary premium is $3,660 per 
worker in that year. For all workers drawn to export-related 
employment by the Export Source Rule, the aggregate wage and 
salary premium is estimated at $1.0 billion in 1992. For 1999, 
the figure rises to $1.7 billion (see Table 4).

Production Response Approach Based on Grubert-Mutti Parameters

    The second approach to estimating the benefits of the 
Export Source Rule is based on estimates of the location of 
production facilities in response to different tax rates. Our 
calculations for this approach rely on the recent econometric 
findings of Grubert and Mutti (1996). Grubert and Mutti 
investigate the location of investment abroad by U.S. 
controlled foreign corporations, typically in manufacturing 
facilities to support foreign exports to third-country 
destinations. They are interested in changes in investment 
location induced by differences in corporate tax rates between 
foreign countries. Among other findings, the two authors report 
a statistically significant estimate of 3.0 for the elasticity 
of total capital invested in individual foreign countries with 
respect to the foreign tax rate.\7\ For the purposes of this 
report, the Grubert-Mutti elasticity estimate of 3.0 is 
multiplied by the incremental inducement provided by the Export 
Source Rule, and then applied to total exports per company by 
the Fortune 50 Top U.S. Exporters (Fortune 1995). The key 
assumption underlying this calculation is that U.S. export 
production facilities can be regarded as if they were an 
additional overseas location for production of tradable goods 
by U.S. multinational firms. Without the Export Source Rule, 
firms would shift production abroad: in fact, they would 
relocate 3 percent of their production facilities abroad for 
each 1 percent increase in the effective U.S. tax rate.\8\ 
Further, it is assumed that a 10 percentage point decrease in 
U.S. production facilities translates into a 10 percentage 
point decrease in U.S. exports. Other assumptions should also 
be noted. We assume that, without the Export Source Rule, 
companies would ship their exports through a Foreign Sales 
Corporation. Hence, the calculation of additional exports only 
reflects the incremental inducement provided by the Export 
Source Rule, beyond the inducement provided by the Foreign 
Sales Corporation (12.25 percentage points in the ``blended'' 
U.S. tax rate). We also assume that only half of the Fortune 
Top 50 U.S. Exporters are in a binding FTC position. This is 
based on Kemsley's full sample of company years, which reports 
half the company-years in a binding position and half in a 
nonbinding position. Finally, for this calculation, we assume 
that only these 25 large exporters use the Export Source Rule.
---------------------------------------------------------------------------
    \7\ An elasticity coefficient indicates the percentage change for 
variable x in response to a 1.0 percent change in variable y. In this 
case, an elasticity of 3.0 means that total capital invested in a 
foreign country is increased three percent for every one percentage 
point increase in the profitability (per unit of output) of production 
in the country attributable to lower corporate taxation in the country.
    \8\ The 3-for-1 response rate reflects an average across a large 
number of firms. Some companies will not shift any production in 
response to a tax change, other companies will shift big segments of 
production.
---------------------------------------------------------------------------
    Applying the Grubert-Mutti parameter estimate, with these 
supplementary assumptions, leads to the finding that the Export 
Source Rule supported $1.2 billion additional exports per 
company, or $31.2 billion additional exports for the 25 large 
exporters in 1992 (Table 2). With regard to U.S. jobs, the 
earnings estimates based on the Grubert-Mutti parameters 
indicate that 482 thousand U.S. jobs are supported by the 
Export Source Rule. The aggregate earnings premium for U.S. 
workers attributable to the Export Source Rule is $1.8 billion 
in 1992. The figure for 1999 is $3.2 billion (see Table 4).

Other Estimates of Production Location

    The proposition that higher business taxes can prompt the 
relocation of production is not new to economics. Ohlin (1933) 
and Haberler (1936), among other pioneers in the modern theory 
of international trade and investment, were keenly aware of the 
impact of taxes. What is new is empirical calculation of the 
size of the response.
    In a recent paper, Hines (1996a) surveyed the empirical 
literature on the response of U.S. direct investment abroad and 
foreign direct investment in the United States to different tax 
rates. While the 20-odd studies (dating from 1981) surveyed by 
Hines cannot be summarized by a single number, a rough 
characterization is that a 1 percentage point increase in the 
effective business tax rate induces a 1 percent decrease in the 
stock of plant and equipment. In other words, the ``modal 
study,'' to use an unscientific concept, finds an elasticity 
coefficient of 1.0.
    However, some scholars detect significantly larger effects. 
Grubert and Mutti estimated an elasticity coefficient of 3.0. 
In another paper, Hines (1996b) estimates an elasticity 
coefficient of 10 for the impact of different state tax rates 
on the state-by-state location of foreign direct investment 
entering the United States. Finally, in a paper studying the 
effect of taxation and corruption on direct investment flows 
from 14 countries to 34 ``host'' countries, Wei (1997) 
estimates an elasticity of 5 for the impact of the host 
country's tax rate on inward foreign direct investment by 
multinational firms.
    To summarize: production location decisions are highly 
sensitive to effective tax rates. We cannot definitely say that 
the response rate is 1-for-1, 3-for-1, or higher. In our 
judgment, a response rate of 3-for-1 (the Grubert-Mutti 
parameter) may be high, but it is not out of the ballpark.

Textbook Approach Based on Export Elasticity Parameters

    The last approach is the familiar textbook approach based 
on export demand and supply elasticities for estimating the 
impact of an exchange rate, price, or tax change on exports. 
Our use of this approach to calculate the benefits of the 
Export Source Rule is based on the quantitative analysis of the 
former Domestic International Sales Corporation (DISC) 
undertaken by the U.S. Department of the Treasury (1983). The 
DISC was replaced in 1984 by the present-day Foreign Sales 
Corporation (FSC). The U.S. Treasury (1993) adopted a similar 
approach to evaluate the FSC in the period 1985 to 1988.
    The Treasury studies use simple demand-supply balance 
models to calculate the impact of tax provisions on U.S. 
exports. In this approach, familiar price elasticities of 
demand and supply for exports determine the responsiveness of 
export sales to changes in after-tax profits. In Table 3, we 
assume a profit-to-export-sales ratio of 0.12 for exports.\9\ 
Also, we assume ``high'' values of the price elasticities of 
demand and supply for U.S. exports of manufactures, -10 and 20 
respectively, in order to calculate the largest possible 
impacts consistent with the export elasticities approach.\10\ 
Finally, we assume that the Export Source Rule is used by only 
25 of the Fortune Top 50 U.S. Exporters (the same assumption 
made for the Grubert-Mutti approach).
---------------------------------------------------------------------------
    \9\ This figure is based on the following considerations. According 
to FSC data for 1985, 1986 and 1987, the ``combined taxable income'' of 
parent U.S. corporations and their FSCs averaged about 0.08 of export 
sales (U.S. Treasury, 1993). We think export profits in those years 
were depressed by the very strong dollar. According to data collected 
by Kemsley (1997) over the 9-year period 1984-92, foreign pre-tax 
income averaged about 0.12 of foreign sales for his full sample of 
firms. In our judgment, this figure better reflects the profit-to-
export sales ratio now prevailing for U.S. firms.
    \10\ The reason we calculated ``upper bound'' estimates for the 
export elasticity approach was to discover whether there was an overlap 
with the production response approach. There was not. Estimates of 
long-run price elasticities of demand and supply for U.S. exports, 
compiled from the econometric findings of a number of investigators, 
are presented in Table 5. It will be seen that the figures we use are 
at the upper end of econometric findings. High values for price 
elasticities (-10 for demand and 20 for supply) imply a ``multiplier'' 
of 6.0. This multiplier relates the proportional change in export sales 
to the tax-induced change in export income (expressed as a percentage 
of export sales) attributable to the Export Source Rule. Even a 
multiplier as large as 6.0 does not yield trade effects that are as big 
as those suggested by the production response approach.
---------------------------------------------------------------------------
    Applying the export elasticities approach to the 25 U.S. 
exporters indicates that the Export Source Rule supported $228 
million additional exports per company in 1992, or $5.7 billion 
additional exports for the 25 firms (Table 3). With regard to 
U.S. jobs, the estimates based on the export elasticities 
approach indicate that about 88 thousand U.S. jobs were 
supported by the Export Source Rule in 1992. The aggregate 
earnings premium for U.S. workers attributable to the Export 
Source Rule was $0.3 billion in 1992. The figure for 1999 is 
$0.6 billion (see Table 4).

                      3. Comparison of Approaches

    In our judgment, the export response suggested by the 
Kemsley findings, about $30 billion in 1999 (see Table 4), best 
captures the likely long-run contribution of the Export Source 
Rule to U.S. export performance. The calculations grounded on 
Kemsley's analysis reflect direct empirical observation. Also, 
Kemsley explores the impact of the Export Source Rule without 
imposing a theoretical framework on his econometric equations, 
and he examines a very large number of companies, pooled across 
nearly 10 years. Finally, Kemsley also takes into account 
factors other than tax rules that affect the export performance 
of different companies.
    That said, the calculations grounded on Kemsley's analysis 
will strike many experts as ``too high.'' The reason for this 
impression is that the estimated export effects are much 
larger, relative to the loss of tax revenue, than can be 
derived by application of the familiar textbook model which 
relies on export demand and supply elasticities. In our view, 
the fact that Kemsley's findings cannot be squared with 
textbook models is a reason for questioning the textbooks, not 
an argument for discarding Kemsley's results.
    Our view is based on two considerations. In the first 
place, the calculations of additional exports that are grounded 
on the Grubert-Mutti production response coefficients are even 
larger than the Kemsley estimates. The Grubert-Mutti production 
response coefficient of 3.0 is somewhat larger, but in the same 
range, as production response coefficients estimated by other 
scholars. The ``modal'' production response coefficient of 1.0 
would indicate export effects one-third the size of the figures 
presented for Grubert-Mutti in Table 4, but still about twice 
the size of the textbook export elasticities approach.
    The second consideration in favor of Kemsley's results is 
that the textbook demand and supply elasticity model may be 
better suited to the measurement of responses to ``transitory'' 
fluctuations in exchange rates and inflation rates, than to 
``permanent'' (or at least semi-permanent) changes in tax 
variables.

                4. Cost and Benefit Forecasts, 1998-2002

    Forecasts of the U.S. export and employment-related 
benefits of the Export Source Rule derived from the three 
different approaches to estimating the benefits are presented 
for the 5-year period 1998 to 2002 in Table 4. These forecasts 
of benefits are based on the estimates for 1992 presented in 
Tables 1, 2, and 3. Specifically, the export benefit estimates 
for 1992 are projected forward to the years 1998-2002 using the 
observed average annual rate of growth of U.S. manufactures 
exports during 1992-96 (about 9 percent).\11\ The employment 
and earnings benefit estimates for 1992 are projected forward 
using observed average annual rates of growth of both U.S. 
manufactures exports and U.S. labor productivity during 1992-
1996 (about 4 percent for labor productivity).
---------------------------------------------------------------------------
    \11\ The historical and projected values of U.S. total and 
manufacturing exports are presented in Table 6.
---------------------------------------------------------------------------
    For 1999, the calculated additional exports attributable to 
the Export Source Rule range between a high value of $57.1 
billion based on the production response approach (Grubert-
Mutti parameters) to a low value of $10.4 billion based on the 
textbook approach (export elasticity parameters). Throughout 
the 5-year forecast period, the additional exports calculated 
using the Kemsley parameters fall about equidistant between the 
estimates found using the other two approaches.
    The 5-year forecasts of employment and earnings also reveal 
the centrality of the jobs and worker earnings calculated using 
the Kemsley estimates. Thus, in the year 1999, the Export 
Source Rule is forecast to support central figures of nearly 
360 thousand manufacturing jobs and about $1.7 billion in 
premium wages and salaries for manufacturing workers employed 
in export-oriented industries.
    Forecasts of the U.S. tax revenue costs attributable to the 
Export Source Rule for the 5-year period 1998-2002 are also 
presented in Table 4. These tax revenue forecasts, which are 
projections by the Treasury (OMB 1997), are supposed to reflect 
obvious changes in business behavior.\12\ If the Export Source 
Rule is repealed, U.S. companies would exclude up to 15 percent 
of their export profits from U.S. taxation by selling exports 
through a Foreign Sales Corporation. Accordingly, both Treasury 
and JCT revenue forecasts reflect an adjustment for greater use 
of Foreign Sales Corporations.
---------------------------------------------------------------------------
    \112\ Projections of ``tax expenditures,'' which are regularly 
reported by the Administration and Congress (e.g., OMB (1996) and JCT 
(1996)), are typically greater in magnitude than tax revenue forecasts 
and provide the basis for projecting tax revenues. However, tax 
expenditure forecasts assume that business firms do not change their 
behavior in response to a change in tax law. Hence, they do not take 
into account the recourse that U.S. firms utilizing the 50-50 division 
of export profits between domestic and foreign source income under the 
Export Source Rule have to excluding up to 15 percent of their export 
profits from U.S. taxation by selling exports through a Foreign Sales 
Corporation. For discussion on how tax expenditures are estimated by 
the U.S. Department of the Treasury and further discussion of the 
difference between tax expenditure and tax revenue estimates, see 
Rousslang (1994) and JCT (1996) respectively.
---------------------------------------------------------------------------
    In our view, the tax revenue forecasts should be further 
reduced to reflect the additional revenues the Treasury 
collects from individual workers who enjoy premium earnings 
attributable to the Export Source Rule. While this is not a 
``standard'' adjustment, it is justified by the fact that 
export jobs pay higher wages and salaries on average than other 
jobs. Therefore, Table 4 presents forecasts of the appropriate 
tax revenue offsets and adjusted net U.S. tax revenue for the 
4-year period 1999-2002. We start with 1999 because that is the 
first year when repeal of the Export Source Rule would have its 
full impact. The revenue offsets are estimated by applying the 
relevant marginal U.S. income tax rate for individuals (21.5 
percent) to the estimates in the table of additional U.S. 
earnings supported by the shift in output towards export 
industries as a consequence of the Export Source Rule.\13\ The 
adjusted revenue forecasts are calculated to be the standard 
revenue forecasts minus the revenue offsets.
---------------------------------------------------------------------------
    \13\ We estimate the relevant marginal tax rate in the following 
manner. In 1998, average manufacturing earnings will be about $38,100 
per worker (Table 4). The average premium of 12 percent for workers 
directly and indirectly supported by exports would put their average 
earnings at $42,700. Currently, a marginal Federal tax rate of 28 
percent applies to married couples with taxable income above $36,000 
and to single persons with taxable income above $22,000. Below those 
cut-off amounts, the marginal tax rate is 15 percent. Taking into 
account deductions and exemptions, we assume that half of workers 
supported by exports pay marginal tax rates of 28 percent and half pay 
15 percent. The relevant ``average marginal tax rate'' is thus 21.5 
percent (28 + 15 divided by 2).
---------------------------------------------------------------------------
    It is apparent from the estimates presented in Table 4 that 
the magnitude of the revenue offsets associated with the Export 
Source Rule depends importantly on which method of estimating 
U.S. export and employment-related benefits is assumed. Based 
on the Kemsley estimates of Export Source Rule benefits, the 
tax revenue offsets are estimated at $0.4 billion in 1999, 
increasing to $0.5 billion by the year 2002. Based on the 
Grubert-Mutti estimates of Export Source Rule benefits, the tax 
revenue offsets are estimated at $0.7 billion in 1999, 
increasing to $0.9 billion by the year 2002. And finally, based 
on the textbook elasticities approach, the tax revenue offsets 
are estimated at $0.1 billion in 1999, increasing to $0.2 
billion in 2002.
    The adjusted revenue forecasts provide the most appropriate 
basis for judging the final budgetary costs of the Export 
Source Rule to the U.S. Treasury, because the adjusted figures 
take into account the substantial tax revenues that will be 
collected from individuals who enjoy premium wages and 
salaries, so long as the Export Source Rule remains in place. 
The adjusted revenue forecasts based on the textbook 
elasticities approach are not much different from the standard 
Treasury and JCT revenue forecasts. However, the adjusted 
revenue forecasts based on the Kemsley estimates and the 
Grubert-Mutti estimates are significantly lower than the 
standard revenue forecasts--about 25 percent lower in the case 
of the forecasts based on the Kemsley estimates and about 50 
percent lower in the case of the forecasts based on the 
Grubert-Mutti estimates.

                             5. Conclusions

    This report has assessed the medium-term cost and benefits 
of the Export Source Rule, based on the findings of two recent 
econometric studies, and the older more traditional textbook 
approach. Our calculations indicate that, for a plausible range 
of estimates, the Export Source Rule supports significant U.S. 
exports, jobs, and worker earnings--all at costs to the U.S. 
Treasury that are lower than usually estimated. For example, in 
the year 1999, for an adjusted net revenue cost of $1.1 billion 
(based on Kemsley's estimates), the United States will ship an 
additional $30.8 billion of exports, support 360 thousand jobs, 
and add $1.7 billion to worker payrolls in the form of the 
export earnings premium.
    One key to these broad conclusions is the fact that export-
oriented industries and jobs are highly productive, partly 
because U.S. producers and workers engaged in export production 
face the considerable discipline of highly competitive 
international markets for traded goods and services. A second 
key is the sensitivity of plant location to the tax 
environment. Not right away perhaps, but over a period of years 
a country that penalizes export production with high taxes will 
forfeit first investment and then export sales.

                               References

    Fortune. 1995. ``The Top 50 U.S. Exporters,'' Fortune, November 13, 
1995, pp.74-75.
    Goldstein, M., and M. Khan. 1985. ``Income and Price Effects in 
Foreign Trade,'' in Handbook of International Economics, Vol. II, eds., 
R.W. Jones and P.B. Kenen (Amsterdam: North-Holland).
    H. Grubert, and J. Mutti. 1996. ``Do Taxes Influence Where U.S. 
Corporations Invest?,'' Paper prepared for the Conference on Trans-
Atlantic Public Economics Seminar, Amsterdam, Netherlands, May 29-31, 
1996 (revised August 1996), mimeo.
    Haberler, G. 1936 (Originally published in German, 1933). The 
Theory of International Trade with its Applications to Commercial 
Policy (London: William Hodge and Co.).
    Hines, J.R. 1996a. ``Tax Policy and the Activities of Multinational 
Corporations,'' Working Paper 5589, National Bureau of Economic 
Research, May 1996.
    ------, 1996b. ``Altered States: Taxes and the Location of Foreign 
Direct Investment in America,'' American Economic Review 86(5), 
December 1996.
    JCT (Joint Committee on Taxation). 1996. Estimates of Federal Tax 
Expenditures for Fiscal Years 1997-2001, November 26, 1996
    Kemsley, D. 1997. ``The Effect of Taxes on Production Location,'' 
Columbia University, January 1997, mimeo.
    OMB (Office of Management and Budget). 1996. ``Tax Expenditures,'' 
Budget of the United States Government: Analytical Perspectives, Fiscal 
Year 1997, February 5, 1996.
    ------. 1997. Budget of the United States Government, Fiscal Year 
1998, February 6, 1997.
    Ohlin, B. 1933. Interregional and International Trade (Cambridge, 
Massachusetts: Harvard University Press).
    Richardson, J.D., and K. Rindal. 1996. Why Exports Matter: More! 
(Washington, D.C.: Institute for International Economics and The 
Manufacturing Institute).
    Rousslang, D.J. 1994. ``The Sales Source Rules for U.S. Exports: 
How Much Do They Cost?,'' Tax Notes, February 21, 1994.
    Stern, R.M., and J. Francis. 1976. Price Elasticities in 
International Trade: An Annotated Bibliography (London: Macmillan for 
the Trade Policy Research Centre).
    U.S. Department of Commerce, Bureau of the Census, Economics and 
Statistics Administration. 1996a. Statistical Abstract of the United 
States 1996.
    ------, Economics and Statistics Administration. 1996b. U.S. Jobs 
Supported by Exports of Goods and Services 19: 83-94, November 1996.
    ------, Economics and Statistics Administration. 1996c. 
``Operations of U.S. Multinational Companies,'' Survey of Current 
Business, December 1996.
    U.S. Department of the Treasury. 1983. The Operation and Effect of 
the Domestic International Sales Corporation Legislation: 1981 Annual 
Report, July 1983.
    ------. 1993. The Operation and Effect of the Foreign Sales 
Corporation Legislation: January 1, 1985 to June 30, 1988, January 
1993.
    Wei, S. 1997. ``How Taxing is Corruption on International 
Investors?'' Kennedy School of Government, Harvard University, January 
9, 1997. Mimeo.

  Table 1. Calculated Impact of the Export Source Rule in 1992: Direct
                  Estimates based on Kemsley Parameters
------------------------------------------------------------------------
                                        Companies   Companies
                                           with       with        All
                                         binding   nonbinding    sample
                                           FTC         FTC     companies
                                        positions   positions
------------------------------------------------------------------------
Sample mean values per company \1\
    Total assets ($ millions)3,805....      2,889       3,254
    Foreign sales ($ millions)1,33....        286      41,100
    Foreign tax rate (%)..............      48.63       35.72      42.25
    U.S. tax rate (%).................      35.00       35.00      35.00
    U.S. tax rate with ESR or FSC (%)       17.50       29.75       n.a.
     \2\..............................
    Addenda: No. of companies per             140         136        276
     Kemsley..........................
    Adjusted no. of companies.........        247        n.a.       n.a.
Additional U.S. exports ($ millions)
 \3\
    Per company.......................         68           0       n.a.
    All companies.....................     16,792           0     16,792
Jobs supported by additional exports
 \4\
    All companies.....................    259,725           0    259,725
Wage and salary premium ($ millions)
 \5\
    All companies.....................        951           0        951
------------------------------------------------------------------------
Sources: Authors' calculations based on D. Kemsley, ``The Effect of
  Taxes on Production Location,'' Columbia University, January 1997,
  mimeo; U.S. Department of Commerce, ``U.S. Jobs Supported by Exports
  of Goods and Services,'' November 1996; J.D. Richardson and K. Rindal,
  Why Exports Matter: More! (Washington, D.C.: Institute for
  International Economics and The Manufacturing Institute, 1996); and
  Bureau of the Census, Economics and Statistics Administration, U.S.
  Department of Commerce, Statistical Abstract of the United States
  1996, October 1996.
Notes: Companies with ``binding FTC positions'' are companies in an
  excess foreign tax credit (FTC) position; companies with ``nonbinding
  FTC positions'' are other companies. The estimates are based on the
  assumption that companies with binding FTC positions take advantage of
  the Export Source Rule (IRC Section 863(b)); while companies with
  nonbinding FTC positions utilize the Foreign Sales Corporation (FSC)
  provisions.
\1\ The full pooled cross-sectional sample of data, compiled by Kemsley
  (1996) from the financial statements of U.S. multinational companies,
  consists of 2,486 manufacturing company-years for the period 1984-92.
  For the calculations presented in the table, the sample mean values
  are conservatively interpreted as 1992 values.
\2\ It is assumed that companies with binding FTC positions (i.e., with
  excess foreign tax credits) exclude half their export profits from
  U.S. taxation by using the Export Source Rule. This reduces the
  effective U.S. tax rate on such profits from the normal rate of 35
  percent to 17.5 percent. It is assumed that companies in nonbinding
  FTC positions (i.e., without excess foreign tax credits) exclude up to
  15 percent of their export profits from U.S. taxation by using the
  Foreign Sales Corporation (FSC) provisions, thereby reducing the
  effective U.S. tax rate on such profits from the normal rate of 35
  percent to 29.75 percent.
\3\ Estimates are based on econometric findings investigating the
  magnitude of exports per company associated with U.S. export tax
  incentives reported by Kemsley (1997), adjusted for the larger number
  of companies that use the Export Source Rule after the Tax Reform Act
  of 1986, and also adjusted for the larger impact per company, taking
  into account exports to foreign affiliates (see text).
\4\ These calculations assume that manufacturing exports support
  employment at the rate of 15,500 jobs per $1 billion of goods exported
  in 1992.
\5\ Calculated as an earnings premium of 12 percent of average
  manufacturing earnings ($30,500 per worker) in 1992, or $3,660 per
  worker.


Table 2. Calculated Impact of the Export Source Rule in 1992: Production
         Response Approach based on Grubert and Mutti Parameters
------------------------------------------------------------------------
                                        Companies   Companies
                                           with       with        All
                                         binding   nonbinding    sample
                                           FTC         FTC     companies
                                        positions   positions
------------------------------------------------------------------------
Sample mean values per company \1\
    Total exports ($ millions)........      2,585       2,585      2,585
    Foreign tax rate (%)..............      48.63       35.72      42.25
    U.S. tax rate (%).................      35.00       35.00      35.00
    U.S. tax rate with ESR or FSC (%)       17.50       29.75       n.a.
     \2\..............................
    Addendum: number of companies.....         25          25         50
Additional U.S. exports ($ millions)
 \3\
    Per company.......................      1,247           0       n.a.
    All companies.....................     31,164           0     31,164
Jobs supported by additional exports
 \4\
    All companies.....................    482,012           0    482,012
Wage and salary premium ($ millions)
 \5\
    All companies.....................      1,766           0      1,766
------------------------------------------------------------------------
Sources: Authors' calculations based on D. Kemsley, ``The Effect of
  Taxes on Production Location,'' Columbia University, January 1997,
  mimeo; H. Grubert and J. Mutti, ``Do Taxes Influence Where U.S.
  Corporations Invest?,'' Paper prepared for the Conference on Trans-
  Atlantic Public Economics Seminar, Amsterdam, Netherlands, May 29-31,
  1996 (revised August 1996), mimeo; U.S. Department of Commerce, ``U.S.
  Jobs Supported by Exports of Goods and Services,'' November 1996; J.D.
  Richardson and K. Rindal, Why Exports Matter: More! (Washington, D.C.:
  Institute for International Economics and The Manufacturing Institute,
  1996); Bureau of the Census, Economics and Statistics Administration,
  U.S. Department of Commerce, Statistical Abstract of the United States
  1996, October 1996; and Fortune, ``The Top 50 U.S. Exporters,''
  November 13, 1995.
Notes: Companies with ``binding FTC positions'' are companies in an
  excess foreign tax credit (FTC) position; companies with ``nonbinding
  FTC positions'' are other companies.
\1\ The figure for total exports per company is based on the experience
  of the Fortune Top 50 U.S. Exporters, 1994 data adjusted back to 1992
  using the average annual growth rate of U.S. manufactures exports. The
  25-25 division of Fortune Top 50 Exporters between those with binding
  FTC positions and those with nonbinding FTC positions is based on
  Kemsley's full sample which classified 1,258 company-years as binding
  and 1,228 company-years as nonbinding.
\2\ It is assumed that companies with binding FTC positions (i.e., with
  excess foreign tax credits) exclude half their export profits from
  U.S. taxation by using the Export Source Rule to characterize those
  profits as foreign source income (thereby absorbing part of their
  excess foreign tax credits). This reduces the effective U.S. tax rate
  on such profits from the normal rate of 35 percent to 17.5 percent. It
  is assumed that companies in nonbinding FTC positions (i.e., without
  excess foreign tax credits) exclude up to 15 percent of their export
  profits from U.S. taxation by using the Foreign Sales Corporation
  (FSC) provisions of the Internal Revenue Code, thereby reducing the
  effective U.S. tax rate on such profits from the normal rate of 35
  percent to 29.75 percent.
\3\ Grubert and Mutti (1996) estimate an elasticity of 3.0 for total
  capital invested by U.S. companies in foreign countries with respect
  to foreign tax rates. We assume that the ratio between capital
  invested and export sales is constant. Hence, the Grubert-Mutti
  elasticity of 3.0 is multiplied by the incremental inducement provided
  by the Export Source Rule, and then applied to total exports of
  companies with binding FTC positions. The key assumption in this
  calculation is that U.S. export production facilities can be regarded
  as if they were an additional overseas location for production of
  tradable goods by U.S. multinational firms. Further, it is assumed
  that, without the Export Source Rule, companies would ship their
  exports through a Foreign Sales Corporation. Hence, the calculation of
  additional exports only reflects the incremental inducement provided
  by the Export Source Rule, beyond the inducement provided by the
  Foreign Sales Corporation--i.e., an incremental reduction of 12.25
  percentage points in the effective tax rate.
\4\ These calculations assume that manufacturing exports support
  employment at the rate of 15,500 jobs per $1 billion of goods exported
  in 1992.
\5\ Calculated as an earnings premium of 12 percent of average
  manufacturing earnings ($30,500 per worker) in 1992, or $3,660 per
  worker.


 Table 3. Calculated Impact of the Export Source Rule in 1992: Textbook
             Approach based on Export Elasticity Parameters
------------------------------------------------------------------------
                                        Companies   Companies
                                           with       with        All
                                         binding   nonbinding    sample
                                           FTC         FTC     companies
                                        positions   positions
------------------------------------------------------------------------
Sample mean values per company \1\
    Total exports ($ millions)........      2,585       2,585      2,585
    Foreign tax rate (%)..............      48.63       35.72      42.25
    U.S. tax rate (%).................      35.00       35.00      35.00
    U.S. tax rate with ESR or FSC (%)       17.50       29.75       n.a.
     \2\..............................
    Addendum: number of companies.....         25          25         50
Additional U.S. exports ($ millions)
 \3\
    Per company.......................        228           0       n.a.
    All companies.....................      5,700           0      5,700
Jobs supported by additional exports
 \4\
    All companies.....................     88,163           0     88,163
Wage and salary premium ($ millions)
 \5\
    All companies.....................        323           0        323
------------------------------------------------------------------------
Sources: Authors' calculations based on D. Kemsley, ``The Effect of
  Taxes on Production Location,'' Columbia University, January 1997,
  mimeo; U.S. Department of the Treasury, The Operation and Effect of
  the Domestic International Sales Corporation Legislation: 1981 Annual
  Report (Washington, D.C., July 1983); U.S. Department of Commerce,
  ``U.S. Jobs Supported by Exports of Goods and Services,'' November
  1996; J.D. Richardson and K. Rindal, Why Exports Matter: More!
  (Washington, D.C.: Institute for International Economics and The
  Manufacturing Institute, 1996); Bureau of the Census, Economics and
  Statistics Administration, U.S. Department of Commerce, Statistical
  Abstract of the United States 1996, October 1996; and Fortune, ``The
  Top 50 U.S. Exporters,'' November 13, 1995.
Notes: Companies with ``binding FTC positions'' are companies in an
  excess foreign tax credit (FTC) position; companies with ``nonbinding
  FTC positions'' are other companies.
\1\ The figure for total exports per company is based on the experience
  of the Fortune Top 50 U.S. Exporters, 1994 data adjusted back to 1992
  using the average annual growth rate of U.S. manufactures exports. Tax
  rates are from Kemsley. The 25-25 division of Fortune Top 50 Exporters
  between those with binding FTC positions and those with nonbinding FTC
  positions is based on Kemsley's full sample which classified 1,258
  company-years as binding and 1,228 company-years as nonbinding.
\2\ It is assumed that companies with binding FTC positions (i.e., with
  excess foreign tax credits) exclude half their export profits from
  U.S. taxation by using the Export Source Rule to characterize those
  profits as foreign source income (thereby absorbing part of their
  excess foreign tax credits). This reduces the effective U.S. tax rate
  on such profits from the normal rate of 35 percent to 17.5 percent. It
  is assumed that companies in nonbinding FTC positions (i.e., without
  excess foreign tax credits) exclude up to 15 percent of their export
  profits from U.S. taxation by using the Foreign Sales Corporation
  (FSC) provisions of the Internal Revenue Code, thereby reducing the
  effective U.S. tax rate on such profits from the normal rate of 35
  percent to 29.75 percent.
\3\ Estimates are derived by applying the textbook export elasticities
  approach to measuring the trade effects of export tax incentives, as
  outlined in U.S. Treasury Department (1983). The profit-to-export-
  sales ratio for all companies is assumed equal to 0.12. High values of
  the price elasticities of demand and supply for U.S. exports of
  manufactures, -10 and 20 respectively, are assumed in order to
  calculate the largest possible impacts of the Export Source Rule under
  the elasticities approach. These price elasticity estimates imply a
  ``multiplier'' value of 6.0, relating the proportional change in
  export sales to the tax-induced change in export income (expressed as
  a percentage of export sales) attributable to the Export Source Rule.
  The Export Source Rule saves firms 12.25 percentage points of
  taxation; assuming a profit-to-export sales ratio of 0.12, this
  translates into additional export income equal to 1.47 percent of
  export sales. Applying the ``multiplier'' of 6.0 indicates export
  gains of 8.82 percent.
\4\ These calculations assume that manufacturing exports support
  employment at the rate of 15,500 jobs per $1 billion of goods
  exported.
\5\ Calculated as an earnings premium of 12 percent of average
  manufacturing earnings ($30,500 per worker) in 1992, or $3,660 per
  worker.


                Table 4. Projected Export and Revenue Impact of the Export Source Rule, 1998-2000
----------------------------------------------------------------------------------------------------------------
                                                              1998       1999       2000       2001       2002
----------------------------------------------------------------------------------------------------------------
Additional U.S. exports ($ millions)
    Based on Kemsley parameters..........................     28,223     30,763     33,532     36,550     39,839
    Based on Grubert-Mutti parameters....................     52,379     57,093     62,231     67,832     73,937
    Based on export elasticities approach................      9,580     10,443     11,382     12,407     13,523
Employment and earnings Jobs supported by additional
 exports
    Based on Kemsley estimates...........................    343,779    360,093    377,182    395,081    413,831
    Based on Grubert-Mutti estimates.....................    638,013    668,291    700,006    733,225    768,021
    Based on export elasticities approach................    116,695    122,233    128,033    134,109    140,474
Addenda: jobs per $1 bill. of exports \1\                     12,181     11,705     11,248     10,809     10,387
Additional wages and salaries ($ m) \2\
    Based on Kemsley estimates...........................      1,572      1,708      1,857      2,018      2,194
    Based on Grubert-Mutti estimates.....................      2,917      3,171      3,446      3,746      4,071
    Based on export elasticities approach................        534        580        630        685        745
Addenda: average earnings per worker in manufacturing ($)     38,104     39,538     41,026     42,570     44,171
 \1\
Tax revenue forecasts ($ millions) \3\
    U.S. Treasury........................................        891      1,474      1,555      1,750      1,855
Revenue offset ($ millions) \4\
    Based on Kemsley parameters..........................       n.a.        367        399        434        472
    Based on Grubert-Mutti parameters....................       n.a.        682        741        805        875
    Based on export elasticity parameters................       n.a.        125        136        147        160
Adjusted tax revenue forecasts ($ m) \5\
    Based on Kemsley parameters..........................       n.a.      1,107      1,156      1,316      1,383
    Based on Grubert-Mutti parameters....................       n.a.        792        814        945        980
    Based on export elasticity parameters................       n.a.      1,349      1,419      1,603      1,695
----------------------------------------------------------------------------------------------------------------
Sources: Tables 1, 2, and 3; International Trade Administration, U.S. Department of Commerce, U.S. Foreign Trade
  Highlights, October 28, 1996; J.D. Richardson and K. Rindal, Why Exports Matter: More! (Washington, D.C.:
  Institute for International Economics and The Manufacturing Institute, 1996); U.S. Department of Commerce,
  ``U.S. Jobs Supported by Exports of Goods and Services,'' November 1996; Bureau of the Census, Economics and
  Statistics Administration, U.S. Department of Commerce, Statistical Abstract of the United States 1996,
  October 1996; and Office of Management and Budget, Budget of the United States Government, Fiscal Year 1998,
  February 6, 1997.
Notes: Projections of additional U.S. exports and employment are based on the estimates for 1992 presented in
  Tables 1, 2, and 3. Additional exports are projected using the recorded average annual growth rate of U.S.
  exports of manufactures during 1992-96 (9 percent).
\1\ The addenda items reflect an annual growth rate of labor productivity in U.S. manufacturing sectors of 4
  percent, based on the record of labor productivity in U.S. industry during 1985-93.
\2\ Additional U.S. wages and salaries in 1992 are estimated using the jobs estimates multiplied by the average
  annual earnings of workers in manufacturing industries in that year ($30,500) and by the higher increment to
  wages and salaries (12 percent) enjoyed by workers in export manufacturing plants, the latter figure as
  reported by the U.S. Department of Commerce (1996). The projections for the years 1998 to 2002 are derived in
  the same manner as those for additional exports and employment.
\3\ Tax revenue forecasts are supposed to reflect obvious changes in business behavior that are induced by a
  change in the tax law. If the Export Source Rule is repealed, U.S. multinational companies would exclude up to
  15 percent of their export profits from U.S. taxation by utilizing the FSC provisions of the Internal Revenue
  Code. This change is reflected in the Treasury revenue forecasts (Office of Management and Budget 1997).
\4\ The tax revenue offsets are the additional tax revenues related to the higher earnings enjoyed by the
  workers who produce the exports supported by the Export Source Rule. The tax revenue offsets are estimated by
  applying the average marginal U.S. income tax rate for individuals in 1996 (calculated at 21.5 percent) to the
  estimates in the table of additional U.S. earnings supported by the shift in output towards export industries
  as a consequence of the Export Source Rule.
\5\ Under each of the three approaches to estimation of the impact of the Export Source Rule, the adjusted
  revenue forecasts are equal to the tax revenue forecasts minus the calculated tax revenue offsets.


 Table 5. Estimates of Long-Run Price Elasticities of Demand and Supply
                            for U.S. Exports
------------------------------------------------------------------------
              Investigator                    Demand          Supply
------------------------------------------------------------------------
Manufacturing exports
    Stern and Francis (1976)............           -1.24            n.a.
    Junz and Rhomberg (1973)............           -3.88            n.a.
    Artus and Sosa (1978)...............           -0.77            3.10
    Lawrence (1978).....................           -1.85            n.a.
    Dunlevy (1978)......................            n.a.            2.10
    U.S. Treasury (1983)................          -10.00           20.00
Total exports
    Houthakker and Magee (1969).........           -1.51            n.a.
    Magee (1970)........................            n.a.           11.50
    Stern and Francis (1976)............           -1.41            n.a.
    Goldstein and Khan (1978)...........           -2.32            6.60
    Gylfason (1978).....................            n.a.            2.40
    Geraci and Prewo (1980).............            n.a.           12.20
------------------------------------------------------------------------
Sources: R.M. Stern and J. Francis, Price Elasticities in International
  Trade: An Annotated Bibliography (London: Macmillan for the Trade
  Policy Research Centre, 1976); U.S. Department of the Treasury, The
  Operation and Effect of the Domestic International Sales Corporation
  Legislation: 1981 Annual Report (Washington, D.C.: July 1983); and M.
  Goldstein and M. Khan, ``Income and Price Effects in Foreign Trade,''
  in Handbook of International Economics, Vol. II, eds., R.W. Jones and
  P.B. Kenen (Amsterdam: North-Holland, 1985).
Notes: The price elasticities of demand for U.S. exports reported by
  Stern and Francis (1976) are ``mean'' estimates compiled by the two
  authors from econometric studies by other investigators. The
  elasticities in U.S. Treasury (1983) are assumed values that are
  intended to represent ``high'' estimates of price elasticities of
  demand and supply for U.S. exports of manufactures.



                           Table 6. U.S. Merchandise and Manufactures Trade, 1985-2002
                                     (Billions of U.S. dollars, Census basis)
----------------------------------------------------------------------------------------------------------------
                                                        Total Goods \1\               Manufactured Goods \2\
                     Year                      -----------------------------------------------------------------
                                                 Exports    Imports    Balance    Exports    Imports    Balance
----------------------------------------------------------------------------------------------------------------
1985..........................................      218.8      336.5     -117.7      168.0      257.5      -89.5
1986..........................................      227.2      365.4     -138.3      179.8      296.7     -116.8
1987..........................................      254.1      406.2     -152.1      199.9      324.4     -124.6
1988..........................................      322.4      441.0     -118.5      255.6      361.4     -105.7
1989..........................................      363.8      473.2     -109.4      287.0      379.4      -92.4
1990..........................................      393.6      495.3     -101.7      315.4      388.8      -73.5
1991..........................................      421.7      488.5      -66.7      345.1      392.4      -47.3
1992..........................................      448.2      532.7      -84.5      368.5      434.3      -65.9
1993..........................................      465.1      580.7     -115.6      388.7      479.9      -91.2
1994..........................................      512.6      663.3     -150.6      431.1      557.3     -126.3
1995..........................................      584.7      743.4     -158.7      486.7      629.7     -143.0
1996..........................................      616.6      783.0     -166.4      521.3      653.9     -132.6
1997..........................................      672.1      568.2
1998..........................................      732.6      619.4
1999..........................................      798.5      675.1
2000..........................................      870.4      735.9
----------------------------------------------------------------------------------------------------------------
Sources: International Trade Administration, U.S. Department of Commerce, U.S. Foreign Trade Highlights, October
  28, 1996; and Bureau of Economic Analysis, U.S. Department of Commerce, Commerce News: U.S. International
  Trade in Goods and Services, September 1996, November 20, 1996.
Notes: All values for 1996 are extrapolated from reported values for the first nine months. Values of exports
  during 1997-2002 are projected, assuming an annual average growth rate of 9 percent.
\1\ Includes nonmonetary gold, military grant aid, special category shipments, trade between the U.S. Virgin
  Islands and foreign countries, and undocumented exports to Canada. Adjustments were also carryover. Import
  values are based on transaction prices whenever possible
\2\ Manufactured goods include commodity sections 5-9 under SITC Rev. 3. Manufactures include undocumented
  exports to Canada, nonmonetary gold (excluding gold ore, scrap, and base bullion), and special category
  shipments.


Gary C. Hufbauer is Reginald Jones Senior Fellow, Institute for 
International Economics, 11 Dupont Circle, Washington, D.C. 
20036. Dean A. DeRosa is Principal Economist, ADR 
International, Ltd., 200 Park Avenue, Suite 202, Falls Church, 
Virginia 22046. The analysis and conclusions are the work of 
the authors and do not reflect the views of their affiliated 
institutions.
      

                                

Statement of John Porter, Tax Director, Financial Executives Institute

                              Introduction

    Mr. Chairman and Members of the Committee:
    The FEI Committee on Taxation is pleased to present its 
views on the Administration's Budget proposals and their impact 
on the international competitiveness of U.S. businesses and 
workers. FEI is a professional association comprising 14,000 
senior financial executives from over 8,000 major companies 
throughout the United States. The Tax Committee represents the 
views of the senior tax officers from over 30 of the nation's 
largest corporations.
    The FEI thanks the House Ways & Means Committee for 
scheduling these hearings on the Administration's budget 
proposals. We support a few of the proposals, for example, the 
extension of the tax credit for research. This provision should 
help improve the competitive position of U.S. companies. 
However, in many of the other tax proposals, the Administration 
replaced sound tax policy with some unwise revenue raisers. 
These latter proposals do nothing to achieve the objective of 
retaining U.S. jobs and making the U.S. economy stronger. For 
example, provisions are found in the Budget to extend Superfund 
taxes with no concomitant improvement of the cleanup programs, 
arbitrarily change the sourcing of income rules on export sales 
by U.S. based manufacturers, and restrict the ability of ``dual 
capacity taxpayers'' to take credit for certain taxes paid to 
foreign countries.
    Targeting publicly held U.S. multinationals doing business 
overseas for budget revenue raisers is unwise and the FEI urges 
that such proposals not be adopted by Congress. Businesses 
establish foreign operations to serve local overseas markets so 
they are able to compete more efficiently with foreign based 
competition. In addition to assisting with the growth of 
exports and consequently job creation in the U.S., investments 
abroad help the U.S. balance of payments. The long-standing 
creditability of foreign income taxes is intended to alleviate 
the double taxation of foreign income. Replacing such credisult 
in double taxation and greatly increase the costs of doing 
business overseas, which will place U.S. multinationals at a 
competitive disadvantage versus foreign based companies.
    U.S. jobs and the economy overall would be best served by 
Congress working with the Administration to do all it can to 
make the U.S. tax code more friendly; a position already 
afforded our international competitors by their home country 
governments. The budget should be written with the goal of 
reintegrating sound tax policy into decisions about the revenue 
needs of the government. Provisions that merely increase 
business taxes by eliminating legitimate business deductions 
should be avoided. Ordinary and necessary business expenses are 
integral to our current income based system, and needless 
elimination of them will only distort that system. Higher 
business taxes impact all Americans, directly or indirectly. It 
should be kept in mind that millions of ordinary Americans are 
shareholders, through their retirement plans, of corporate 
America and that proposals that decrease the competitiveness of 
U.S. business harm those persons both as shareholders and 
employees.

                            Effective Dates

    The FEI would like to voice its view that it is bad tax 
policy to add significant tax burdens on business in a 
retroactive manner. Businesses should be able to rely on the 
tax rules in place when making economic decisions, and expect 
that those rules will not change while their investments are 
still ongoing. It seems plainly unfair to encourage businesses 
to make economic decisions based on a certain set of rules, but 
then change those rules midstream after the taxpayer has made 
significant investments in reliance thereon. Thus, whenever 
possible, we call on Congress to assure that significant tax 
changes do not have retroactive application. To do otherwise 
can have a chilling effect on business investments which could 
be adversely impacted by rumored tax changes.

                 Provisions that Should not Be Adopted

    Sound and paramount when deciding on taxation of business--
not mere revenue needs. In this light, the FEI offers the 
following comments on certain specific tax increase proposals 
set forth in the Administration's budget:

                     Repeal of Code Section 863(b)

    When products manufactured in the U.S. are sold abroad, 
Code Sec. 863(b) enables the U.S. manufacturer to treat half of 
the income derived from those sales as foreign source income, 
as long as title passes outside the U.S. Since title on export 
sales to unrelated parties often passes at the point of origin, 
this provision is more often applied to export sales to foreign 
affiliates.
    The Administration proposes to repeal Sec. 863(b) because 
it allegedly gives multinational corporations a competitive 
advantage over U.S. exporters that conduct all of their 
business activities in the U.S. It also believes that replacing 
Sec. 863(b) with an allocation based on actual economic 
activity will raise $6.6 billion over five years. This proposal 
is nonsensical.
    First, to compete effectively in overseas markets, most 
U.S. manufacturers find that they must have operations in those 
foreign markets to sell and service their products. Many find 
it necessary to manufacture products specially designed for a 
foreign market in the country of sale, importing vital 
components of that product from the U.S. wherever feasible. 
Thus, the supposed competitive advantage over a U.S. exporter 
with no foreign assets or employees is a myth. There are many 
situations in which a U.S. manufacturer with no foreign 
activities simply cannot compete effectively in foreign 
markets.
    Second, except in the very short term, this proposal could 
reduce the Treasury's revenues rather than increase them. This 
is because the multinational corporations, against which this 
proposal is directed, may have a choice. Instead of exporting 
their products from the U.S., they may be able to manufacture 
them abroad to the extent of excess capacity in foreign plants. 
If even a small percentage of position to make such a switch, 
the proposal will fail to achieve the desired result and taxes 
on manufacturing profits and manufacturing wages will go to 
foreign treasuries, instead of to the U.S. Amazingly, the 
Administration seems to encourage this result by calling for an 
allocation based on ``actual economic activity,'' which would 
cause a behavioral response to increase economic activity in 
foreign jurisdictions that could result in more foreign jobs, 
investment, and profits.
    At present, the U.S. has too few tax incentives for 
exporters, especially compared to foreign countries with VAT 
regimes. The U.S. should be stimulating the expansion of 
exports. Given our continuing trade deficit, it would be unwise 
to remove a tax incentive for multinational corporations to 
continue making GATT legal export sales from the United States. 
Ironically, this proposal could result in multinationals using 
existing foreign manufacturing operations instead of U.S. based 
operations to produce export products. We encourage Congress 
not to adopt it.

                  Limiting Use of ``Hybrid'' Entities

    It is troubling that the Administration (i.e., Treasury) feels 
compelled to request congressional authority to issue potentially 
sweeping legislative regulations after non-specific tax guidance has 
been given. If Treasury has specific issues to address, it should do so 
through specific legislative proposals. This would permit normal 
congressional consideration, including hearings on such proposals.
    One such proposal would limit the ability of certain foreign and 
U.S. persons to enter into transactions that utilize so-called ``hybrid 
entities,'' which are entities that are treated as corporations in one 
jurisdiction, but, as branches or partnerships in another jurisdiction. 
Although most hybrid transactions do not attempt to generate tax 
results that are ``inconsistent with the purposes of U.S. tax law,'' 
the Administration feels that there are enough taxpayers taking unfair 
advantage of the current rules thatxtend the earlier government issued 
tax guidance (Notices 98-5 and 98-11) on this subject.
    U.S. multinationals compete in an environment wherein foreign 
competitors use tax planning techniques to reduce foreign taxes without 
incurring home country tax. The use of ``hybrid entities'' allows U.S. 
multinationals to compete on a level playing field and promotes 
additional U.S. exports. The use of hybrids is consistent with the 
initial balance between competitiveness and export neutrality that was 
intended by Congress in enacting the ``Subpart F'' rules. Although 
Congress specifically enacted a branch rule for foreign base company 
sales under Code Sec. 954(d)(3), similar rules were not enacted for 
foreign personal holding company income. If enacted, these proposals 
would represent an unwarranted extension of legislative authority by 
Congress to the Executive Branch to impose new rules by regulation 
without Congressional debate.
    Notices 98-5 and 98-11 have a chilling effect on the ability of 
U.S. companies to structure their foreign operations consistent with 
the commercial objective to regionalize businesses. They also adversely 
impact companies' abilities to effectively reduce their overall costs 
by reducing local taxes in their overseas operations. The Notices are 
drafted so broadly and so vaguely that they confuse U.S. taxpayers and 
their advisors, and introduce a compelling need to seek clarification 
as to whether taxpayers can continue to rely on the simple ``check-the-
box'' regulations issued just last year. All these effects are 
exacerbated by the Notices' immediate effective dates.
    The world has changed dramatically since enactment of the Subpart F 
rules in 1962. We feel that it would be more appropriate for Congress 
to request a study regarding the trade and tax policy issues associated 
with Notices 98-5 and 98-11. In this regard, a moratorium on further 
regulatory action by Treasury should be imposed until enactment of 
specific legislative proposals resulting

                        Foreign Built-In Losses

    Another proposal would require the Treasury to issue 
regulations to prevent taxpayers from ``importing built-in 
losses incurred outside U.S. taxing jurisdictions to offset 
income or gain that would otherwise be subject to U.S. tax.'' 
The administration argues that although there are rules in the 
Code that limit a U.S. taxpayer's ability to avoid paying U.S. 
tax on built-in gain (e.g., Code Secs. 367(a), 864(c)(7), and 
877), similar rules do not exist that prevent built-in losses 
from being used to shelter income otherwise subject to U.S. tax 
and, as a result, taxpayers are avoiding Subpart F income 
inclusions or capital gains tax. We believe that this 
directive, which is written extremely broadly, is unnecessary 
due to the existence of rules already available in the Code, 
e.g., the anti-abuse provisions of Code Secs. 269, 382, 446(b), 
and 482. Both this proposal, and the one immediately above 
regarding the use of hybrid entities, would severely impact the 
ability of U.S. multinationals to compete on an equal footing 
against foreign-based companies.

                       Foreign Oil and Gas Income

    The President's budget proposal dealing with foreign oil 
and gas income moves in the direction of limiting use of the 
foreign tax credit on foreign oil and gas income. This 
selective attack on a single industry's utilization of the 
foreign tax credit is not justified. U.S. based oil companies 
are already at a competitive disadvantage under current law 
since most of their foreign based competition pay little or no 
home country tax on foreign oil and gas income. Perversely, 
this proposal cedes an advantage to overseas competitors by 
subjecting foreign oil and gas income to U.S. double taxation, 
which will severely hinder U.S. oil companies in the global oil 
and gas exploration, production, refining and marketing arena.

                            Superfund Taxes

    The three taxes that fund Superfund (corporate 
environmental tax, petroleum excise tax, and chemical feed 
stock tax) all expired on December 3 would reinstate the two 
excise taxes at their previous levels for the period after the 
date of enactment through September 30, 2008. The corporate 
environmental tax would be reinstated at its previous level for 
taxable years beginning after December 31, 1997 and before 
January 1, 2009. In addition, the funding cap for the Oil Spill 
Tax would be increased from the current $1 Billion amount, to a 
much higher level of $5 Billion.
    These taxes, which were previously dedicated to Superfund, 
would instead be used to generate revenue to balance the 
budget. This use of taxes historically dedicated to funding 
specific programs for deficit reduction purposes should be 
rejected. The decision whether to re-impose these taxes 
dedicated to financing Superfund should instead be made as part 
of a comprehensive examination of reforming the entire 
Superfund program.

                      Payments to 80/20 Companies

    Currently, a portion of interest or dividends paid by a 
domestic corporation to a foreign entity may be exempt from 
U.S. withholding tax provided the payor corporation is a so-
called ``80/20 Company,'' i.e., at least eighty percent of its 
gross income for the preceding three years is foreign source 
income attributable to the active conduct of a foreign trade or 
business. The Administration believes that the testing period 
is subject to manipulation and allows certain companies to 
improperly avoid U.S. withholding tax on certain distributions 
attributable to a U.S. subsidiary's U.S. source earnings. As a 
result, it proposes to arbitrarily change the 80/20 rules by 
applying the test on a group-wide (as opposed to individual 
company) basis. However, there is little evidence that these 
rules have been manipulated on a broad scale in the past and we 
do not believe such a drastic change is needed at this time.

            Modifying the Substantial Understatement Penalty

    The Administration proposed to make any tax deficiency 
greater than $10 million ``substantial'' for purpose of the 
penalty, rather than applying the existing test that such tax 
deficiency must exceed 10% of the taxpayer's liability for the 
year. While to the individual taxpayer or even a privately-held 
company, $10 million may be a substantial amount of money--to a 
publicly-held multinational company, in fact, it may not be 
``substantial.'' Furthermore, a 90% accurate return, given the 
agreed-upon complexities and ambiguities contained in our 
existing Internal Revenue Code, should be deemed substantial 
compliance, with only additional taxes and interest due and 
owing. There is no policy justification to apply a penalty to 
publicly-held multinational companies which are required to 
deal with much greater complexities than are all other 
taxpayers.
    The difficulty in this area is illustrated by the fact that 
the Secretary of the Treasury has yet to comply with Code Sec. 
6662(d)(2)(D), which requires thepositions being taken for 
which the Secretary believes there is not substantial authority 
and which would affect a significant number of taxpayers. The 
list is to be revised not less frequently than annually. 
Taxpayers still await the Secretary's first list.

            Increased Penalties for Failure To File Returns

    The Administration also proposed to increase penalties for 
failure to file information returns, including all standard 
1099 forms. IRS statistics bear out the fact that compliance 
levels for such returns are already extremely high. Any 
failures to file on a timely basis generally are due to the 
late reporting of year-end information or to other unavoidable 
problems. Under these circumstances, an increase in the penalty 
for failure to timely file returns would be unfair and would 
fail to recognize the substantial compliance efforts already 
made by American business.

                   Limiting Mark-to-Market Accounting

    Certain trade receivables would no longer be eligible for 
treatment under the mark-to-market accounting rules. Under 
those rules, certain taxpayers who purchase and sell their own 
trade receivables are exempt from the mark-to-market method of 
accounting unless they elect to be included. If they do, those 
taxpayers can currently write-off certain non-interest bearing 
receivables, and account, note, and trade receivables unrelated 
to the active business of a security dealer. There appear to be 
no tax policy reasons for prohibiting taxpayers from 
accelerating their bad debt deductions for these trade 
receivables, only government revenue considerations.

           Repealing Lower of Cost or Market Inventory Method

    Certain taxpayers can currently determine their inventory 
values by applying the lower of cost or market method, or by 
writing down the cost of goods that are not salable at normal 
prices, or not usable because of damage or other causes. The 
Administration is proposing to repeal these options and force 
taxpayers to recognize income from changing their method of 
writing down unusable or non-salable goods somehow 
``understates taxable income.'' We strongly disagree with this 
unwarranted proposal. In addition, we believe that in the 
least, the lower of cost or market method should continue to be 
permissible when used for financial accounting purposes, to 
avoid the complexity of maintaining separate inventory 
accounting systems.

  Modification of the Corporate-Owned Life Insurance (``COLI'') Rules

    The Administration proposes to substantially change the 
taxation of business-owned life insurance by disallowing a pro-
rata portion of a business' general deduction for interest 
expense. Moreover, the Administration has proposed retroactive 
application of the new tax to existing life insurance 
contracts. This proposal should not be adopted.
    Life insurance has long been used by businesses to protect 
against financial loss caused by the death of key employees and 
to finance the soaring cost of employee benefits, especially 
post-retirement health benefits. Life insurance provides a 
secure and stable source of financing for such employee 
benefits, and it is particularly well suited to this purpose 
because its long-term nature matches the correspondingly long-
term nature of the liabilities. The Administration's proposal 
would have a devastating effect on employee benefit programs 
and key-person protection by effectively taxing life insurance 
contracts out of existence. Businesses should not be 
discouraged from providing employee health benefits or from 
seeking to protect themselves from key-person losses.
    Moreover, the Administration's proposal would apply 
retroactively to existing life insurance contracts that were 
purchased by businesses in good faith, based on existing law. 
There can be no question of abuse: business use of life 
insurance is well known and the taxation of insurance contracts 
has been settled for many years. In addition, Congress has 
reviewed the taxation of business-owned life insurance in each 
of the last two yearrved the existing taxation of business-
owned life insurance on the lives of employees. The 
Administration's proposal represents the worst kind of 
retroactive tax--it would not only cause the termination of 
most or all existing contracts, but, would also have the effect 
of taxing past earnings under those contracts.

                  Deferral of OID on Convertible Debt

    The Administration has included a number of past proposals 
aimed at financial instruments and the capital markets, which 
were fully rejected during the last session of Congress. These 
reintroduced proposals should again be rejected out of hand. 
One proposal would defer deductions by corporate issuers for 
interest accrued on convertible debt instruments with original 
issue discount (``OID'') until interest is paid in cash. The 
proposal would completely deny the corporation an interest 
deduction unless the investors are paid in cash (e.g., no 
deduction would be allowed if the investors convert their bonds 
into stock). Investors in such instruments would still be 
required to pay income tax currently on the accrued interest. 
In effect, the proposal defers or denies an interest deduction 
to the issuer, while requiring the holder to pay tax on the 
interest currently.
    The FEI opposes this proposal because it is contrary to 
sound tax policy and symmetry that matches accrual of interest 
income by holders of OID instruments with the ability of 
issuers to deduct accrued interest. There is no justifiable 
reason for treating the securities as debt for one side of the 
transaction and as equity for the other side. There is also no 
reason, economic or otherwise, to distinguish a settlement in 
cash from a settlement in stock.
    Moreover, the instruments in question are truly debt rather 
than equity. Recent statistics show that over 70 percent of all 
zero-coupon convertible debt instruments were retired with 
cash, while only 30 percent of these instruments were 
convertible to common stock. Re-characterizing these 
instruments as equncorrect and will put American companies at a 
distinct disadvantage to their foreign competitors, who are not 
bound by such restrictions. These hybrid instruments and 
convertible OID bond instruments have allowed many U.S. 
companies to raise tens of billions of dollars of investment 
capital used to stimulate the economy. Introducing this 
imbalance and complexity into the tax code will discourage the 
use of such instruments, limit capital raising options, and 
increase borrowing costs for corporations.

          Eliminating the ``DRD'' for Certain Preferred Stock

    Another proposal would deny the dividend received deduction 
(``DRD'') for certain types of preferred stock, which the 
Administration believes are more like debt than equity. 
Although concerned that dividend payments from such preferred 
stock more closely resembles interest payments than dividends, 
the proposal does not simultaneously propose to allow issuers 
of such securities to take interest expense deductions on such 
payments. Again, the Administration violates sound tax policy 
and, in this proposal, would deny these instruments the tax 
benefits of both equity and debt.
    The FEI opposes this proposal as not being in the best 
interests of either tax or public policy. Currently, the U.S. 
is the only major western industrialized nation that subjects 
corporate income to multiple levels of taxation. Over the 
years, the DRD has been decreased from 100% for dividends 
received by corporations that own over 80 percent of other 
corporations, to the current 70% for less than 20 percent owned 
corporations. As a result, corporate earnings have become 
subject to multiple levels of taxation, thus driving up the 
cost of doing business in the U.S. To further decrease the DRD 
would be another move in the wrong direction.

                         Pro Rata Disallowance

    The FEI strongly opposes the Administration's proposal to 
extend the pro rata disallowance of tax-exempt interest expense 
to all corporations. By reducing corporate demand for tax-
exempts,he financing costs of state and local governments. The 
application of the pro rata rule on an affiliated company basis 
penalizes companies that hold tax-exempt bonds to satisfy state 
consumer protection statutes, such as state money transmitter 
laws, but happen to be affiliated with other businesses that 
have interest expense totally unrelated to the holding of the 
tax-exempt bonds. These corporate investors, holding 
principally long-term bonds, are critical to the stable 
financing of America's cities and states. Treasury currently 
has the authority to prevent any abuse in this area by showing 
that borrowed funds were used to carry tax-exempt securities; 
this more targeted approach provides appropriate protection 
without disrupting the public securities market.
    Secondly, corporations often invest some operating funds in 
tax-exempt bonds for cash management reasons. No evidence 
exists that these corporations are engaged in improper 
interest-rate arbitrage. Not only are there no tax-motivated 
abuses in this area which merit increasing the borrowing costs 
of state and local governments, these investors help support an 
active and liquid short-term municipal bond market vital to 
states and localities. Again, the result of the 
Administration's proposal would be to reduce demand for tax-
exempt bonds and drive up costs for state and local 
governments. This is something that Congress should not do when 
it is looking to these very same state and local governments to 
do more.

                         Positive Tax Proposals

    As stated above, certain of the Administration's tax 
proposals will have a positive impact on the economy. For 
example:

                    Extension of Research Tax Credit

    The proposal to extend the research tax credit is to be 
applauded. The credit, which applies to amounts of qualified 
research in excess of a company's base amount, has served to 
promote research that otherwise may never have occurred. The 
buildup of ``knowledge capital'' is absolutely essential to 
enhance the competitive position of the U.S. in international 
markets--especially in what some refer to as the Information 
Age. Encouraging private sector research work through a tax 
credit has the decided advantage of keeping the government out 
of the business of picking specific winners or losers in 
providing direct research incentives. The FEI recommends that 
Congress work together with the Administration to extend the 
research tax credit on a permanent basis.

          Accelerating Effective Date of 10/50 Company Change

    Another proposal would accelerate the effective date of a 
tax change made in the 1997 Tax Relief Act affecting foreign 
joint ventures owned between ten and fifty percent by U.S. 
parents (so-called ``10/50 Companies''). This change will allow 
10/50 Companies to be treated just like controlled foreign 
corporations by allowing ``look-through'' treatment for foreign 
tax credit purposes for dividends from such joint ventures. The 
1997 Act, however, did not make the change effective for such 
dividends unless they were received after the year 2003 and, 
even then, required two sets of rules to apply for dividends 
from earnings and profits (``E&P'') generated before the year 
2003, and dividends from E&P accumulated after the year 2002. 
The Administration's proposal will, instead, apply the look-
through rules to all dividends received in tax years after 
1997, no matter when the E&P constituting the makeup of the 
dividend was accumulated.
    This change will result in a tremendous reduction in 
complexity and compliance burdens for U.S. multinationals doing 
business overseas through foreign joint ventures. It will also 
reduce the competitive bias against U.S. participation in such 
ventures by placing U.S. companies on a much more level playing 
field from a corporate tax standpoint. This proposal epitomizes 
the favored policy goal of simplicity in the tax laws, and will 
go a long way toward helping the U.S. economy by strengthening 
the competitive position of U.S. based multinationals.

               Netting of Underpayments and Overpayments

    The proposal to requiyments and underpayments for purposes 
of calculating interest (commonly referred to as ``global 
interest netting'') is a large step forward towards fairness 
and equity. A new interest rate would be added to Code Sec. 
6621 that equalizes interest in cases of overlapping periods of 
mutual indebtedness for tax periods not barred by an expiring 
statute of limitations. In other words, no interest would 
accrue on a deficiency to the extent that a taxpayer is owed a 
refund in the same amount, during periods that both are 
outstanding. We suggest that this change be made to apply to 
all open tax years, consistent with Congress' long-stated 
position on this issue.

                               Conclusion

    The FEI urges Congress not to adopt the revenue raising 
provisions identified above when formulating its own budget 
proposals. They are based on unsound tax policy. Congress, in 
considering the Administration's budget, should elevate sound 
and justifiable tax policy over mere revenue needs. Revenue can 
be generated consistent with sound tax policy, and that is the 
approach that should be followed as the budget process moves 
forward.
    The Administration's proposals would add complexity in 
direct contrast to the Administration's stated need to simplify 
the tax law in order to assist the Internal Revenue Service in 
more effectively filling its role as the nation's tax 
collector.
      

                                

Statement of Michael W. Yackira, President, FPL Energy, Inc.

    Mr. Chairman and members of the Committee, my name is 
Michael W. Yackira, and I am the President of FPL Energy, Inc. 
I thank you for the opportunity to submit this statement on 
behalf of my company on the importance of extending the wind 
energy production tax credit (PTC) for an additional five 
years.
    FPL Energy, an affiliate of Florida Power & Light Company 
and subsidiary of FPL Group, Inc., has interests in over 700 
megawatts of operating wind power facilities located in 
California and Northern Ireland. This makes FPL Energy the 
largest owner/producer of wind generated electric energy in the 
United States. FPL Energy also has interests in more than 375 
megawatts of utility scale wind power generation facilities 
under construction or development in Iowa, Minnesota, Texas, 
Oregon, and California. We are committed to clean energy 
sources and believe that, among renewable energy technologies, 
wind energy has the greatest future potential to economically 
satisfy large scale demand across the largest geographic 
regions in the United States.
    I want to commend Representatives Bill Thomas and Bob 
Matsui, and all of the cosponsors of H.R. 1401, and Senators 
Charles Grassley and Kent Conrad, and all of the cosponsors of 
S. 1459, for their leadership in supporting legislation to 
extend the wind energy PTC until the year 2004. I also want to 
commend President Clinton for including, and funding, a five-
year extension of the wind energy PTC in the Administration's 
FY 1999 Budget.
    I hope the Congress will take swift action to extend the 
wind energy PTC by enacting the provisions of H.R. 1401--S. 
1459 before the end of the second session.

                  I. Background of the Wind Energy PTC

    The wind energy PTC, enacted as part of the Energy Policy 
Act of 1992, provides an inflation-adjusted 1.5 cents/kilowatt-
hour credit for electricity produced with wind equipment for 
the first ten years of a project's life. The credit is 
available only if the wind energy equipment is located in the 
United States and electricity is generated and sold. The credit 
applies to electricity produced by a qualified wind energy 
facility placed in service after December 3, 1993, and before 
July 1, 1999. The credit is set to expire on July 1, 1999.

                 II. Why do we Need a Wind Energy PTC?

A. The wind energy PTC supports wind energy development and production.

    The credit assists wind-generated energy in competing with fossil 
fuel-generated power. In the 1980s, electricity generated with wind 
could cost as much as 25 cents/kilowatt-hour. Since that time, the 
efficiency of wind energy production has increased by over 80% to the 
current cost of 4.5 cents/kilowatt hour. The 1.5 cent/kilowatt-hour 
credit enables the industry to compete with other generating sources 
being sold at 3 cents/kilowatt-hour. The extension of the credit will 
enable the industry to continue to develop and improve its technology 
so it will be able to fully stand on its own in only a few short years. 
Indeed, experts predict the cost of wind equipment alone can be reduced 
by another 40% from current levels. This is exactly what Congress 
envisioned when it enacted the wind energy PTC, the development and 
improvement of wind energy technology.

B. Wind power will play an important role in a deregulated electrical 
market.

    The electrical generation market is going through radical changes 
as a result of efforts to restructure the industry at both the Federal 
and State levels. If the wind energy PTC is extended, renewable 
energies such as wind power are certain to play an important role in a 
deregulated electrical generation market. Wind power alone has the 
potential to generate power to as many as 10 million homes by the end 
of the next decade. Extending the credit will help the wind energy 
industry secure its position in the deregulated marketplace as a fully 
competitive, renewable source of electricity.

C. Wind power contributes to the reduction of greenhouse emissions.

    Wind-generated electricity is an environmentally-friendly form of 
renewable energy that produces no greenhouse gas emissions. ``Clean'' 
energy sources such as wind power are particularly helpful in reducing 
greenhouse gas emissions. The reduction of greenhouse gas emissions in 
the United States will necessitate the promotion of clean, 
environmentally-friendly sources of renewable energy such as wind 
energy. The extension of the wind energy PTC will assure the continued 
availability of wind power as a clean, renewable energy source.

D. Wind power has significant economic growth potential.

    1. Domestic.--Wind energy has the potential to play a meaningful 
role in meeting the growing electricity demand in the United States. As 
stated above, with the appropriate commitment of resources to wind 
energy projects, wind power could generate power to as many as 10 
million homes by the end of the next decade. There currently are a 
number of wind power projects operating across the county. These 
projects are currently generating 1,761 megawatts of wind power in the 
following states: New York, Minnesota, Iowa, Texas, California, Hawaii 
and Vermont.
    There also are a number of new wind projects currently under 
development in the United States. These new projects will generate 670 
megawatts of wind power in the following states: Texas, Colorado, 
Minnesota, Iowa, Wyoming and California.
    The domestic wind energy market has great potential for future 
growth because, as the sophistication of wind energy technology 
continues to improve, new geographic regions in the United States 
become suitable for wind energy production. The top twenty states for 
future wind energy potential include:

1. North Dakota

2. Texas

3. Kansas

4. South Dakota

5. Montana

6. Nebraska

7. Wyoming

8. Oklahoma

9. Minnesota

10. Iowa

11. Colorado

12. New Mexico

13. Idaho

14. Michigan

15. New York

16. Illinois

17. California

18. Wisconsin

19. Maine

20. Missouri \1\


    2. International.--The global wind energy market has been growing 
at a remarkable rate over the last several years and is the world's 
fastest growing energy technology. The growth of the market offers 
significant export opportunities for United States wind turbine and 
component manufacturers. The World Energy Council has estimated that 
new wind capacity worldwide will amount to $150 to $400 billion worth 
of new business over the next twenty years. Experts estimate that as 
many as 157,000 new jobs could be created if United States wind energy 
equipment manufacturers are able to capture just 25% of the global wind 
equipment market over the next ten years. Only by supporting its 
domestic wind energy production through the extension of the wind 
energy PTC can the United States hope to develop the technology and 
capability to effectively compete in this rapidly growing international 
market.
---------------------------------------------------------------------------
    \1\ Source: An Assessment of the Available Windy Land Area and Wind 
Energy Potential in the Contiguous United States, Pacific Northwest 
Laboratory, 1991.

---------------------------------------------------------------------------
E. The immediate extension of the wind energy PTC is critical.

    Since the wind energy PTC is a production credit available only for 
energy actually produced from new facilities, the credit is 
inextricably tied to the financing and development of new facilities. 
The financing and permitting requirements for a new wind facility often 
require up to two to three or more years of lead time. With the credit 
due to expire in less than a year and a half (July 1999), wind energy 
developers and investors are concerned about the cost impact of halting 
and restarting new wind development. Moreover, if the credit is not 
extended this year, it is extremely unlikely Congress will be able to 
address an extension of the wind energy PTC before its expiration in 
1999. The immediate extension of the wind energy PTC is therefore 
critical to the continued development of the wind energy market.

                            III. Conclusion

    Extending the wind energy PTC for an additional five years 
is critical for a number of reasons. The credit enables wind-
generated energy to compete with fossil fuel-generated power, 
thus promoting the development of an industry that has the 
potential to meet the electricity demands of millions of homes 
across the United States. If the wind energy PTC is extended, 
wind energy is certain to be an important form of renewable 
energy in a deregulated electrical market, and also is an 
environmentally-friendly energy source that could aid in the 
reduction of greenhouse gas emissions. The economic 
opportunities of the wind energy market are significant, both 
domestically and internationally. As such, I recommend that 
Congress act quickly to extend the wind energy PTC until the 
year 2004 so that the industry can continue to develop this 
important renewable energy resource.
      

                                

Statement of Hybrid Branch Coalition \1\

                                Overview

    The Hybrid Branch Coalition (the ``Coalition'') is composed 
of U.S. companies representing a broad cross-section of 
industries that are competing in the global marketplace. The 
Coalition opposes the proposal in the President's budget that 
would grant Treasury broad regulatory authority to ``address 
tax avoidance through the use of hybrids.'' To a large extent, 
the President's proposal requests from Congress the legal 
authority needed to issue regulations implementing two notices 
issued by the IRS, one in December of 1997 and the other in 
January of 1998. In addition, the proposal would give the IRS 
legislative authority to issue regulations well beyond the 
scope of the two notices.
---------------------------------------------------------------------------
    \1\ This testimony was prepared by Arthur Andersen on behalf of the 
Hybrid Branch Coalition.
---------------------------------------------------------------------------
    The two notices describe in very general terms the content 
of regulations that the IRS plans to issue, and contain a few 
examples illustrating the intended application of those 
regulations. The notices provide that the regulations are 
intended to apply to certain transactions retroactively to the 
date the notices were issued. The Coalition strongly believes 
that the IRS has no current authority to issue these 
retroactive regulations, and opposes any request for 
legislation that would allow retroactive effect.
    More fundamentally, however, the Coalition believes that 
the regulations described in the notices would be misguided and 
out of step with traditional and long-standing U.S. tax 
principles. The regulations would also inhibit a wide range of 
legitimate business transactions in which the only perceived 
abuse is a reduction of foreign taxes, a result that U.S. tax 
policy has historically favored. The Coalition therefore 
opposes any grant of regulatory authority along the lines 
proposed. Instead, Congress should enact legislation codifying 
the current rules.

                              Introduction

    In Notice 98-11 and Notice 98-5, the Internal Revenue 
Service and the Treasury Department announced their intention 
to issue retroactive regulations that would reverse long-
standing fundamental principles underlying the U.S. taxation of 
international transactions. These notices are nothing less than 
an attempt to add new provisions to the Internal Revenue Code--
a task that is not within the regulatory purview of either 
agency. According to the notices, the regulations will seek to 
define ``appropriate tax results'' when transactions involve a 
hybrid entity (an entity classified in one jurisdiction as a 
corporation and in another as a partnership or branch) or a 
hybrid security (an instrument treated as debt in one 
jurisdiction and as equity in another).
    Following the issuance of the notices, the executive branch 
sought statutory authority to support its retroactive 
initiatives. The Administration's fiscal 1999 Budget Proposal 
asks Congress to give the IRS regulatory authority to determine 
unilaterally the ``appropriate tax results with respect to 
hybrid transactions.''
    This standard is far too vague to be worthy of 
Congressional endorsement. In its analysis of the President's 
request for regulatory authority in this area prepared the in 
conjunction with this hearing, the Joint Committee on Taxation 
(``JCT'') stated that a broad grant of regulatory authority to 
specify the tax consequences of hybrid transactions may not be 
appropriate.\2\ Furthermore, said the JCT, broad regulatory 
authority without specific parameters could severely impact 
transactions entered into in the ordinary course of business 
operations. We agree with both conclusions.
---------------------------------------------------------------------------
    \2\ Joint Committee on Taxation, Description of Revenue Provisions 
Contained in the President's Fiscal Year 1999 Budget Proposal, JCS-4-
98, February 24, 1998, at 197.
---------------------------------------------------------------------------
    The regulations described by the notices, if promulgated, 
would drastically depart from long-accepted principles 
underlying the U.S. taxation of taxpayers operating overseas. 
Notice 98-11 seeks to impose current U.S. tax on transactions 
where the benefit derived by the taxpayer is the reduction of 
its foreign tax liability--a policy previously encouraged by 
Treasury because the resulting reduced foreign tax credit 
increases the ultimate U.S. tax. This result would be reached 
by giving tax effect to payments between branches or divisions 
of a single taxpayer, an approach that until now has been 
almost unheard of in U.S. tax policy. Notice 98-5 seeks to 
impose a nebulous ``economic return'' prerequisite for claiming 
foreign tax credits, although one searches the Code in vain for 
any such requirement.
    One of the responsibilities of the IRS and Treasury is to 
provide guidance to U.S. taxpayers. These notices provide no 
guidance. Rather, they undermine previously settled guidance 
and introduce substantial and needless uncertainty into 
international taxation. If the government is concerned about 
abusive transactions, there are a number of anti-abuse rules 
already in the Code that have so far provided ample ammunition 
to attack such arrangements. If Congress believes additional 
anti-abuse provisions are needed, they should be carefully and 
narrowly drafted to clearly distinguish the targeted abuse from 
normal business transactions. The proposed rules are extremely 
vague and go farther than anti-abuse; they upset the balance, 
stability, and certainty in tax matters that U.S. companies 
must have to remain competitive in the global marketplace.
    In this testimony, we will review the genesis of the 
notices--the so-called ``check-the-box'' regulations that 
facilitated the use of hybrids in the international setting. We 
will show that the Treasury adopted these regulations only 
after careful thought, taxpayer input, and full consideration 
of the U.S. tax policy concerns that the regulations might 
raise. We will then describe how the notices not only reverse 
substantial portions of Treasury's own ``check the box'' 
regulation but also fundamentally alter bedrock assumptions on 
which the U.S. international tax regime rests.

                      The Long History of Hybrids

    Hybrids are not new to U.S. tax law. Regulations issued in 
1960 established a four-factor test for determining whether an 
entity is a partnership or a corporation for U.S. tax purposes; 
these factors were drawn from a 1954 decision of the Court of 
Appeals for the Ninth Circuit.\3\ The long-standing position of 
the IRS was (and is) that the classification of a foreign 
entity as a corporation, partnership, or branch must be 
determined under U.S. tax principles, not under foreign law.
---------------------------------------------------------------------------
    \3\ United States v. Kintner, 216 F.2d 418 (9th Cir. 1954).
---------------------------------------------------------------------------
    The application of these principles is illustrated in a 
1977 revenue ruling. Rev. Rul. 77-214 \4\ examined the 
treatment of a German Gesellschaft mit beschrankte Haftung 
(``GmbH''), a business entity that is governed by flexible 
provisions of German law. The ruling examined the legal 
relationships established by the corporate charter of the GmbH 
at issue and concluded that the entity was a corporation for 
U.S. tax purposes because it met the regulatory tests for 
corporate status.
---------------------------------------------------------------------------
    \4\ 1977-1 C.B. 408.
---------------------------------------------------------------------------
    The clear implication of the ruling is that the GmbH would 
have been a partnership for U.S. purposes had it failed those 
tests, even though its status as a corporation (Gesellschaft) 
under German law would be unchanged. (Rev. Rul. 93-4 \5\ 
subsequently modified the application of the four-factor test 
in this situation, but left unchanged the general premise that 
the GmbH could be either a corporation or a partnership for 
U.S. tax purposes.)
---------------------------------------------------------------------------
    \5\ 1993-1 C.B. 225.
---------------------------------------------------------------------------
    Many private letter rulings issued during the years before 
1995 confirm that foreign hybrids were possible and even 
common. Authority also existed to support the proposition that 
a single-owner entity could be disregarded for tax purposes 
under the four-factor test.\6\
---------------------------------------------------------------------------
    \6\ LTR 8533003 (GCM 39395) and LTR 8737100. See also Lombard 
Trustees, Ltd. v. Commissioner, 136 F.2d 22 (9th Cir. 1943) and Hynes 
v. Commissioner, 74 T.C. 1266, 1279-81 (1980).
---------------------------------------------------------------------------

          Check-the-Box: Tax Simplification, Not Tax Avoidance

    As the corporate and partnership laws of the various U.S. 
states and of foreign countries evolved, the four-factor test 
grew less and less relevant. Partnerships and other 
unincorporated organizations were allowed to have 
characteristics traditionally associated only with corporations 
(for example, limited liability). For these reasons, Treasury 
ultimately concluded that an elective regime would add 
certainty to entity classifications and eliminate the need for 
artificial provisions in organizational documents that bore 
little relevance to the purpose of the four-factor test as it 
was originally conceived.
    The genesis of the check-the-box regulations was Notice 95-
14, which was issued on March 29, 1995. This notice invited 
public comments on hybrid transactions, an early indication 
that the government was fully aware of the potential effects of 
hybrids on U.S. tax. The notice explained that new entity 
classification regulations were being considered because of the 
continuing erosion of non-tax, legal distinctions between 
partnerships and corporations.
    After review and consideration of the public comments 
submitted in response to this request, the IRS and Treasury 
issued a notice of proposed rulemaking on May 13, 1996. The 
proposed regulations adopted an elective entity classification 
regime in both the domestic and international context. Certain 
entities, both foreign and domestic, were deemed to be per se 
corporations; these were entities that in the government's view 
could never have qualified as partnerships or branches under 
the four-factor test. All other entities were eligible to elect 
their U.S. tax classification.
    The IRS made a second request for public comments on the 
proposed regulations. After considering the comments received, 
both in writing and at a public hearing, Treasury issued final 
entity classification regulations on December 17, 1996, 
establishing the new simplified regime for classifying both 
foreign and domestic entities.
    It is clear from all of these pronouncements that Treasury 
and the IRS were aware that the new regulations would 
facilitate the creation of hybrid entities. After thoughtful 
consideration of the issues raised by hybrids in the 
international context, the final regulations allowed taxpayers 
to choose hybrid treatment for any eligible entity. The 
preamble to the final regulations noted that ``future 
monitoring of partnerships'' might be appropriate, but 
otherwise was silent on hybrids.
    There is a good reason why the check-the-box regulations 
did not create special rules for hybrid entities in the foreign 
context. Both the entity classification rules and the anti-
deferral rules were highly complex prior to the issuance of the 
regulations. Addressing hybrid issues would have significantly 
increased complexity in both areas without a commensurate 
benefit to the government. Simplification was felt to be the 
more desirable goal. Congressional efforts to simplify the 
anti-deferral provisions have continued with the repeal of the 
tax on excess passive assets held offshore and the elimination 
of the overlap between the passive foreign investment company 
rules and the controlled foreign corporation rules.
    In contrast, the notices and the legislation requested in 
the budget proposal would add tremendous complexity to the 
subpart F and foreign tax credit rules. In effect, hybrid 
arrangements would be subject to a special set of rules under 
those provisions, but would continue to be treated under old 
rules for all other purposes of the Code. Nothing in the 
pronouncements issued by the government to date justifies this 
heavy extra burden at a time when simplification of the Code is 
a top priority of both the legislative and administrative 
branches.

                              Notice 98-11

    Subpart F contains provisions that impose current U.S. 
income tax on United States persons who control a foreign 
corporation. If the subpart F requirements are met, the U.S. 
shareholders are taxed on their proportionate shares of the 
``subpart F'' income earned by the controlled foreign 
corporation (``CFC''). Subpart F income is composed of many 
elements, but two principal categories are (1) foreign personal 
holding company income--passive income such as dividends, 
interest, rents, and royalties, and (2) foreign base company 
income--certain kinds of active income earned outside the CFC's 
country of incorporation. The subpart F provisions are intended 
to prevent U.S. taxpayers from deferring tax on ``portable'' 
income by moving it to a low-taxed foreign jurisdiction.
    Other kinds of active business income are not taxed to the 
U.S. shareholder until the CFC actually distributes the 
earnings as a dividend. Such income is normally subject to tax 
in the foreign country where it is earned; the dividend to the 
U.S. shareholder carries with it a right to a credit for the 
foreign taxes paid. The United States collects any tax still 
payable on the dividend after the allowance of the credit. 
Thus, a lower foreign tax rate results in more money actually 
paid to the U.S. treasury.
    Notice 98-11 addresses situations where a CFC reduces its 
foreign income tax liability by making tax-deductible payments 
(interest, rents, or royalties) to a related party in another 
country. The income received by the related party is subject to 
a low tax rate in its home country. If the related party is 
also a CFC, this passive income would normally be subpart F 
income currently taxed to the U.S. shareholder. However, if the 
recipient is treated as a branch of the paying CFC, it will be 
ignored for U.S. tax purposes, and the transaction (loan, 
license, or lease) will also be ignored. No subpart F income 
would result, because for U.S. tax purposes the paying CFC is 
still the owner of the funds. This result is consistent with 
the U.S. tax result with respect to the first CFC's income had 
it never entered into the structure to reduce foreign taxes.
    Notice 98-11 requires that the disregarded entity be 
treated as a separate corporation when determining whether the 
payment is subpart F income. Under this approach, the 
transaction just described would create such income, subjecting 
the U.S. shareholder to immediate taxation. The notice applies 
similar treatment to a payment made by the CFC to a branch of a 
brother-sister CFC that (absent the notice) would be excluded 
from subpart F income by an exception for payments to CFCs 
organized in the same country as the paying CFC.
    Notice 98-11 cites no authority for these conclusions other 
than ``the policies and rules of subpart F.'' This is not 
surprising, because no authority appears to exist. 
Nevertheless, the notice adds that similar transactions 
involving partnerships and trusts may be subject to rules of 
this sort in separate regulations.

 Notice 98-11 Overturns the Basic Premise that Branch Transactions are 
                                Ignored

    The inherent problem with Notice 98-11 and the legislation 
requested in the budget proposal is that they seek to overturn 
the fundamental premise that transactions between a branch and 
its home office generally are ignored for U.S. income tax 
purposes. The check-the-box regulations unambiguously state 
that if an entity is disregarded, its activities will be 
treated in the same manner as those of a sole proprietorship, 
branch, or division of its owner. This long-standing premise 
has recently been reaffirmed in several related areas, 
including the new withholding tax regulations, the transfer 
pricing regulations, the global dealing regulations, notional 
principal contract rules, and interest allocation rules. There 
is no reason to disturb this principle, and every reason to 
retain it.
    The U.S. tax system is founded on the concept of income--
that is, an accretion in wealth. The Internal Revenue Code 
imposes tax on the income of ``persons,'' a term that is 
clearly defined and that does not include a branch or division. 
When a single taxable entity transfers money from one part of 
the entity to another, no wealth is created and no income 
arises. As early as 1920, the United States Supreme Court \7\ 
announced this principle in affirming the separate taxable 
identity of a corporation and its shareholders:
---------------------------------------------------------------------------
    \7\ Eisner v. Macomber, 252 U.S. 189 (1920).
---------------------------------------------------------------------------
    ``Did we regard corporation and stockholders as altogether 
identical, there would be no income except as the corporation 
acquired it .... [I]f there were entire identity between [the 
shareholders] and the company they could not be regarded as 
receiving anything from it, any more than if one's money were 
to be removed from one pocket to another.''
    This reasoning applies fully to transactions between 
branches of a single corporation. Absent a limited exception 
for currency transactions, income is not created when money is 
moved from one branch to another.
    There are other objections to the abandonment of this 
cardinal tenet of U.S. tax law. First, the proposed rule would 
be limited to determinations under subpart F. The treatment of 
such a payment under all other provisions of the Code would 
remain the same, raising the possibility of inconsistent tax 
treatment of the same transaction. Second, the proposed rule 
would run counter to decades of established precedent and 
practice. Years of uncertainty could ensue while the limits and 
effects of the proposed rule were established through 
examinations, rulings, and court decisions. Finally, the 
subpart F rules already contain a carefully crafted, limited 
branch rule enacted by Congress to deal with a narrowly 
perceived problem. The presence of this rule argues strongly 
that Congress did not intend to create any other branch rules. 
If a new branch rule is required, it is for Congress to create 
it.

   Hybrid Branch Transactions Reduce Foreign Taxes on Offshore Income

    The principal effect (and, in many cases, the principal 
purpose) of the transactions described in Notice 98-11, and 
others like them, is a reduction of foreign income taxes. 
Because such taxes are ordinarily creditable against U.S. 
income taxes, a reduction of foreign tax means an increase in 
U.S. taxes. Therefore, it has been the long-standing policy of 
the U.S. government to encourage taxpayers to reduce their 
foreign tax liability in order to reduce foreign tax credits 
and increase U.S. tax receipts.
    For example, the foreign tax credit regulations 
affirmatively require taxpayers to interpret foreign tax law in 
a way that reduces foreign tax liability, and to exhaust 
available remedies for credits or refunds, in order to qualify 
for a foreign tax credit. In addition, the legislative history 
of the Tax Reform Act of 1986 (``TRA 86'') confirms that 
Congress specifically encourages companies to make payments 
that are deductible under foreign law. Under TRA 86, interest, 
rent, and royalty payments qualify for the taxpayer-favorable 
foreign tax credit ``look-through'' rules applicable to 
dividends. Congress reasoned that since interest, rents, and 
royalties were generally deductible under foreign law, while 
dividends were not, these payments would reduce the local 
country tax liability. Consequently, less foreign tax would be 
available to reduce the taxpayer's ultimate U.S. tax liability.
    In contrast to this sound and long-standing policy, Notice 
98-11 penalizes taxpayers for tax planning strategies that 
allow significant reductions in foreign tax. The U.S. 
government should not be concerned over reductions in the tax 
base of a foreign country; indeed, as discussed above, it 
should welcome such reductions and the corresponding increases 
in U.S. tax payments. The Code should not appoint the IRS as 
the ``tax police'' to ensure that U.S. companies pay the 
highest possible tax to other countries.

              Good Faith Reliance Should Not Be Penalized

    As discussed above, the check-the-box regulations were 
adopted after a long period of deliberation, the receipt of 
public comments, and a clear acknowledgement of the issues 
presented by hybrids. The final regulations represent a 
considered policy decision that the benefits of simplification 
outweighed any possible difficulties presented by hybrids, and 
a confidence that abuses, if any, could be adequately dealt 
with.
    Notice 98-11 upsets this balanced decision. If the Treasury 
were to issue far-reaching regulations limiting--or even 
preventing--the use of hybrid arrangements to reduce foreign 
taxes after the issuance of the final check-the-box 
regulations, taxpayers that relied on the regulations in good 
faith (and incurred substantial costs in often irreversible 
restructuring) would be severely penalized. This is unfair. 
Taxpayers acted in response to the regulations as they should 
have been expected to act. There is no way that taxpayers could 
have reasonably foreseen that ``the policies of subpart F'' 
could be invoked to override long-standing principles of law in 
situations where the chief benefit of a transaction is the 
reduction of foreign tax.

  Congress, Not the Treasury, Should Make a Decision of this Magnitude

    The Constitution assigns to Congress the power to enact 
legislation. The Treasury's responsibility is to interpret, 
administer, and enforce these laws under statutorily prescribed 
procedures. The proposed regulations would make significant 
changes in fundamental principles of U.S. tax law. Changes of 
this magnitude are beyond the scope of administrative 
``interpretation.'' If Congress is concerned over the effect of 
hybrids on the policies of subpart F, it should speak to those 
concerns itself.

JCT is Concerned about the Administration's Proposal To Grant Treasury 
                          Regulatory Authority

    Congressional staff have already indicated that they share 
in the concerns we have presented. In its description of the 
revenue provisions of the Administration's proposal on hybrid 
entities, the JCT observed that a grant of broad regulatory 
authority to prescribe the tax consequences of hybrid 
transactions may not be appropriate. The JCT stated that the 
lack of definition of the scope of such rules could have a 
profound impact on business operations in the global market-
place: ``Granting broad authority, without further enumerating 
the reach of the authority, could create an environment of 
uncertainty that has the potential for stifling legitimate 
business transactions.''
    The JCT stated that additional information would be 
required in order to evaluate the scope and content of the 
regulations. Insufficient information also prevented the JCT 
from estimating the revenue to be raised by the 
Administration's proposal. Finally, the JCT stated that it was 
not clear how the Administration's proposal on hybrid 
arrangements would interact with Notice 98-11.

         These IRS Actions Undermine the Self-Assessment System

    Fair and impartial administration of the tax law is the 
cornerstone of a self-assessment system. Taxpayers are required 
to follow, and therefore entitled to rely on, interpretive 
guidance published by the Internal Revenue Service and the 
Treasury Department. If the rules and regulations that give 
this guidance are not supported by statutory authority, or are 
not issued in a manner that allows for the execution of 
ordinary business transactions, then respect for these rules is 
eroded, and so is voluntary compliance.
    For more than a decade, Congress has worked to improve and 
protect taxpayer's rights. The first Taxpayer Bill of Rights 
was passed by Congress in 1988. The bill provided taxpayers 
with rights and procedures that must be observed in dealing 
with the IRS. The Taxpayer Bill of Rights 2 followed in 1996, 
which established the Office of Taxpayer Advocate in order to 
ensure that taxpayer rights were receiving attention at the 
highest level. The Taxpayer Advocate reports directly to the 
Deputy Commissioner of the IRS.
    Yet in 1997, the IRS Restructuring Commission still found 
``serious deficiencies in governance, management, performance 
measures, training, and culture'' at the IRS.\8\ The Commission 
recommended the appointment of an independent board of 
directors to oversee the IRS and ensure implementation of ``the 
fundamental reforms necessary to make the IRS a respected, 
stable institution that everyday Americans find to be fair and 
efficient.'' \9\ In subsequent hearings conducted by the Senate 
Finance Committee, Treasury Secretary Rubin agreed with the 
findings of the Commission and acknowledged the need for these 
reforms.\10\
---------------------------------------------------------------------------
    \8\ National Commission on Restructuring the Internal Revenue 
Service, A Vision for a New IRS, June 25, 1997, at 11.
    \9\ Id. at 1.
    \10\ Unofficial Transcript of Senate Finance Committee Hearing on 
IRS Restructuring on January 28, 1998, Tax Notes Today, 98 TNT 24-61, 
para. 196.
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    Despite these continuing efforts to improve the fairness of 
the system, the IRS and Treasury have once again failed in 
their responsibility to administer our tax laws in an objective 
and equitable manner. As we have outlined, Notice 98-11 exceeds 
the authority granted to the IRS and Treasury by Congress, 
seeks to overturn fundamental U.S. tax principles, and proposes 
to do so without proper regard for established regulatory 
processes.

 Notice 98-5 Suffers from the Same Infirmities as Those of Notice 98-11

    Notice 98-11 was issued shortly after Notice 98-5, which 
deals with the impact of hybrid arrangements on foreign tax 
credits. Although different provisions of the Code are 
involved, the two notices are similar in their overall lack of 
authority and their disregard of long-standing U.S. tax 
policies.
    Notice 98-5 states that the IRS and Treasury will seek to 
deny U.S. credits for otherwise creditable foreign income taxes 
where ``the expected economic profit is insubstantial compared 
to the foreign tax credits generated.'' The notice then gives 
five examples of arrangements where this result is believed to 
occur. However, the applicability of the notice beyond these 
five enumerated transactions is vague at best, and the notice 
purports to give the IRS extremely wide latitude in deciding on 
the amount of expected economic profit and how it compares to 
the foreign tax credits.
    Because of this vagueness, Notice 98-5 provides little real 
guidance and generates enormous uncertainty. The notice could 
be read, for example, to disallow foreign tax credits simply 
because of differences between the computation of the tax base 
under U.S. law and foreign law. This would represent a 
significant departure from long-established U.S. tax 
principles.
    Because the U.S. subjects to tax the worldwide income of 
its citizens and residents, the foreign tax credit is a vital 
mechanism for ensuring that American businesses do not pay 
double tax and remain competitive in the global marketplace. 
For this reason, Treasury should not be granted broad 
regulatory authority without a clear delineation of the scope 
and purpose of the regulations to be promulgated. Congress must 
ensure that Treasury regulations will be consistent with, and 
limited to, Congressional intent behind the statute. The 
Treasury and IRS already have at their disposal tools 
sufficient to combat foreign tax credit abuses, including the 
recently enacted economic ownership requirements, along with 
the judicially developed sham transaction doctrine and 
substance-over-form principles.

                            Relief Requested

    (1) Congress should reject the President's budget proposal 
to grant to the IRS broad regulatory authority to interfere in 
legitimate business transactions where the perceived abuse is 
the reduction of foreign taxes.
    (2) Congress should enact legislation codifying the 
application of the final check-the-box regulations to single-
member entities and clarifying that intra-company transactions 
do not generate income that is taxed to U.S. shareholders.
    (3) Congress should enact a moratorium on the issuance of 
regulations under Notice 98-5, with a postponement of the 
effective date of that notice, until Treasury demonstrates to 
Congress the need for regulatory action and provides a specific 
regulatory proposal.
      

                                

Statement of INMC Mortgage Holdings, Inc.

    INMC Mortgage Holdings, Inc. appreciates the opportunity to 
respond to the Chairman's request for testimony to the 
Committee on Ways and Means on the revenue-raising provisions 
of the Clinton Administration's FY 1999 budget plan. We are 
testifying to express our strong opposition to the 
Administration's proposal to restrict businesses indirectly 
conducted by real estate investment trusts (REITs), in 
particular with respect to the portion of the proposal dealing 
with preferred stock subsidiaries.

                       Mortgage Conduit Business

    INMC Mortgage Holdings, Inc. (``INMC''), based in Pasadena, 
California, is the largest publicly traded mortgage REIT \1\ in 
terms of stock market capitalization. INMC is a diversified 
lending company with a focus on residential mortgage products, 
and is active in residential and commercial construction 
lending, manufactured housing lending, and home improvement 
lending. INMC is a NYSE-traded company with $6 billion in 
assets and 900 employees.
---------------------------------------------------------------------------
    \1\ A mortgage REIT invests primarily in debt secured by mortgages 
on real estate assets. An equity REIT, by contrast, invests primarily 
in equity or ownership interests directly in real estate assets.
---------------------------------------------------------------------------
    As one of its most important business activities, INMC and 
its affiliate, IndyMac, Inc., operate as one of only a small 
number of private ``mortgage conduits'' in this country. While 
small in number, mortgage conduits play a vital financing role 
in America's residential housing market, essentially acting as 
the intermediary between the originator of a mortgage loan and 
the ultimate investor in mortgage-backed securities (MBSs). The 
conduit first purchases mortgage loans made by financial 
institutions, mortgage bankers, mortgage brokers, and other 
mortgage originators to homebuyers and others. When a conduit 
has acquired sufficient individual loans to serve as collateral 
for a loan pool, it creates an MBS or a series of MBSs, which 
then is sold to investors through underwriters and investment 
bankers. After securitization, the conduit acts as a servicer 
of the loans held as collateral for the MBSs, meaning that the 
conduit collects the principal and interest payments on the 
underlying mortgage loans and remits them to the trustee for 
the MBS holders.
    Perhaps the best-known mortgage conduits are the 
government-owned Government National Mortgage Association 
(Ginnie Mae) and the government-sponsored Fannie Mae and 
Freddie Mac. These government sponsored enterprises (GSEs) act 
as conduits for loans meeting specified guidelines that pertain 
to loan amount, product type, and underwriting standards, known 
as ``conforming'' mortgage loans. Private conduits such as INMC 
play a similar role for ``nonconforming'' mortgage loans that 
do not meet GSE selection criteria. Mortgage loans purchased by 
INMC include nonconforming and jumbo residential loans, sub-
prime loans, manufacturing housing loans, and other mortgage-
related assets. Many of INMC's borrowers are low-income and 
minority consumers who are not eligible for programs currently 
offered by the GSEs or Ginnie Mae. In sum, INMC and its 
affiliate IndyMac, through their conduit activities, play a 
critical role in providing liquidity to our nation's housing 
markets.

                       INMC's Business Structure

    INMC's mortgage conduit business is conducted primarily 
through two entities: INMC itself (hereafter referred to as 
``IndyMac REIT'') and its taxable affiliate, IndyMac, Inc. 
(hereafter referred to as ``IndyMac Operating''). IndyMac REIT 
owns all of the preferred stock and 99 percent of the economic 
interest in IndyMac Operating, a C corporation. IndyMac 
Operating is thus a ``preferred stock'' affiliate of INMC that 
would be adversely impacted by one part of the Administration's 
REIT proposals.
    IndyMac REIT is the arm of the conduit business that 
purchases mortgage loans. IndyMac Operating is the arm of INMC 
that securitizes and services the loans acquired by IndyMac 
REIT and others. In order to control the interest rate risks 
associated with managing a pipeline of loans held for sale, 
IndyMac Operating also conducts hedging activities. In 
addition, IndyMac Operating performs servicing for all loans 
and MBSs owned or issued by it. IndyMac Operating is liable for 
corporate income taxes on its net income, which is derived 
primarily from gains on the sale of mortgage loans and MBSs and 
servicing fee income.
    Use of this ``preferred stock'' structure for conducting 
business is in part a product of the tax law. IndyMac REIT, by 
itself, effectively is unable to securitize its loans through 
the most efficient structure, a real estate mortgage investment 
conduit (``REMIC''). This is because the issuance of REMICs by 
a REIT in effect would be treated as a sale for tax purposes; 
such treatment in turn would expose the REIT to a 100-percent 
prohibited tax on ``dealer activity.'' In like fashion, IndyMac 
Operating would be unable to deduct certain hedging losses 
related to its loans held for sale. Similarly, we note that the 
ability to service a loan is critical to owning a loan, and 
that IndyMac REIT would be subject to strict and unworkable 
limits on engaging in mortgage servicing activities. Such 
activities would generate nonqualifying fee income under the 
95-percent REIT gross income test, \2\ potentially 
disqualifying IndyMac REIT from its status as a REIT. It is 
critical to keep in mind that all net income derived by IndyMac 
Operating from its business activities is subject to two tiers 
of taxation at state and federal levels.
---------------------------------------------------------------------------
    \2\ The 95-percent test generally limits REITS to receiving income 
that qualifies as rents from real property and, to a lesser degree, 
portfolio income.
---------------------------------------------------------------------------
    In business terms, INMC's use of the preferred stock 
structure aligns its ``core competencies,'' which has allowed 
it to compete in the mortgage conduit business. This alignment 
makes available the benefits of centralized management, lowers 
costs, provides operating efficiencies, and allows INMC to 
respond to market changes, such as trends toward 
securitization. It is important to note that INMC's structure 
does not involve the type of ``stapled REIT'' arrangement that 
has given rise to other legislative proposals advanced by 
Treasury.

               Impact of Administration Proposal on INMC

    The Administration's FY 1999 budget includes a proposal 
aimed at eliminating use of the preferred stock subsidiary 
structure. Specifically, the proposal would amend section 
856(c)(5)(B) of the Internal Revenue Code to prohibit REITs 
from holding stock possessing more than 10 percent of the vote 
or value of all classes of stock of a corporation.
    The Administration's FY 1999 budget proposal would force 
IndyMac REIT to reduce, to below 10 percent of value, its 
ownership of IndyMac Operating stock. This effectively would 
force INMC to end IndyMac REIT's preferred stock affiliation 
with IndyMac Operating.
    The proposal therefore would force INMC to consider less 
efficient structures, such as spinning off IndyMac Operating as 
a wholly separate entity. Conducting a mortgage conduit 
business through two unrelated companies would eliminate the 
benefits and efficiencies of centralized management. This split 
also potentially would lead to conflicts, as one company would 
be responsible for servicing loans on behalf of an unrelated 
MBS trustee that may have different interests. The result would 
be lower returns for INMC's investors and higher borrowing 
costs for the homeowners for whom INMC's mortgage conduit 
business has meant lower mortgage interest rates.
    The Treasury proposal also would jeopardize INMC's ability 
to compete in the mortgage business, which has hinged on its 
ability to align the two arms of its mortgage conduit business. 
In all likelihood, mortgage originators and other parties 
transacting in the mortgage conduit business would curtail 
significantly their business with INMC and other mortgage 
REITs. Moreover, partnerships would continue to be able to 
perform these activities and be subject to only one level of 
tax, giving them a significant competitive advantage. If the 
proposal were to be adopted, INMC might not be able to serve 
those borrowers ineligible for programs offered by the GSEs or 
Ginnie Mae.
    We also should note that the ``grandfather relief'' 
proposed by Treasury would not apply to INMC.\3\ Specifically, 
INMC would not be able to meet the requirement that IndyMac 
Operating could not acquire ``substantial new assets'' after 
the specified date. While IndyMac Operating is not an acquirer 
of companies or businesses, its securitization of an ever-
rotating pool of loans would appear to violate this test. If 
the proposal were to be adopted, one alternative grandfather 
test might involve a cap on total assets.
---------------------------------------------------------------------------
    \3\ The proposal would be effective with respect to stock acquired 
on or after the date of first committee action. Stock acquired before 
such date would become subject to the proposal when the corporation in 
which stock is owned engages in a trade or business in which it does 
not engage on the date of first committee action or if the corporation 
acquires substantial new assets on or after such date.
---------------------------------------------------------------------------

                      Treasury's Flawed Rationale

    Treasury's ``Green Book'' description of the 
Administration's FY 1999 budget states its reasoning behind the 
proposal. Treasury argues that a preferred stock subsidiary of 
a REIT often is significantly leveraged with debt held by the 
REIT; this generates interest deductions intended to eliminate, 
or significantly reduce, the taxable income of the affiliate 
corporation. Treasury also argues that the operating income of 
the corporation effectively is ``transmuted'' into interest 
paid to the REIT, and thus is not subject to corporate-level 
tax.
    INMC takes exception to these arguments. First, we believe 
the income-shifting argument is significantly overstated. The 
REIT rules strictly regulate the types and amount of income 
that may be earned by a REIT. INMC and others in the REIT 
industry are strongly discouraged from taking aggressive tax 
positions, given the severity of potential tax penalties, 
including loss of REIT status and the 100-percent prohibited 
transactions tax. Moreover, a recent Price Waterhouse LLP study 
found no evidence of transfer pricing abuse in situations where 
a REIT is ``paired'' with a management company, a situation 
similar to the combined activities of IndyMac REIT and IndyMac 
Operating. We believe Treasury should offer this reason for a 
legislative change only if it can document evidence, rather 
than perception, of abuse.
    Second, we reject Treasury's inference that preferred stock 
subsidiaries like IndyMac Operating are in existence primarily 
to be loaded up with debt. IndyMac Operating had pre-tax income 
of $32.7 million and $31.6 million in 1997 and 1996, 
respectively; tax liability of $13.9 million and $13.5 million 
in 1997 and 1996, respectively; and net income of $18.8 million 
and $18.1 million in 1997 and 1996, respectively. This 
aggregated to a return on equity of 34.4 percent and 36.4 
percent in 1997 and 1996, respectively.
    Moreover, IndyMac Operating is careful to use market-based 
rates for intercompany debt, and the vast majority of financing 
for IndyMac Operating comes from unrelated third-party lenders. 
INMC does not engage in earnings stripping because to do so 
would jeopardize INMC's status as a REIT.

                   Policy Objectives Underlying REITs

    The Administration proposal is fundamentally at odds with 
Congressional intent in enacting the REIT rules and updating 
them to respond to changing market realities.
    Congress enacted the REIT rules in 1960 to allow small 
investors the same access to real estate markets available to 
larger investors, just as regulated investment companies 
(mutual funds) allow small investors greater access to equity 
markets. Benefits of the REIT structure, as envisioned by 
Congress, included diversification of investments and thus 
minimization of risk, expert advice on investments, and means 
for individuals on a collective basis to finance larger 
projects.
    INMC's alignment of a REIT with a related active business 
is entirely consistent with these original policy goals. State-
of-the-art mortgage lending requires the use of all the tools 
and techniques available in the financial marketplace, 
including the use of hedging, securitization, and investment in 
derivative mortgage instruments such as mortgage servicing 
rights. Without access to these tools and techniques, a 
mortgage entity will not be able to maximize profits to its 
investors and will be exposed to a level of market risks to 
which other traditional and non-traditional lenders are not 
exposed. The result would be an entity that is inefficient in 
the marketplace and that ultimately will not be able to 
compete.
    Mortgage REITS also have helped to fill a significant void 
in the mortgage investment industry that GSEs have been unable 
to fill. The benefits of our business to American homeowners at 
all income levels and with a wider variety of credit histories 
should not be overlooked.

                            Recommendations

    As an initial matter, INMC respectfully urges the Congress 
to reject the Administration proposal to restrict businesses 
indirectly conducted by REITs. The proposal would penalize the 
investors whom the REIT provisions originally were enacted to 
benefit. The Administration prescribes an overly broad 
``remedy''--effectively banning the alignment of a REIT with a 
related active business--to address unfounded allegations of 
abuse relating to debt and income shifting. Moreover, the 
revenues estimated to be raised by the proposal (a total of $19 
million over the FY 1998-2003 period) are relatively small when 
judged against its harsh impact on our industry and the 
availability of financing to segments of the housing industry 
not currently served by GSEs.
    It seems to us that a more proper point of inquiry for the 
Congress, taking into account the original pro-shareholder 
objectives underlying enactment of the REIT provisions, would 
be to consider ways to facilitate the ability of REITs to 
compete. Indeed, the Congress has amended the REIT statute at 
least nine times since 1960--most recently in 1997--to reflect 
the dramatic changes that have taken place in the real estate 
marketplace.
    INMC strongly believes the REIT rules as they relate to our 
industry should encourage, rather than discourage, the 
alignment of a mortgage REIT with the core competencies of 
servicing and securitizing mortgage loans. We are prepared to 
work with Congress to develop solutions in this regard.
      

                                

Statement of the Service Bureau Consortium and the Interstate 
Conference of Employment Security Agencies

    The Interstate Conference of Employment Security Agencies 
(ICESA) is the national organization of state administrators of 
unemployment insurance, employment and training services, and 
labor market information programs. The Service Bureau 
Consortium (SBC) represents businesses providing payroll 
processing and employment tax services directly to employers. 
SBC members serve more than 600,000 employers and are 
responsible for more than one-third of the private sector 
payroll. Together, these organizations represent both those who 
collect UI taxes and those who process the tax payments.
    SBC and ICESA oppose the Administration's proposals to 
change the frequency of collections under the Unemployment Tax 
Act (``FUTA'') and believe that any restructuring of the FUTA/
State Unemployment Insurance (``SUI'') tax rules should only be 
considered in the context of broad-based UI programmatic 
reforms. Furthermore, we believe any reform of the UI system 
should include a streamlining of the FUTA/SUI collection 
system, thereby creating greater efficiencies and reduced costs 
for the federal and state governments and for employers.
    We are deeply concerned that the FUTA proposals contained 
in the Administration's FY 1999 budget would create substantial 
new burdens for both taxpayers and state government 
administrators. 

               The Administration's FY 1999 UI Proposals

    The Administration's FY 1999 budget would accelerate, from 
quarterly to monthly, the collection of most federal and state 
UI taxes beginning in the year 2004.
    Accelerating the collection of existing federal and state 
UI taxes is a device that generates a one-time artificial 
revenue increase for budget-scoring purposes and real, every 
year increases in both compliance costs for employers and 
collection costs for FUTA and SUI tax administrators. The 
Administration's proposal is fundamentally inconsistent with 
every reform proposal that seeks to streamline the operation of 
the UI system and with its own initiatives to reduce paperwork 
and regulatory burdens.
    The proposal would increase federal revenues in FY 2004, as 
taxes scheduled to be collected in FY 2005 are accelerated into 
the previous year.\1\ No new revenues would be collected by the 
federal or state governments by virtue of this proposal--the 
federal government would simply record, in FY 2004, revenues 
that would otherwise be received a year later.
---------------------------------------------------------------------------
    \1\ Ironically, the amount of revenue recorded through this one-
time accounting speed-up results from yet another budgeting device. 
State UI tax revenues are included as assets of the federal government 
for budget-scoring purposes, notwithstanding the fact that the federal 
government does not mandate the rate of this tax, collect it, or even 
have the right to use the proceeds. All state monies in these Trust 
Fund Accounts are automatically transferred back to the states to pay 
UI benefit obligations as they occur. In the interim, they cannot be 
used by the federal government for any other purpose.
---------------------------------------------------------------------------
    This proposal is even more objectionable than other tax 
speed-up gimmicks considered in the past. For example, 
proposals that might move an excise tax deposit date forward by 
one month into an earlier fiscal year make little policy sense, 
but also do not create major additional administrative burdens. 
This particular proposal would result directly in significant 
and continuing costs to taxpayers and to the federal and state 
governments. By tripling the number of required UI tax 
collection filings from 8 to 24 per affected employer each 
year, the proposal would substantially raise costs to employers 
and both federal and state UI tax administrators. Tripling the 
required number of deposits can only dramatically escalate the 
cost to employers inherent in the current separate FUTA/SUI 
quarterly collection practices--now estimated to cost employers 
up to $500 million a year.
    Furthermore, the one-time, budget score-keeping gain will 
be far more than offset by the real, every year administrative 
costs of additional FUTA tax collection to the IRS and SUI tax 
collection to the states. Monthly submission requirements can 
only increase the $100 million the IRS now receives annually 
from the UI trust funds to process and verify the quarterly 
FUTA deposits. In addition, since the federal government is 
required to reimburse states for their UI administrative costs, 
reimbursement of states for the added costs of monthly SUI 
collection is another hidden federal outlay cost in this ill-
conceived proposal.\2\ To the extent the federal government 
does not reimburse the states for these higher SUI collection 
costs, the states will experience yet another form of unfunded 
mandate.
---------------------------------------------------------------------------
    \2\ The Administration's budget does not appear to factor in such 
increased federal and state collection costs as an outlay offset to the 
increased FUTA revenues projected.
---------------------------------------------------------------------------
    The Administration implicitly recognizes that the added 
federal and state deposit requirements would be burdensome, at 
least for small business, since the proposal includes an 
exemption for certain employers with limited FUTA liability. 
Many smaller businesses that add or replace employees or hire 
seasonal workers would not qualify for the exemption since new 
FUTA liability accrues with each new hire, including 
replacement employees. Further, this new exemption would add 
still another distinction to the many already in the tax code 
as to what constitutes a ``small'' business. This deposit 
acceleration rule makes no sense for businesses large or small, 
and an exception for small business does nothing to improve 
this fundamentally flawed concept.

                               Conclusion

    UI reform should focus on simplifying the system, reducing 
the burden of our employers and reducing the costs of 
administration to federal and state governments. Adopting the 
revenue raising provisions in the Administration's FY 1999 
budget proposal would take the system in exactly the opposite 
direction, creating even greater burdens than the current 
system.
    We urge the Committee to reject the speed-up in collection 
of FUTA and SUI taxes proposed in the Administration's budget. 
Any consideration of tax collection issues should take place 
only in the context of system-wide reform. We believe that such 
consideration will demonstrate that FUTA/SUI tax collection 
should be simplified, not further complicated as the 
Administration has proposed.
      

                                
Statement of Investment Company Institute

    The Investment Company Institute (the ``Institute'') \1\ 
submits for the Committee's consideration the following 
comments regarding proposals to (1) exempt from withholding tax 
all distributions made to foreign investors in certain 
qualified bond funds, (2) enhance retirement security, (3) 
modify section 1374 of the Internal Revenue Code \2\ to require 
current gain recognition on the conversion of a large C 
corporation to an S corporation, and (4) increase the penalties 
under section 6721 for failure to file correct information 
returns.
---------------------------------------------------------------------------
    \1\ The Investment Company Institute is the national association of 
the American investment company industry. Its membership includes 6,860 
open-end investment companies (``mutual funds''), 441 closed-end 
investment companies and 10 sponsors of unit investment trusts. Its 
mutual fund members have assets of about $4.419 trillion, accounting 
for approximately 95% of total industry assets, and have over 62 
million individual shareholders.
    \2\ All references to ``sections'' are to sections of the Internal 
Revenue Code.
---------------------------------------------------------------------------

    I. Withholding Tax Exemption for Certain Bond Fund Distributions

Background

    Individuals around the world increasingly are turning to 
mutual funds to meet their diverse investment needs. Worldwide 
mutual fund assets have increased from $2.4 trillion at the end 
of 1990 to $7.2 trillion on September 30, 1997. This growth in 
mutual fund assets is expected to continue as the middle class 
continues to expand around the world and baby boomers enter 
their peak savings years.
    U.S. mutual funds offer numerous advantages that could be 
attractive to foreign investors. The expertise of the 
industry's portfolio managers and analysts, for example, could 
provide superior fund performance, particularly with respect to 
U.S. capital markets. Moreover, the U.S. securities laws 
provide strong shareholder safeguards that foster investor 
confidence in our funds.
    While the U.S. fund industry is the world's largest, with 
over half of the world's mutual fund assets, foreign investment 
in U.S. funds is low. Today, less than one percent of all U.S. 
fund assets are held by non-U.S. investors.
    One significant disincentive to foreign investment in U.S. 
funds is the manner in which the Code's withholding tax rules 
apply to distributions to non-U.S. shareholders from U.S. funds 
(treated for federal tax purposes as ``regulated investment 
companies'' or ``RICs''). Under U.S. law, foreign investors in 
U.S. funds receive less favorable U.S. withholding tax 
treatment than they would receive if they made comparable 
investments directly or through foreign funds. This withholding 
tax disparity arises because a U.S. fund's income, without 
regard to its source, generally is distributed as a 
``dividend'' subject to withholding tax.\3\ Consequently, 
foreign investors in U.S. funds are subject to U.S. withholding 
tax on distributions attributable to two types of income--
interest income (on ``portfolio interest'' obligations and 
certain other debt instruments) and short-term capital gains--
that would be exempt from U.S. withholding tax if received 
directly or through a foreign fund.
---------------------------------------------------------------------------
    \3\ Dividends paid to foreign investors are subject to U.S. 
withholding tax at a 30 percent rate, although that rate may be 
reduced, generally to 15 percent, by income tax treaty.
---------------------------------------------------------------------------
    A U.S. fund may ``flow through'' the character of the 
income it receives only pursuant to special ``designation'' 
rules in the Code. One such character preservation rule permits 
a U.S. fund to designate distributions of long-term gains to 
its shareholders (both U.S. and foreign) as ``capital gain 
dividends.'' As capital gains are exempt from U.S. withholding 
tax, foreign investors in U.S. funds are not placed at a U.S. 
tax disadvantage with respect to distributions of funds' long-
term gains.
    Legislation introduced in every Congress since 1991 would 
permit all U.S. funds also to preserve, for withholding tax 
purposes, the character of interest income and short-term gains 
that would be exempt from U.S. withholding tax if received by 
foreign investors directly or through a foreign fund. The 
Institute strongly supports these ``investment 
competitiveness'' bills.

Proposal

    Under the President's Fiscal Year 1999 budget proposal, 
distributions to foreign investors by a U.S. fund that invests 
substantially all of its assets in U.S. debt securities or cash 
generally would be treated as interest exempt from U.S. 
withholding tax. A fund's distributions would remain eligible 
for this withholding tax exemption if the fund invests some of 
its assets in foreign debt instruments that are free from 
foreign tax pursuant to the domestic laws of the relevant 
foreign countries. The taxation of U.S. investors in U.S. funds 
would not be affected by the proposal.
Recommendation 

    The Institute urges enactment of this proposal as an 
important first step toward eliminating all U.S. tax incentives 
for foreign investors to prefer foreign funds over U.S. funds. 
The imposition of U.S. withholding tax on distributions by U.S. 
funds, where the same income would be exempt from U.S. tax if 
the foreigners invested directly or through foreign funds, 
serves as a very powerful disincentive to foreign investment in 
U.S. funds. By providing comparable withholding tax treatment 
for our bond funds, the proposal would enhance the competitive 
position of U.S. fund managers and their U.S.-based work force.
    As noted above, the Administration's proposal would exempt 
from U.S. withholding tax distributions by a U.S. fund that 
also holds some foreign bonds that are free from foreign tax 
under the laws of the relevant foreign countries. This is in 
recognition of the fact that U.S.-managed bond funds may hold 
some foreign bonds. These can include ``Yankee Bonds,'' which 
are U.S. dollar-denominated bonds issued by foreign companies 
that are registered under the U.S. securities laws for sale to 
U.S. investors, and other U.S. dollar-denominated bonds that 
may be held by U.S. investors (e.g., ``Eurobonds''). The 
Institute urges appropriate standards ensuring that U.S. funds 
seeking foreign investors may continue to hold them.
    The Institute supports drawing a distinction between a 
foreign bond (such as a Yankee Bond or a Eurobond) that is 
exempt from foreign withholding tax under the domestic law of 
the relevant foreign country and one that is exempt only 
pursuant to an income tax treaty with the U.S. By treating 
investments in foreign bonds that are exempt from withholding 
tax pursuant to treaty as ``nonqualifying'' for purposes of the 
``substantially all'' test, the proposal prevents foreign 
investors from improperly taking advantage of the U.S. treaty 
network.

                  II. Retirement Security Initiatives

    The U.S. mutual fund industry serves the needs of American 
households saving for their retirement and other long-term 
financial goals. By permitting millions of individuals to pool 
their savings in a diversified fund that is professionally 
managed, mutual funds provide an important financial management 
role for middle-income Americans.\4\ Mutual funds also serve as 
the investment medium for employer-sponsored retirement 
programs, including small employer savings vehicles like the 
new Savings Incentive Match Plan for Employees (``SIMPLE'') and 
section 401(k) plans, and for individual savings programs such 
as the traditional and Roth IRAs. As of December 31, 1996, 
mutual funds held over $1.24 trillion in retirement assets.\5\
---------------------------------------------------------------------------
    \4\ An estimated 37 million households, representing 37% of all 
U.S. households, owned mutual funds in 1996.  See Brian Reid, ``Mutual 
Fund Developments in 1996,'' Perspective, Vol. 3, No. 1 (Investment 
Company Institute, March 1997).
    \5\ Reid and Crumrine, Retirement Plan Holdings of Mutual Funds, 
1996. (Investment Company Institute, 1997).
---------------------------------------------------------------------------
    The Institute has long supported legislative efforts to 
enhance retirement savings opportunities for Americans. It 
strongly advocates legislation to increase small employer 
retirement plan coverage and make retirement savings more 
portable, thus enabling Americans to more easily manage their 
retirement savings. Our prescriptions for attaining these 
goals, however, differ in some respects from the 
Administration's.

A. Small Employer Retirement Plan Coverage

    Background.--Retirement plan coverage is a matter of 
serious public concern. Coverage rates remain especially low 
among small employers. Less than one-half of employers with 25 
to 100 employees sponsored retirement plans. More starkly, 
under 20 percent of employers with fewer than 25 employees 
offer their employees a retirement plan.\6\ The enactment of 
legislation creating SIMPLE plans was a major first step toward 
improving coverage, but more remains to be done.
---------------------------------------------------------------------------
    \6\ In 1993, the most recent year for which data is available, only 
19 percent of employers with fewer than 25 employees sponsored a 
retirement plan. EBRI Databook on Employee Benefits. Employee Benefit 
Research Institute, 1997.
---------------------------------------------------------------------------
    Recommendations.--Congress should (1) improve the SIMPLE 
plan program for small employers by raising the salary deferral 
limitation, (2) eliminate or modify regulations, such as the 
``top-heavy'' rule, that continue to retard small employer plan 
formation and (3) assure that new small employer plan 
initiatives provide effective incentives for plan establishment 
and do not undermine currently successful programs.
    1. Raise the SIMPLE Plan Deferral Limitation.--In 1996, 
Congress created the successful SIMPLE program. The SIMPLE is a 
simplified defined contribution plan available to small 
employers with fewer than 100 employees. In just the first 
seven months of its availability, an Institute survey of its 
largest members found that no less than 18,250 SIMPLE plans had 
been established, covering over 95,000 employees. Virtually all 
(97 percent) SIMPLE plan formation is among the smallest of 
employers--those with fewer than 25 employees. Indeed, 
employers with 10 or fewer employees established about 87 
percent of these plans. For the first time, significant numbers 
of small employers are able to offer and maintain a retirement 
plan for their employees.
    Presently, however, an employee working for an employer 
offering the SIMPLE may save only up to $6,000 annually in his 
or her SIMPLE account. Yet, an employee in a 401(k) plan, 
typically sponsored by a mid-size or larger employer, is 
permitted to contribute up to $10,000. Congress can readily 
address this inequity by amending the SIMPLE program to permit 
participating employees to defer up to $10,000 of their salary 
into the plan, that is, up to the limit set forth at section 
402(g) of the Internal Revenue Code. This change would enhance 
the ability of many individuals to save for retirement and, 
yet, would impose no additional costs on small employers 
sponsoring SIMPLEs.
    2. Reduce Unnecessary, Costly Regulations, Such as The Top-
Heavy Rule, That Retard Small Employer Plan Formation.--
Congress could raise the level of small employer retirement 
plan formation if it reduced the cost of plan formation and 
maintenance. One way to reduce these costs is for the federal 
government to subsidize them. The Administration has proposed a 
``start-up tax credit'' for small employers that establish a 
retirement plan in 1999. Such a tax incentive may induce 
certain small employers to establish retirement plans.
    Another approach would be to seek the actual reduction of 
on-going plan costs attributed to regulation. For example, 
repeal or modification of the ``top-heavy'' rule \7\ may lead 
to more long-term plan formation than a one-time tax credit 
program. A 1996 U. S. Chamber of Commerce survey showed that 
the top-heavy rule is the most significant regulatory 
impediment to small businesses establishing a retirement 
plan.\8\
---------------------------------------------------------------------------
    \7\ Section 416 of the Internal Revenue Code. The top-heavy rule 
looks at the total pool of assets in a plan to determine if too high a 
percentage (more than 60 percent) of those assets represent benefits 
for ``key'' employees. If so, the employer is required to (1) increase 
the benefits paid to non-key employees, and (2) accelerate the plan's 
vesting schedule. Small businesses are particularly effected by this 
costly rule, because ``key'' employees include individuals with an 
ownership interest in the company. Small businesses are more likely to 
have concentrated ownership and individuals with ownership interests 
working at the company and in supervisory or officer positions, each of 
which exacerbates the impact of the rule.
    \8\ Federal Regulation and Its Effect on Business--A Survey of 
Business by the U.S. Chamber of Commerce About Federal Labor, Employee 
Benefits, Environmental and Natural Resource Regulations, U.S. Chamber 
of Commerce, June 25, 1996.
---------------------------------------------------------------------------
    Finally, Congress certainly should avoid discouraging plan 
formation by adding to the cost of retirement plans. Thus, the 
Institute strongly urges that Congress not enact the 
Administration's recommendation that a new mandatory employer 
contribution be required of employers permitted to use design-
based safe harbor formulas in their 401(k) plans beginning in 
1999.
    3.  New Programs For Small Employers Should Provide 
Effective Incentives For Plan Establishment and Not Undermine 
Currently Successful Programs.--The Administration has also 
proposed enhancing the ``payroll deduction IRA'' program and 
creating a new simplified defined benefit plan program for 
small employers. In considering these proposals, it is 
important to assure that incentives are appropriately designed 
to induce program participation and that the programs do not 
undermine current retirement plan options.
    For instance, the Administration would create an additional 
incentive to use the payroll deduction IRA program by excluding 
payroll deduction contributions from an employee's income. 
Accordingly, they would not be reported on the employee's Form 
W-2. As the success of the 401(k) and SIMPLE programs 
demonstrate, payroll deduction provides an effective, 
disciplined way for individuals to save, and its encouragement 
is a laudable policy goal. However, simplifying tax reporting 
may not add sufficient incentive for employers to establish a 
payroll deduction IRA program. More importantly, the 
interaction of an expanded payroll deduction IRA program with 
the new and successful SIMPLE program should be carefully 
considered. As noted above, the SIMPLE plan program has been 
extremely attractive to the smallest employers, exactly those 
for whom a payroll deduction IRA program is designed. Any new 
program expansion should not undermine already existing, 
successful small employer programs. Because the maximum IRA 
contribution amount is $2,000 (an amount not increased since 
1981), it may not be appropriate to induce small employers to 
use that program rather than the popular SIMPLE program, which 
would permit employees a larger plan contribution. Similar 
considerations should be made with regard to any simplified 
defined benefit program.

B. Retirement Account Portability

    Background.--Because average job tenure at any one job is 
under 5 years,\9\ individuals are likely to have at least 
several employers over the course of their careers. As a 
result, the portability of retirement plan assets is an 
important policy goal. The Administration advocates an 
accelerated vesting schedule for 401(k) plan matching 
contributions to address this issue. Consideration should be 
given to a broader approach to portability that would enhance 
the ability of all individuals to move their account balances 
from employer to employer when they change jobs.
---------------------------------------------------------------------------
    \9\ The Changing World of Work and Employee Benefits, Employee 
Benefit Research Institute, Issue Brief No. 172 (April 1996).
---------------------------------------------------------------------------
    Under current law, an individual moving from one private 
employer to another, where both employers provide section 
401(k) plan coverage, generally may roll over his or her vested 
account balance to the new employer. Where an individual moves 
from a private employer to a university or hospital or to the 
government sector, however, such account portability is not 
permitted. The problem arises because each type of employer has 
its own separate type of tax-qualified individual account 
program. Neither the university's section 403(b) program nor 
the governmental employer's ``457 plan'' program may accept 
401(k) plan money, and vice versa. Moreover, with the exception 
of ``conduit IRAs,'' moving IRA assets into an employer-
sponsored plan is prohibited.
    Recommendation.--Legislation to permit portability amongst 
these retirement plans would enable individuals to bring 
retirement savings with them when they change jobs, consolidate 
accounts and more readily manage retirement assets. Congress 
should amend the tax laws pertaining to all individual account-
type retirement plans to permit individuals to roll over 
retirement account balances as they move from employer to 
employer, regardless of the nature of the employer.

C. Variable Annuities

    Background.--The Administration has proposed imposing new 
taxes on the owners of variable annuity contracts. Proposals 
include taxing owners upon the exchange of one contract for 
another and in the event of a reallocation of contract savings 
from one investment option to another under the variable 
annuity contract.
    Recommendation.--The Institute opposes these proposals, 
because they would tax many individuals who save for retirement 
through variable annuities.

       III. Conversions of Large C Corporations to S Corporations

Background

    Section 1374 generally provides that when a C corporation 
converts to an S corporation, the S corporation will be subject 
to corporate level taxation on the net built-in gain on any 
asset that is held at the time of the conversion and sold 
within 10 years. In Notice 88-19, 1988-1 C.B. 486, the IRS 
announced that regulations implementing repeal of the so-called 
General Utilities doctrine would be promulgated under section 
337(d) to provide that section 1374 principles, including 
section 1374's ``10-year rule'' for the recognition of built-in 
gains, would be applied to C corporations that convert to 
regulated investment company (``RIC'') or real estate 
investment trust (``REIT'') status.
    Notice 88-19 was supplemented by Notice 88-96, 1988-2 C.B. 
420, which states that the regulations to be promulgated under 
section 337(d) will provide a safe harbor from the recognition 
of built-in gain in situations in which a RIC fails to qualify 
under Subchapter M for one taxable year and subsequently 
requalifies as a RIC. Specifically, Notice 88-96 provides a 
safe harbor for a corporation that (1) immediately prior to 
qualifying as a RIC was taxed as a C corporation for not more 
than one taxable year, and (2) immediately prior to being taxed 
as a C corporation was taxed as a RIC for at least one taxable 
year. The safe harbor does not apply to assets acquired by a 
corporation during the C corporation year in a transaction that 
results in its basis in the assets being determined by 
reference to a corporate transferor's basis.
Proposal 

    The President's Fiscal Year 1999 budget proposes to repeal 
section 1374 for large corporations. For this purpose, a 
corporation is a large corporation if its stock is valued at 
more than five million dollars at the time of the conversion to 
an S corporation. Thus, a conversion of a large C corporation 
to an S corporation would result in gain recognition both to 
the converting corporation and its shareholders. The proposal 
further provides that Notice 88-19 would be revised to provide 
that the conversion of a large C corporation to a RIC or REIT 
would result in the immediate recognition of the corporation's 
net built-in gain. Thus, the Notice, if revised as proposed, 
would no longer permit a large corporation that converts to a 
RIC or REIT to elect to apply rules similar to the 10-year 
built-in gain recognition rules of section 1374.

Recommendation

    Because the safe harbor set forth in Notice 88-96 is not 
based upon the 10-year built-in gain rules of section 1374, the 
repeal of section 1374 for a large C corporation should have no 
effect on Notice 88-96. The safe harbor is based on the 
recognition that the imposition of a significant tax burden on 
a RIC that requalifies under Subchapter M after failing to 
qualify for a single year would be inappropriate. Moreover, the 
imposition of tax in such a case would fall directly on the 
RIC's shareholders, who are typically middle-class investors.
    The Institute understands from discussions with the 
Treasury Department that the proposed revision to section 1374 
and the related change to Notice 88-19 are not intended to 
impact the safe harbor provided by Notice 88-96.
    Should the Congress adopt this proposal, the Institute 
recommends that the legislative history include a statement, 
such as the following, making it clear that the proposed 
revision to section 1374 and the related change to Notice 88-19 
would not impact the safe harbor set forth in Notice 88-96 for 
RICs that fail to qualify for one taxable year:
    This provision is not intended to affect Notice 88-96, 
1988-2 C.B. 420, which provides that regulations to be 
promulgated under section 337(d) will provide a safe harbor 
from the built-in gain recognition rules announced in Notice 
88-19, 1988-1 C.B. 486, for situations in which a RIC 
temporarily fails to qualify under Subchapter M. Thus, it is 
intended that the regulations to be promulgated under section 
337(d) will contain the safe harbor described in Notice 88-96.

IV. Increased Penalties for Failure to File Correct Information Returns

Background

    Current law imposes penalties on payers, including RICs, 
that fail to file with the Internal Revenue Service (``IRS'') 
correct information returns showing, among other things, 
payments of dividends and gross proceeds to shareholders. 
Specifically, section 6721 imposes on each payer a penalty of 
$50 for each return with respect to which a failure occurs, 
with a maximum penalty of $250,000.\10\ The $50 penalty is 
reduced to $15 per return for any failure that is corrected 
within 30 days of the required filing date and to $30 per 
return for any failure corrected by August 1 of the calendar 
year in which the required filing date occurs.
---------------------------------------------------------------------------
    \10\ Failures attributable to intentional disregard of the filing 
requirement are generally subject to a $100 per failure penalty that is 
not eligible for the $250,000 maximum.

---------------------------------------------------------------------------
Proposal

    The President's Fiscal Year 1999 budget contains a proposal 
which would increase the $50-per-return penalty for failure to 
file correct information returns to the greater of $50 per 
return or five percent of the aggregate amount required to be 
reported correctly but not so reported. The increased penalty 
would not apply if the total amount reported for the calendar 
year was at least 97 percent of the amount required to be 
reported.

Recommendation

    The Institute opposes the proposal to increase the penalty 
for failure to file correct information returns. Information 
reporting compliance is a matter of serious concern to RICs. 
Significant effort is devoted to providing the IRS and RIC 
shareholders with timely, accurate information returns and 
statements. As a result, a high level of information reporting 
compliance is maintained within the industry.
    The Internal Revenue Code's information reporting penalty 
structure was comprehensively revised by Congress in 1989 to 
encourage voluntary compliance. Information reporting penalties 
are not designed to raise revenues.\11\ The current penalty 
structure provides adequate, indeed very powerful, incentives 
for RICs to promptly correct any errors made.


----------
    \11\ In the Conference Report to the 1989 changes, Congress 
recommended to IRS that they ``develop a policy statement emphasizing 
that civil tax penalties exist for the purpose of encouraging voluntary 
compliance.'' H.R. Conf. Rep. No. 386, 101st Cong., 1st Sess. 661 
(1989).
      

                                

Statement of Joint Venture's Council on Tax and Fiscal Policy

Reasons Why the Export Source Rule Should Not Be Replaced with an 
Activity-Based Rule \1\

                           Executive Summary

    High-technology industries comprise integrated industries 
with numerous companies occupying critical niches. Product 
cycles of 1-5 years are not uncommon and successful companies 
at each stage of the high-tech food chain must adapt and 
constantly improve their product lines. As these cycles repeat 
and new products and markets are created, residual markets from 
prior product cycles remain and as a result, the absolute 
market size and opportunity increases.
---------------------------------------------------------------------------
    \1\ These comments were prepared by Tax Policy Group member Bill 
Barrett, Director: Tax, Export & Customs, Applied Materials, Inc. These 
comments are an updated version of comments on this proposal that were 
submitted to the Senate Finance Committee in April 1997.
---------------------------------------------------------------------------
    High-tech industries are heavily export oriented. Recent 
statistics show that Silicon Valley's exports grew 9 percent in 
1996 to $39.7 billion. For many Silicon Valley companies, 
exports exceed 50 percent of total sales. Much of this exported 
product is manufactured in the United States and because of the 
nature of high-tech industries and their product cycles, a 
tremendous amount of research and development accompanies the 
manufacturing function. The linkage between research and 
manufacturing is very strong within high-tech industries.
    The export source rule helps to mitigate the double 
taxation faced by many U.S. exporters when income is taxed both 
in the United States and in a foreign country, and as a result, 
can have a direct effect on a high-tech company's global tax 
burden. The export source rule only applies when goods are 
manufactured in the United States and exported. In high tech 
industries, significant U.S. research and research related jobs 
accompany the U.S. manufacturing function. Repeal of the export 
source rule would place upward pressure on the after tax cost 
of performing the manufacturing and related research activity 
in the United States.
    Capital investment decision-making is influenced by both 
tax and non-tax factors. However, as global infrastructure and 
education levels improve, non-tax factors become increasingly 
less important in the capital investment decision-making and, 
therefore, U.S. tax laws that increase the after-tax cost of 
doing business could have a profound impact on location of 
investment. This will in turn have a direct impact on exports 
and export-related jobs not only for companies that respond 
quickly to after-tax returns, but also supplier companies that 
support the U.S. manufacturing and research activities. The 
various sectors within high-tech industries tend to be very 
closely linked and interdependent so that investment decisions 
by one sector will have a multiplier effect on where future 
geographic income will be earned.
    U.S. high-tech industries are innovative, highly 
profitable, drive academic institution curriculum and 
excellence, produce high-paying jobs, produce a tremendous 
volume of exports, and serve as a model to the world. Repeal of 
the export source rule would serve to discourage these U.S.-
based activities.

Marketing and Sales, Not Tax, Drives Multinational Corporate Structures

    A Silicon Valley high-tech start up company begins with an 
innovative idea. This idea may or may not have large market 
potential in the early life cycle of the company. Those 
companies destined to become successful will either have a 
product that is ready for the current market[s] or the product 
idea will create a new market. High-tech products change every 
1-5 years because industry innovation and global markets are 
constantly evolving. Successful companies at each stage of the 
high-tech food chain must adapt and constantly improve their 
product lines. High-tech companies that do not adapt or evolve 
their product lines do not survive.
    High-technology represents integrated industries with 
numerous companies occupying critical niches. For example, 
semiconductor equipment companies supply the semiconductor chip 
companies and the chipmakers in turn provide the means for 
computers to perform complex software functions ranging from 
number crunching to multimedia. The explosion of the Internet 
and networking companies that link computers has been a more 
recent evolution in high-tech industries. Computer software 
companies have been both pushing the semiconductor industry as 
well as adapting new software applications to existing computer 
capability. At each component stage, companies must keep pace 
with evolution and product cycles to survive. As these cycles 
repeat and new products and markets are created, residual 
markets from prior product cycles remain and as a result, the 
absolute market size and opportunity increases.
    The profile of a high-tech multinational company is no 
different from the above description, but for the fact that it 
either competes in or develops markets in multiple countries. 
To be successful in countries outside the U.S., the 
multinational must understand different markets and adapt its 
corporate structure to accommodate those markets. A not 
uncommon profile as product lines evolve and/or the 
multinational adapts to foreign markets, is that specific 
segments of manufacturing may be located offshore.\2\ These 
segments may be older product lines or components of a product 
that are produced more efficiently offshore. In most cases, 
newer product lines, and the requisite research and development 
remain in the U.S. and close to development centers.
---------------------------------------------------------------------------
    \2\ A successful company locates offshore to increase its global 
sales revenue and market share. Often, this raison d'etre is lost in 
political rhetoric. If a company is less competitive in the global 
marketplace (i.e., does not increase its global market share) because 
of higher tax rates, that company will naturally evaluate where it 
places manufacturing and R&D capability. Similarly, import tariffs will 
influence global investment patterns. For example, the European Union 
in 1992 effectively placed a European manufacturing content requirement 
through imposition of duties on non-European manufactured 
semiconductors. United States and Asian semiconductor manufacturers now 
dominate the European semiconductor industry, which illustrates how 
investment decisions can be altered to reduce government imposed costs 
of doing business.
---------------------------------------------------------------------------
    Silicon Valley high-tech companies do not structure their 
global operations solely on the basis of local country tax 
rates. For example, as high-tech product lines mature, 
investment in alternate manufacturing sites is a natural 
process of growth and diversification of risk. However, this 
statement should not be interpreted to mean tax rates do not 
play a significant role. An increase in U.S. tax increases the 
cost of business in the U.S. and if a company is to maintain an 
after-tax shareholder return, it must evaluate lower cost site 
locations. Popular rhetoric often characterizes U.S. industries 
as intent on the wholesale migration of manufacturing to 
offshore locations with the sole purpose of minimizing 
corporate income tax when in reality, companies are trying to 
remain competitive in a global market and taxes represent only 
one, albeit a significant, cost of doing business.
    An analysis of a new manufacturing location will involve a 
comparison of factors, such as the following:
     Labor skills, consistent with the demands of 
product technical requirements.
     Labor productivity.
     Cost of labor.
     Cost of land and construction costs.
     Financial and physical infrastructure (e.g., 
highway and airport).
     Proximity to customers and the market.
     Protection of intellectual property.
     Tax rates.
    In reviewing this list, the superordinate goal of 
generating additional sales revenue and global market share may 
be overlooked. Any successful high-tech company is in the 
business of selling product and increasing financial return to 
its investors and when tax rates reduce potential return, they 
play an increased role in the decision-making process. A 
company that makes sensible investment decisions based on 
after-tax returns that improve the ability to competitively 
price product stands a good chance to improve its market share.

   There are Fundamental Flaws in the Administration's Export Source 
                                Proposal

    President Clinton's FY 1999 budget proposal contains a 
provision that would eliminate the export source rule, which 
allows 50 percent of the income from the sale of goods 
manufactured in the U.S. and exported to be considered 
``foreign source income.'' The proposal would instead source 
income from export sales under an ``activity based'' standard--
effectively eliminating the export source rule. ``Activity 
based'' sourcing is not defined in the proposal, but might be 
patterned after a current income tax regulation example.\3\ For 
U.S. exporters with excess foreign tax credits, the export 
source rule alleviates double taxation, and thereby operates as 
an export incentive for U.S. multinationals. The foreign source 
income rule only applies if companies manufacture goods in the 
U.S. and export them. In the case of high-tech companies this 
usually means the company is also performing substantial R&D in 
the U.S.
---------------------------------------------------------------------------
    \3\ Treas. Reg. Sec. 1.863-3(b)(2) Ex. 1. The Tax Court in both 
Phillips Petroleum Co., 97 T.C. 30 (1991) and Intel Corp., 100 T.C. 616 
(1993), found that the fact pattern in the regulations example did not 
apply to the facts of these cases. The facts in these cases are typical 
of most exporters and therefore, under current law ``activity based'' 
sourcing as described in Example 1 would rarely produce any foreign 
source income. The result, using an ``activity based'' model, would be 
zero percent foreign source income on exported U.S. manufactured 
product, which increases the global tax burden on this income.
---------------------------------------------------------------------------
    The Administration makes the following argument in support 
of repeal:
    The existing 50/50 rule provides a benefit to U.S. 
exporters that also operate in high-tax foreign countries. 
Thus, U.S. multinational exporters have a competitive advantage 
over U.S. exporters that conduct all their business activities 
in the United States.\4\
---------------------------------------------------------------------------
    \4\ General Explanations of the Administration's Revenue Proposals, 
February 1998, page103; http://www.ustreas.gov/press/releases/
grnbk98.htm.
---------------------------------------------------------------------------
    There are at least three flaws in this argument. First, 
companies without foreign operations do not face the double 
taxation the export source rule is designed to alleviate. Thus, 
the rule does not create a competitive advantage; instead, it 
levels the playing field. Double taxation increases the cost of 
doing business offshore and therefore, the multinational with 
foreign operations becomes less competitive without benefit of 
the foreign source income rule. Second, a company without 
foreign operations may be a start-up that has not entered 
global markets. This new company cannot be compared to a large 
and well-established multinational. As the new company grows 
into global markets, it too will benefit from the export source 
rule. Finally, the argument in favor of eliminating the foreign 
source income rule fails to take into account additional [non-
tax] expenses that will be incurred by the multinational with 
foreign operations. Selling, marketing, administrative expenses 
associated with a foreign location, and product adaptation to 
local market, all must be incurred to support the local market. 
The conclusion is inescapable that establishing foreign 
operations will produce additional operating costs. Although 
operating costs will increase with foreign operations, the 
reality is that a U.S. manufacturing company cannot compete for 
global market share without establishing offshore operations. 
The resulting increased global market share increases high--
paying R&D and manufacturing jobs in the U.S.

       Tax Treaties are No Substitute for the Export Source Rule

    The Administration has stated that the United States income 
tax treaty network protects export sales income from tax in the 
foreign country where the goods are sold and thus, protects 
companies from double taxation. Treasury argues that the export 
source rule is no longer necessary as a result of this treaty 
protection.
    The tax treaty network is not a substitute for the export 
source rule, but even if it was, the treaty network is far from 
complete. The U.S. treaty network is limited to 56 countries, 
leaving many more countries (approximately 170) without 
treaties with the U.S. Moreover, many of the countries without 
treaties are developing countries, which are frequently high-
growth markets for American exporters. For example, the U.S. 
has no treaty with any Central or South American country.
    With or without a tax treaty, under most foreign countries' 
tax laws, the mere act of selling goods into the country, 
absent other factors such as having a sales or distribution 
office, does not subject the United States exporter to income 
tax in the foreign country. Thus, export sales are not the 
primary cause of the excess foreign tax credit problem that 
many companies face in trying to compete overseas.
    The real reason most multinational companies face double 
taxation is that U.S. tax provisions unfairly restrict their 
ability to credit foreign taxes paid on these overseas 
operations against their U.S. taxes. Requirements to allocate a 
portion of the costs of U.S. borrowing and research activities 
against foreign source income (even though such allocated costs 
are not deductible in any foreign country), cause many 
companies to have excess foreign tax credits, thereby 
subjecting them to double tax, i.e., taxation by both the U.S. 
and the foreign jurisdiction.
    As previously explained, the export source rule alleviates 
double taxation by allowing companies who manufacture goods in 
the United States for export abroad to treat 50 percent of the 
income as ``foreign source,'' thereby increasing their ability 
to utilize their foreign tax credits. Thus, the rule encourages 
these companies (facing double taxation as described above) to 
produce goods in the U.S. for export abroad.
    As an effective World Trade Organization-consistent export 
incentive, the export source rule is needed now more than ever 
to support quality, high-paying jobs in U.S. export 
industries.\5\ Exports have provided the spark for much of the 
growth in the U.S. economy over the past decade. Again, the 
existence of tax treaties does nothing to change the importance 
of this rule to the U.S. economy.
---------------------------------------------------------------------------
    \5\ Studies have shown that average exporting plants have higher 
blue-collar and white-collar wages, and that average workers at 
exporting plants have higher benefits. J. David Richardson and Karin 
Rindal, Why Exports Matter: More!, The Institute for International 
Economics and The Manufacturing Institute, February 1996, page 11.
---------------------------------------------------------------------------
    The decision to allow 50 percent of the income from export 
sales to be treated as ``foreign source'' was in part a 
decision based upon administrative convenience to minimize 
disputes over exactly which portion of the income should be 
treated ``foreign'' and which should be ``domestic.'' The rule 
still serves this purpose, and neither the tax treaty network 
nor the Administration's proposal to adopt an ``activities-
based'' test for determining which portion of the income is 
``foreign'' and which is ``domestic'' addresses this problem. 
Moreover, adopting an ``activities-based'' rule would create 
endless factual disputes similar to those under the Section 482 
transfer pricing regime.
    Tax treaties are critically important in advancing the 
international competitiveness of U.S. companies' global 
operations and trade. In order to export effectively in the 
global marketplace, most companies must eventually have 
substantial operations abroad in order to market, service or 
distribute their goods. Tax treaties make it feasible in many 
cases for business to invest overseas and compete in foreign 
markets. Foreign investments by U.S.-based multinationals 
generate substantial exports from the United States. These 
foreign operations create a demand for U.S. manufactured 
components, service parts, technology, etc., while also 
providing returns on capital in the form of dividends, interest 
and royalties.
    Tax treaties are not a substitute for the export source 
rule. They do not provide an incentive to produce goods in the 
United States. Nor do they address the most significant 
underlying cause of double taxation--arbitrary allocation 
rules--or provide administrative simplicity in allocating 
income from exports.

   Capital Export Neutrality Model As A Guide For Tax Simplification

    In an ideal income tax system, income tax would not 
influence how a company structures transactions or where the 
company decides to build a manufacturing plant. Investment 
decisions would be influenced by other economic factors such as 
those listed above. To eliminate income tax from the investment 
location decision it would be necessary to structure the system 
such that the global tax rate on income earned anywhere in the 
world is no different than the domestic rate of tax. A system 
patterned after the ``capital export neutrality'' (CEN) concept 
would achieve this result.\6\
---------------------------------------------------------------------------
    \6\ CEN is also referred to as a classical tax system. In addition 
to the United States, Japan and the United Kingdom loosely base their 
tax systems on this concept. An alternative concept is ``capital import 
neutrality'' (CIN). Under CIN, the global rate of tax on foreign income 
does not exceed the foreign tax rate. In other words, under CIN income 
earned outside the home country is not taxed in the home country when 
received as a dividend or when the foreign operation is sold. 
``Territorial'' based tax systems are patterned after the CIN concept. 
The Netherlands and France apply the ``territorial'' concept. Germany, 
Canada, and Australia apply the concept pursuant to income tax treaty 
with certain trading partners. For a detailed description of these 
principles, see Factors Affecting The International Competitiveness Of 
the United States, prepared by the Joint Committee on Taxation (JCS-6-
91), Part 2. III.
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    The CEN concept holds that an item of income, regardless of 
where it is earned, will not suffer a global rate of tax higher 
than the U.S. tax rate. Dividends received from both high and 
low tax countries suffer a double rate of tax first in the 
country in which the income was earned and second in the United 
States when received. The credit for foreign tax paid is 
designed to mitigate this double taxation. The export source 
rule operates to increase the credit for foreign taxes paid 
which in turn operates to more closely align the United States 
tax system with the concept of CEN. With sufficient foreign 
source income, the global rate of income tax on income earned 
in high tax countries approaches 35 percent.
    A classical tax system that diverges from the CEN concept 
will increase the importance of income tax in plant location 
decision-making. If the foreign source income rule is repealed, 
the double taxation of U.S. multinationals that export from the 
United States will increase and for many high-tech companies 
this increase in taxes, and corresponding reduction in return 
to shareholders, will alter plant investment decisions. Many 
companies will be forced to invest offshore rather than build 
new plants in the U.S. to remain competitive and maintain 
shareholder rate of return. Foreign investment decisions will 
have a ripple effect within high-tech industries because they 
are so closely interrelated. For example, a natural consequence 
of additional offshore investment by a semiconductor 
manufacturer will be that equipment suppliers will increase 
their offshore presence to meet the demands of their customers. 
This dynamic will be repeated in other industry segments 
creating a foreign investment multiplier effect.

 The Proposal Would Tend To Encourage Manufacturing Outside of the U.S.

    The elimination or scale back of the foreign source income 
rule will have a negative tax impact on U.S. multinationals 
that export U.S. manufactured product. For many companies this 
will result in a tax disincentive to manufacture in the U.S. 
vis-a-vis other countries with lower tax rates and is contrary 
to a ``capital export neutrality'' model, which holds that 
income tax should play a minor role in plant location decision-
making. Repeal of the foreign source income rule would elevate 
the importance of taxes in offshore plant location decision-
making and is contrary to tax simplification within a ``capital 
export neutral'' model.\7\
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    \7\ As income earned offshore increases as a result of additional 
foreign plant investment, history suggests complicated tax laws will be 
introduced in an attempt to tax this income before it is remitted back 
to the U.S., contrary to efforts towards a more simplified income tax 
mode. PFIC and subpart F, as it relates to operating income earned from 
related party sales, are examples of this type of legislation.
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                                Summary

    United States high-tech industries are innovative, highly 
profitable, drive academic institution curriculum and 
excellence, produce high-paying jobs, produce a tremendous 
volume of exports, and serve as a model to the world.\8\ U.S. 
government policies that discourage these U.S.-based activities 
risk impeding very desirable attributes and drivers in the U.S. 
economy. Government policies that encourage these attributes 
will obviously promote these attributes. Therefore, the 
Administration's export sourcing proposal should not be 
enacted.
---------------------------------------------------------------------------
    \8\ Studies have documented the impact exports have in job 
creation. Hufbauer and DeRosa project that in 1999, exports will 
increase $30.8 billion and $2.3 billion of additional wage income. In 
addition, the effect of the rule and the exports it generates will 
support 360,000 workers in export-related jobs, which also tend to be 
higher paying jobs (Costs and Benefits of the Export Source Rule, 1998-
2002, Gary Hufbauer and Dean DeRosa, February 19, 1997). In Silicon 
Valley, it is estimated that over 200,000 jobs were added since 1992. 
Also, in 1997 the average real wage, after accounting for inflation, 
grew about 2.2 percent compared to a wage increase of 1.2 percent at 
the national level (Joint Venture's Index of Silicon Valley, 1998, 
prepared by Joint Venture: Silicon Valley Network). The Joint Venture 
study also reported that in 1996, Silicon Valley exports grew 9 percent 
to $39.7 billion, while California exports grew 4 percent and U.S. 
exports grew 6 percent.
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Statement of M Financial Holdings Incorporated

                                Overview

    The President's budget proposal calls for unwarranted tax 
increases on American life insurance policyholders and products 
that would discourage long-term investment and saving. Several 
provisions of the budget would prevent life insurance products 
from continuing to provide effective solutions to long-term 
benefit, savings, and retirement security needs. This 
unfortunate proposal drastically undermines the government's 
decades-long policy of encouraging individuals and businesses 
to provide for their own and their employees' financial 
security. At a time when long-term financial planning is 
encouraged of all Americans, the President's budget takes away 
several key methods of providing for that financial security. 
In many cases, the proposals result in a retroactive tax 
increase on middle-class working Americans.
    The provisions in the 1999 Administration budget that 
particularly concern us include the following:
     COLI Proposal--Increased taxation on companies 
that own life insurance policies on their officers and 
employees. This tax increase could significantly reduce the 
level of funding for employee-related benefits, undermining 
employee security associated with these benefits and the 
financial protection of families and businesses. The proposal 
particularly hurts small businesses who rely on life insurance 
policies to provide benefits and incentives to their employees.
     Investment in Contract Proposal--Elimination of 
annual cost of insurance and expense charges from the insurance 
owner's basis in the contract. This proposal contradicts the 
well-established tax principle that a return of invested funds 
is not taxed. Furthermore, it reduces the effectiveness of the 
savings element of the policies.
     Variable Life Insurance and Annuities Proposal--
Taxation of gains in variable policies at the time values are 
moved among investment options within one policy or transferred 
between similar policies. This tax increase effectively 
eliminates the use of these products as long-term retirement 
investments, thereby making it harder for millions of Americans 
to save for retirement
     Crummey Proposal--Elimination of the Crummey 
provisions to obtain the gift tax annual exclusion. This tax 
increase would reduce the availability of life insurance 
proceeds to provide funds to pay future estate taxes on many 
closely held business interests.
    These proposals will reduce the financial protection being 
provided to millions of Americans and thousands of businesses 
of all sizes. The provisions would adversely affect the 
economic viability of existing life insurance policies and 
severely limit new insurance policy purchases, thus reducing 
overall savings. Furthermore, the proposals would reduce 
private retirement savings by increasing the administrative and 
tax expense associated with owning these products. Taken 
together, the proposals also could cause thousands of employees 
to lose their jobs. Particularly hard hit would be U.S. small 
businesses.
    Given the uncertain economic impact, it is reasonable to 
expect that these Budget proposals may have a negative effect 
on general revenue. These proposals also seem to 
disproportionately isolate and disadvantage insurance 
businesses. The reduced purchase of insurance as a result of 
these proposals would produce a corresponding reduction in 
certain federal and state tax revenue. By example, in 1996, 
approximately $1.8 billion in revenue was paid by the insurance 
industry in state premium taxes on life insurance. 
Additionally, approximately $1 billion was generated at the 
federal level just from the ``DAC'' tax on life insurance 
premiums. The current level of revenue generated at both the 
state and federal level would be threatened by this set of 
proposals.

                           M Financial Group

    M Financial Group is a marketing and reinsurance 
organization comprised of over 100 independently owned firms, 
located across the country, that focus on providing financial 
security and solutions to the estate and benefit planning needs 
of individuals and businesses.
    Collectively, these firms manage life insurance policies in 
force for their clients representing over $1 billion of annual 
life insurance premiums, over $10 billion of policyholder 
account values, and over $40 billion of total death benefit 
protection.
    These policies provide benefits for a variety of needs that 
enhance individual
     Allowing businesses an effective vehicle to fund 
benefit liabilities for employee retirement income payments, 
salary continuance for employees' spouses, and other post-
retirement benefits.
     Providing for financial liquidity to families at 
time of death to pay estate taxes. Many families' assets are in 
illiquid forms such as family owned real estate or small 
businesses. Life insurance helps families meet their estate tax 
and business continuity needs without having to sell the 
underlying asset. Life insurance provides a liquid source of 
funds to meet the liability without disrupting families and 
small businesses, allowing them to continue into the next 
generation and continue to provide jobs to their employees.
     Providing businesses with a financial means to 
continue operation upon death of a key executive, allowing the 
business to continue operations while replacing the key 
individual.
     Providing individuals with the ability to provide 
survivors with death benefit protection while supplementing 
retirement savings.
    Life insurance is a particularly effective and efficient 
vehicle to defray the costs of these benefits and provide 
individuals and employers with a future income stream to offset 
various unpredictable future needs, such as untimely death or 
long-term medical needs. The impact of the proposal on the 
ability to use life insurance on all of these areas is 
devastating.
    In addition, the proposed retroactive application of 
several provisions to policies already purchased and owned by 
millions of Americans makes effective tax-planning virtually 
impossible. A precedent of retroactive application of tax 
increases to existing contracts is inherently unfair and 
reduces the potential for tax law to provide effective long-
term incentives for establishing any private savings programs. 
Moreover, retroactive tax increases reduce compliance with our 
Federal Tax system at a time when the system is already under 
broad attack. We applaud the strong opposition to 
retroactivity, as expressed recently by Chairman Archer, who 
made the following statement related to the Administration's FY 
1999 Budget:
    ``I do not intend to put my name on anything that is 
retroactive.''
    The balance of this document provides specific background 
on the impact of these proposals on certain uses of life 
insurance that help provide financial security to millions of 
Americans.

    Proposal: Repeal of the exception for employees, officers, and 
  directors under the Corporate Owned Life Insurance (COLI) proration 
                               rules.\1\
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    \1\ The written statement addresses the negative impact of the 
Administration's Proposal on traditional COLI plans, and does not 
address Bank-Owned Life Insurance (BOLI). We are aware that in addition 
to the use of traditional COLI plans, there has also developed a use of 
life insurance products as pure financial vehicles, used to take 
advantage of tax deferred investment or tax arbitraged nature of the 
products. Congress has been concerned about the use of COLI as a 
``pure'' investment vehicle without the appropriate insurance elements 
and has in the past enacted legislation to limit the attractiveness of 
such uses. Of particular concern today is the use of COLI by financial 
institutions that borrow funds at low cost and invest the funds in tax 
deferred investments, thus creating additional tax leverage due to the 
deductibility of the borrowing costs while the offsetting investment is 
tax deferred. These plans are commonly referred to as BOLI.

---------------------------------------------------------------------------
Background:

    COLI policies have long been used as a tool by businesses 
to provide employee and retirement benefits. COLI helps promote 
the long-term financial security of employees, provide 
employees an incentive to save for their own retirement, and 
help corporations effectively manage financial consequences of 
the untimely death of a key employee.
    The need to use COLI to provide employee and retirement 
benefits arises from prior legislative initiatives such as 
ERISA, TEFRA, and DEFRA, which have limited a company's use of 
pension arrangements. Over time, these limitations have made 
the use of traditional pension arrangements more complex and 
less effective. Hit most hard are middle-level executives, as 
defined by the Department of Labor. The popularity of non-
qualified plans has increased commensurate with the compression 
on qualified plans and corporate desire to provide the 
restoration of such benefits.
    In the interest of enabling employees with a means to 
provide themselves and their families with long-term financial 
security benefits, corporations have created non-qualified 
plans to provide long-term benefits. The use of these plans is 
an effective vehicle for increasing the personal savings rate 
at a time when Americans are living longer and there is more 
uncertainty of the ability of other social programs to support 
these benefits. These plans have long-term emerging liabilities 
and actuarial risk, which are well suited to funding with life 
insurance. This use of COLI serves a valid social and economic 
purpose in financing these plans. Some examples of the many 
employee and retirement benefit beneficial programs and other 
business needs funded by COLI are:
     Supplements retirement income and survivor 
benefits beyond those available under qualified plan limits. 
These benefits promote the financial security of millions of 
Americans.
     The ability for employees to contribute after-tax 
dollars to enhance their retirement and survivor benefits.
     The ability for businesses to provide benefits 
needed to attract and retain key employees.
     Supports the ability, particularly for small 
businesses, to withstand the significant financial loss 
resultant from the premature death of a key employee.
     Provides business continuity in circumstances that 
could otherwise result in failure and significant economic 
hardship for all employees.
    To accomplish these purposes, many corporations use COLI as 
a tool to effectively manage the liabilities related to 
employee and retirement benefits. Defraying the costs of these 
liabilities with after-tax dollars in COLI policies is 
consistent with Federal retirement savings incentives and is 
good public policy.

Effect of Proposal:

     The changes to COLI increase current taxes for all 
businesses that own or are beneficiaries of a life insurance 
policy. This proposal would seriously curtail the availability 
of the benefits these policies fund, reduce personal savings, 
and increase the risk of business failure from loss of a key 
employee. Most hard hit by the proposal is small businesses and 
their employees.
    The proposed changes to IRC Sec. 264 increase taxes by 
disallowing a portion of the company's interest deduction for 
unrelated debt. This proposal would affect all business uses of 
life insurance, not just abusive uses. To preserve the 
motivation and opportunity for private saving, it is important 
to preserve the ability for businesses to purchase life 
insurance to provide an array of benefits to their employees. 
At a time when Congress is increasing incentives for employee-
based savings through the expansion of Roth IRAs and other 
provisions, it is contradictory to tax the use of life 
insurance to fund the same benefits.
    Current law already limits potential abuses in COLI 
applications used to defray the costs of the types of 
liabilities previously mentioned: Qualified plan limits 
restrict the amount of insurance that can be purchased by an 
employer on a currently deductible basis. IRC Sec. 7702 and IRC 
Sec. 7702A require corporate-owned policies to provide a 
reasonable amount of true death benefit protection. IRC 
Sec. 264 prevents leverage arbitrage from tax deductible 
borrowing against a corporate-owned life insurance policy. All 
these provisions combine to provide reasonable protection that 
the COLI may be used to defray the costs of real benefit 
liabilities in a manner consistent with tax policy.
    Unfortunately, the effect of the COLI proposal in the 
Administration's Budget would be to limit wholly appropriate 
business uses of life insurance--such as assuring that 
employees receive the retirement benefits they have been 
promised and are counting on getting--by making the cost of 
insurance products economically unfeasible. The proposal would 
unnecessarily deny the benefits of COLI to millions of 
Americans.
    Moreover, the Administration's rationale for the COLI 
proposal is fundamentally flawed and unjustified. The 
Administration believes that allowing a taxpayer a deduction 
for interest incurred on indebtedness in the operation of a 
business is wrong if the business owns life insurance on its 
employees, even if the business indebtedness is completely 
unrelated to the insurance. This belief flies in the face of 
fundamental principals of tax law, which allow for ordinary and 
necessary business expenses.
    Under recent changes in current law, interest on 
indebtedness directly related or ``traced'' to corporate owned 
life insurance is already subject to disallowance. The new COLI 
proposal would go well beyond current law and deny deductions 
for interest that is completely unrelated to the insurance. 
This is not only unjustified, but is overbroad and creates 
inequities between businesses that rely on debt financing and 
those that are equity financed.
    In cases where a business provides insurance-financed 
benefit programs such as broad-based health coverage for 
retirees, non-qualified pensions, or savings benefits, a 
``tax'' would now be imposed if the business had any 
indebtedness on its books. This resulting ``tax'' will most 
likely cause the business to rethink and scale back its benefit 
programs, causing harm to the long-term health and security of 
its employees. Across the country, this would have a 
devastating impact on many small and mid-sized businesses who 
rely on insurance to fund such programs.
    By indirectly ``taxing'' retirement and benefit programs, 
the COLI proposal moves in the complete opposite direction of 
recent efforts by the Administration and Congress to provide 
incentives to increase U.S. savings (e.g. expansion of IRAs, 
Roth IRAs, SIMPLE IRAs). The COLI proposal undermines these 
initiatives and is contradictory to the goals of the 
Administration and Congress.
    Finally, the effective date of the COLI proposal would 
create a retroactive tax increase on millions of businesses and 
middle-class working Americans by denying an interest deduction 
on policies that have been in place for years. Businesses that 
relied on existing tax laws would be penalized and employees 
who relied on benefits funded by existing insurance policies 
would be unconscionable harmed.
    While we understand the concern in Congress regarding 
perceived abusive transactions, we believe the Administration's 
proposal is overbroad, unjustified and inconsistent with 
Congressional incentives to encourage retirement savings and 
employee benefits. Accordingly, the COLI proposal should be 
rejected out of hand.

    Proposal: Reduce the life insurance and annuity policy owner's 
   ``investment in the contract'' (basis) for mortality and expense 
                                charges.

Background:

     Cash value life insurance and deferred annuities allow 
individuals to provide for future financial security for 
themselves and their dependents through benefits paid to 
survivors at death or lifetime income benefits paid during 
retirement. Premiums paid for these benefits are usually made 
with after-tax dollars. The public policy reason for 
encouraging such insurance purchases is directly linked to the 
social value the benefits provided, both in terms of quality of 
life for surviving beneficiaries and additional retirement 
income available to further reduce demands that may fall on 
publicly funded social insurance programs. For this reason, the 
``inside build-up'' of life insurance and annuity policy cash 
values has served a beneficial and socially justified purpose.

Effect of Proposal:

     This proposal would reduce the effectiveness of life 
insurance and annuity policies as long-term financial security 
vehicles. The proposal would reduce retirement savings by 
reducing a policy owner's basis each year by internal mortality 
and expense charges for cash value life insurance and deferred 
annuity contracts for the purpose of calculating investment in 
the contract under IRC Sec. 72.
    This proposal is contrary to the notion of not paying tax 
on the amount invested in an asset. Policyholders pay premiums 
with after-tax dollars, and they should not be subject to a 
second tax on the return of their investment amount. The long-
term cumulative effect of the proposed reduction in 
policyholder basis is the reduction of cash values available to 
Americans upon retirement.
    The proposal actually operates to the detriment of 
responsible Americans who hold their annuity investments until 
retirement. The proposal would add back reductions to the 
policyholder's basis only if the contract is annuitized for 
life at the guaranteed rate in the contract, even if the 
guaranteed rate is less favorable than other rates then 
available. The logic of requiring retiring individuals to 
receive less than the amount they otherwise could receive is 
far from clear.
    It is reasonable to consider taxing gains from contracts 
that are surrendered without ever providing the intended death 
and retirement benefits, but current law already accomplishes 
that purpose. Not only is ordinary income tax paid on the total 
difference between cash value and premium paid when a policy is 
surrendered, but there are several situations where a penalty 
tax also applies to such transactions. Those situations include 
all surrenders of deferred annuity policies or life insurance 
Modified Endowment Contracts before the policy owner reaches 
age 59\1/2\. Thus, current law already taxes and provides tax 
penalties on cumulative gains that are withdrawn without being 
used for the intended long-term financial security benefits of 
insurance.
    The existing penalty taxes for withdrawals from Modified 
Endowment and annuity contracts apply only to withdrawals 
before the insured reaches age 59\1/2\. That age limit 
recognizes the multiple financial needs that can arise in the 
retirement years and increases the availability of life 
insurance and annuity values to address life changes at that 
time. The proposed basis changes would penalize life insurance 
and annuity owners who need to make withdrawals from their 
policies for other financial security reasons, such as the 
payment of nursing home costs, at any age.
    The proposal would also introduce a high degree of 
additional and unnecessary complexity to supporting tax 
regulations and to the record-keeping and reporting 
requirements of insurers and individual policyholders. The 
impact of this complexity would ultimately be borne by the 
individual taxpayers, through the added costs and time involved 
in preparing their own returns and higher insurance company 
administrative costs passed through to policy owners, thus 
reducing the amount of their retirement savings.

      Proposal: Tax Certain Exchanges of Insurance Contracts and 
      Reallocations of Assets within Variable Insurance Contracts

Background:

     As described previously in the discussion of proposed 
reductions in basis, tax law has encouraged individuals to 
provide for the financial needs of their survivors and their 
retirement years through purchase of life insurance and annuity 
contracts. To accomplish this result, cash value is allowed to 
accumulate in life insurance and annuity policies without being 
subject to current income taxation.
    Furthermore, public policy has recognized that there are a 
number of different types of insurance contracts available in 
the market, and that it may sometimes be in the consumer's best 
interest to exchange one policy for another. For that reason 
IRC Sec. 1035 has long permitted transfers of value from one 
annuity or life insurance contract to another without taxation 
on the growth in cash values up to that time.
    During the last decade, there has been increasing use of 
variable life insurance and variable annuity policies. These 
contracts provide the same basic financial security features of 
more traditional contracts, but they allow individuals greater 
flexibility in the general investment strategy of the assets 
backing policy cash values through access to equity returns. 
This opportunity generally allows individuals to lower the 
overall cost of their benefits, while enhancing long-term 
security. For example, a relatively young individual wishing 
permanent death benefit protection and the opportunity to save 
for retirement income may choose a variable product that allows 
allocation of current cash values to an equity-based fund. This 
fund may have the potential of providing higher long-term 
returns than the traditional fixed income investments of an 
insurer's general account. As retirement age approaches, that 
individual might wish to reallocate the cash values to a fund 
with less risk than equities, minimizing the volatility risk 
when the benefits are needed most.

Effect of Proposal:

     This proposal would penalize individuals who seek to use 
life insurance and annuity contracts to save for retirement. 
Specifically, the proposal has two parts. First, it eliminates 
IRC Sec. 1035-exchange treatment for transfers between any 
contract and a variable contract. Therefore all variable policy 
exchanges would be subject to tax on any gain in the contract. 
Secondly, it treats each separate account of a variable 
contract as a separate contract, so any transfer between 
accounts within a variable contract would be a taxable event.
    The elimination of Sec. 1035 exchange treatment would 
discourage individuals from changing from one policy to another 
with more attractive features or cost. The ability to make such 
exchanges without current tax impact is one factor that 
encourages insurers to offer policyholders increasingly 
favorable terms to keep their products competitive. Thus, this 
change would harm policyholders by reducing the natural 
marketplace incentive to maximize policy performance.
    The second part of the proposal--taxing interim gains at 
the time funds are moved between separate account options 
within a single variable policy--also creates an unwarranted 
and inconsistent penalty to the individual who wishes to use 
his contractual rights most efficiently. Given the public 
policy of encouraging the use of life insurance and annuity 
contracts to facilitate the ability of individuals to provide 
for their own financial security, there is no reason to apply 
taxes to interim gains upon internal asset reallocations. 
Annuity and life insurance contracts already contain 
restrictions on transfers and liquidity. Policy owners may not 
withdraw funds from their account values without reducing or 
eliminating the long-term death or retirement income benefits 
that will be provided. As long as funds remain inside a policy 
that will provide those benefits, the gains should not be 
taxed.
    This proposal would also increase the cost of variable 
products due to significantly more complexity in administration 
and record keeping for insurers and for buyers of variable 
products who reallocate assets among sub-accounts. These costs 
would be passed along to policy owners. Many details would need 
to be clarified through further complex regulations.

 Proposal: Repeal the so-called ``Crummey Rule'' for gifts after 1998.

Background:

    As Congress intended, the $10,000 gift tax annual exclusion 
is widely used and encouraged to provide a mechanism for 
relatively small gifts to be made to individuals, primarily 
family members, without gift or estate tax consequences.
    The ``Crummey Rule'' has, since 1968, been a widely used 
approach to appropriately utilize the gift tax annual 
exclusion. This long-established and well-recognized rule 
relies on the legal power of the beneficiaries of the Crummey 
power to withdraw amounts contributed to the trust for their 
benefit. It is primarily used to make gifts to family members 
and, more particularly minor children and grandchildren, while 
at the same time, providing them the protections of a trust to 
help safeguard their interests.
    Frequently, the trust is used to purchase life insurance in 
order to provide family members liquidity for estate taxes 
without use of the insured's unified credit. This helps avoid 
unnecessary liquidation at the insured's death of important 
family assets such as a business and the displacement of 
employees, which would result therefrom.
Effect of Proposal:

    The proposal substantially hurts families wanting to make 
appropriate use of the annual gift tax exclusion in order to 
make gifts in trust which protect family members, provide 
liquidity, and safeguard important family assets. The proposal 
would apply to all future gifts, including those which would be 
made to previously existing trusts. In a large percentage of 
those situations, life insurance has been utilized and those 
plans would be substantially disrupted or discontinued. This 
would frustrate the taxpayer's reasonable expectations of 
having irrevocably gifted their policies and having the law in 
effect at the time continue to apply.
      

                                

Statement of Management Compensation Group

                            I. Introduction

    We appreciate the opportunity to submit this statement for 
the record of the Committee's hearing on the revenue proposals 
included in the President's FY 1999 Budget. We are Management 
Compensation Group, a group of independently owned firms 
located across the country, dedicated to assisting businesses 
to provide retirement, health and other benefits to their 
employees. We help small, medium and larger businesses finance 
benefit plans through the purchase of corporate-owned life 
insurance (``COLI''). The use of COLI serves a valid social and 
economic purpose in financing these benefit plans.
    We strenuously OBJECT to the President's proposal to apply 
the proration rule adopted in the Taxpayer Relief Act of 1997 
(P.L. 105-34) to virtually all COLI, by eliminating exceptions 
to the rule for employees, officers and directors (the ``COLI 
proposal''). In this statement, we will provide background on 
the legitimate business uses of COLI, and the history of tax 
issues associated with COLI. We will then discuss the 
President's COLI proposal and explain why we think it should be 
rejected outright by Congress.

                             II. Background

1) Permanent Life Insurance For Business

    The use of permanent life insurance in a business setting first 
arose as a means to protect against the premature death of key 
employees. The savings element in permanent life insurance also allowed 
for the accumulation of value for use in the buyback of stock or to 
protect against business interruption.
    As businesses saw a need to fund for pension and other benefit 
liabilities that fell outside of their qualified plans, COLI in its 
current use evolved. The combination of predictable premiums, long-term 
asset accumulation and protection against death benefit liabilities 
makes COLI an ideal funding vehicle for these programs.
    In these arrangements, businesses purchase COLI in an amount 
necessary to match the emerging liabilities for benefits outside of 
qualified plans. The COLI asset is typically placed in a trust, and 
specific arrangements are made to eliminate excess assets from building 
up within the trust. While such assets remain available to creditors 
should bankruptcy occur, they are otherwise pledged and held in trust 
for the sole purpose of extinguishing corporate liability associated 
with the benefit plans.
    Funds used to purchase COLI are paid with after-tax dollars. The 
tax-deferred growth of these funds only serves to help the plans keep 
pace with the emerging liability. The company foregoes a current 
deduction, unlike qualified pension plans, and provides a dedicated 
buffer for future pension payments. Funding under these plans is 
typically limited to those eligible for participation in these 
programs.

2) History Of Tax Changes Related To COLI

    In the past, Congress has been concerned about the use of COLI as a 
pure investment vehicle without appropriate insurance elements. As a 
consequence, it has acted to restrict COLI and certain investment-
oriented insurance products, while protecting the tax-deferred nature 
of permanent life insurance.
    The 1954 Code contained a provision limiting interest deductions on 
loans taken out directly or otherwise to purchase insurance (Code 
section 264). Since then, Congress has strengthened this provision 
several times. Most recently, in the Taxpayer Relief Act of 1997 (the 
``1997 Act''), Congress eliminated a broad range of exceptions and 
generally disallowed any interest on indebtedness ``with respect to'' 
the ownership of a life insurance contract. This disallowed any direct 
and ``traceable'' interest. A limited exception for ``key person'' 
policies under $50,000 remained in place.
    The 1997 Act also added a new ``proration'' rule which denied 
interest deductions on indebtedness ``unrelated'' to the ownership of 
insurance policies. An exception to the proration rule was provided for 
insurance purchased on lives of employees, officers, directors, and 20 
percent owners (Code section 264(f)). This exception is the subject of 
the President's COLI proposal.\1\
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    \1\ Other changes impacting insurance products occurred over the 
years. Certain investment-oriented insurance products called ``modified 
endowments'' were restricted by Congress in 1988. This class of 
policies loses many or some of the favorable treatment available to 
other contracts under Code section 72. Congress in 1990 imposed another 
limitation on insurance policies with the enactment of the deferred 
acquisition cost provision (Code section 848)(the ``DAC tax''). This 
provision limits the ability of insurance companies to deduct 
immediately the costs incurred in issuing a policy. The economic effect 
of the DAC provision has been to impose a federal premium tax.
---------------------------------------------------------------------------

                   III. The President's COLI Proposal

    Under current law, businesses are generally allowed a tax 
deduction for interest on indebtedness incurred in their trade 
or business. Businesses often own life insurance policies on 
the lives of their employees, officers and directors. These 
policies meet a number of business needs, including: (1) 
providing financial liquidity; (2) allowing businesses to fund 
employee and retirement benefits; (3) providing continuation of 
business operations upon the death of a key executive; and (4) 
providing survivors with death benefit protections.
    Recent changes to the tax laws deny an interest deduction 
on any indebtedness WITH RESPECT TO life insurance policies. 
Therefore, any interest which is directly related or 
``traceable'' to a life insurance policy is already denied 
under current law. If there is no relationship between the 
indebtedness and a corporate-owned life insurance policy on an 
employee, officer or director, then there is no denial of 
interest.
    The President's FY 1999 Budget plan contains a proposal 
which would change the current COLI rules, resulting in the 
denial of interest deductions on indebtedness incurred by a 
business completely UNRELATED to the ownership of insurance on 
an employee, officer or director. The Administration believes 
this would prevent unwarranted tax arbitrage benefits. This 
proposal would have a devastating impact on businesses and 
employees throughout the country.

                             IV. Discussion

    The President's COLI proposal is seriously flawed, 
inequitable, overly broad, and unjustified. It must be REJECTED 
by Congress.

1) ``Tax Arbitrage'' Is A Smoke-Screen

    While the Administration suggests that traditional COLI 
provides unwarranted tax arbitrage, the argument is not 
persuasive and is nothing but a smoke screen to mask its 
attempt to tax inside build up of life insurance--a proposal 
that has been resoundingly rejected in the past.
    There are legitimate tax policy reasons for allowing 
ordinary and necessary tax deductions for businesses that incur 
indebtedness and pay interest expenses. Similarly, there is a 
valid tax policy reason for allowing businesses to own 
permanent life insurance and for allowing the growth of these 
policies to be tax-deferred.
    To arbitrarily tie these two fundamental tax concepts 
together as a means of raising revenue is disingenuous. If 
denying a deduction for an expense completely unrelated to an 
item of income were acceptable, we would have complete chaos in 
the tax code.
    An example of how ill-conceived this policy would be is the 
case of a taxpayer who earns tax-deferred income in a ROTH IRA 
and also makes tax deductible mortgage interest payments. If 
the taxpayer's mortgage interest deduction were denied on the 
theory that he/she has ``tax arbitrage'' from unrelated tax-
deferred earnings in the ROTH IRA, the entire tax code would 
have to be reviewed and the deductibility of deductions would 
always be in question. The purpose of the tax deferral, in this 
case to increase the ability of Americans to save for 
retirement and the interest deduction, to promote home 
ownership, are completely unrelated. There is no connection 
between the ROTH IRA and the mortgage indebtedness just as 
there is no connection here between the business indebtedness 
and the COLI policy. In the business setting, the analogy would 
be to deny an interest deduction on the purchase of office 
equipment solely because a business purchased key man life 
insurance.
    Importantly, current law has safe guards for interest that 
is related or ``traceable'' to the ownership of life insurance, 
denying such interest deduction in such cases. The President's 
proposal attempts to disallow deductions for unrelated 
interest. The Administration apparently believes that allowing 
a taxpayer a deduction for interest incurred on indebtedness in 
the operation of a business is wrong if the business owns life 
insurance on its employees, officers, or directors, even if the 
business indebtedness is completely unrelated to the insurance. 
This belief is contrary to fundamental principals of tax policy 
as well as the social objectives such deductions are meant to 
achieve.

2) The COLI Proposal is Inequitable

    By denying interest deductions on businesses that own life 
insurance, the President's COLI proposal creates unjustified 
inequities between businesses that rely on debt financing and 
those that are equity-financed. Under the proposal, two 
taxpayers in the same industry would be treated differently for 
tax purposes depending on whether they incurred debt in the 
operation of their business or whether they relied on equity 
investments.
    In addition, businesses in different industries would be 
treated differently as a result of the proposal. Many capital 
intensive industries rely heavily on debt and would be 
disproportionately disadvantaged because the proposal would 
deny their interest deductions. This would occur even though 
the debt-financed businesses would own the same amount of life 
insurance and provide the same amount of employee and 
retirement benefits as their equity-financed competitors.

3) Back Door Tax Increase on Cash Value and Unrealized 
Appreciation in Business Assets

    The President's FY 1999 budget proposal would apply the 
1997 proration rules to all COLI and BOLI. Effectively, this 
would result in a backdoor taxation of cash values on all 
business life insurance.
    As stated above, permanent life insurance has traditionally 
been a tax-favored investment for good social and tax policy 
reasons. The essential element of the insurance--to protect 
against the premature death of a key employee--and the use of 
the ``cash value'' savings element--to protect against business 
interruption or to fund pension and retirement benefits--have 
long been recognized as worthy goals.
    By denying an interest deduction to businesses that own 
such policies and tying the denial to the ``pro-rated'' amount 
of ``unborrowed cash value,'' the Administration is indirectly 
``taxing'' the cash value on permanent insurance owned by a 
taxpayer. Traditional concepts of fairness should prevent the 
Administration to do indirectly what they choose not to do 
directly.
    Moreover, this indirect tax increase on the cash value of a 
life insurance policy results in a tax on the ``unrealized 
appreciation'' in a taxpayer's asset. This result would be 
similar to taxing a homeowner each year on the appreciation of 
his/her home.
    Fundamental concepts of tax policy dictate that taxes 
generally should be incurred on the ``recognition'' of a 
taxable event, such as a sale or exchange of property. To now 
impose a tax on ``unrealized appreciation'' would not only 
violate traditional concepts of tax policy, but could result in 
huge administrative burdens on taxpayers and the government if 
followed in other areas of the law.

4) Unjustified Elimination of Funding for Employee and 
Retirement Benefits

    The President's COLI proposal would increase current taxes 
on all businesses that own or are the beneficiaries of a 
permanent life insurance policy. It would seriously curtail the 
availability of the benefits these policies fund and increase 
the risk of business failure from loss of a key employee. While 
there is a clear relationship between the providing of 
insurance and the funding of benefits, there is no relationship 
between interest on business indebtedness and unrelated 
insurance used to fund benefits.
    Current rules already limit potential abuses in traditional 
COLI applications. Code section 264 prevents leveraged 
arbitrage from tax-deductible borrowing ``related to'' a 
corporate-owned life insurance policy. Code section 7702 and 
7702A require corporate-owned policies to provide a reasonable 
amount of death benefit protection. And qualified plan limits 
restrict the amount of insurance that can be purchased by an 
employer on a currently deductible basis. It is not clear what 
public purpose extending these rules to cover unrelated 
interest deductions would serve.
    The effect of the President's COLI proposal would be to 
limit wholly appropriate business uses of life insurance by 
making the cost of insurance products economically infeasible. 
Eliminating business owned life insurance could result in the 
elimination or reduction in the amount of employer-provided 
employee and retirement benefits. Such a change would put 
unnecessary and undue pressure on Social Security and public 
financing of benefits. At a time when the country faces 
significant funding problems with Social Security, there is no 
sound policy reason to put additional burdens on financing of 
employee benefits and retirement savings.
    In attempting to correct perceived abuses of COLI, the 
proposal unnecessarily deprives businesses of the legitimate 
benefits of COLI to protect against business interruption, loss 
of a key employee, or to fund employee benefits. The COLI 
proposal is overly broad and imposes restrictions far beyond 
those needed to address any perceived abuse. If there are 
abuses to be corrected, they should be addressed in a more 
narrow manner.

5) COLI Proposal is Inconsistent with Well-founded Savings and 
Retirement Policies

    At the very same time that the President and Congress are 
calling for more tax incentives for personal savings and 
directing attention to the impending retirement security 
crisis, the President is proposing a provision that would 
ultimately reduce personal savings.
    The President and Congress have repeatedly called for new 
long-term savings provisions (e.g., ROTH IRAs, Education IRAs, 
SIMPLE IRAs) and expansions of existing savings provisions 
(e.g., increases in traditional IRA limits). By indirectly 
``taxing'' life insurance which funds retirement and benefit 
programs, the COLI proposal moves in the complete opposite 
direction of such efforts. By undermining these initiatives, 
the COLI proposal stands out as a stark example of inconsistent 
and contradictory tax and retirement policy.

6) Retroactive Tax Increase

    Finally, the effective date of the COLI proposal would 
create a retroactive tax increase on millions of businesses and 
middle-class working Americans by denying an interest deduction 
on policies that have been in place. Businesses that relied on 
existing tax laws would be penalized and employees who relied 
on benefits funded by existing insurance policies would be 
unconscionable harmed.
    We applaud the strong opposition by the Committee to 
retroactive tax increases, as expressed most recently by 
Chairman Archer, who made the following statement regarding the 
Administration's FY 1999 Budget:
    ``I do not intend to put my name on anything that is 
retroactive.''
    A precedent of retroactive application of tax increases to 
existing contracts, particularly in the case where there is no 
attempt at ``tax avoidance'' or ``tax abuse,'' is inherently 
unfair and would reduce the incentives provided in the tax code 
for establishing private savings by injecting significant 
uncertainty into long-term planning.

                             V. Conclusion

    We urge the Committee to reject in its entirety the 
President's COLI proposal. The COLI proposal is seriously 
flawed, inequitable, overly broad, and unjustified. Moreover, 
it goes well beyond any perceived abuses raised by the 
Administration.
    We would be happy to provide the Committee with additional 
information about the legitimate business uses of life 
insurance at any time.
      

                                

Statement of Massachusetts Mutual Life Insurance Company

    Massachusetts Mutual Life Insurance Company is the seventh 
largest mutual life insurance company in the United States, 
doing business throughout the nation. The Company offers life 
and disability insurance, deferred and immediate annuities, 
pension employee benefits, mutual funds and investment 
services. Massachusetts Mutual serves more than two million 
policyholders nationwide and, with its subsidiaries and 
affiliates, has more than $130 billion in assets under 
management. We are very concerned about the proposals in the 
President's Fiscal Year 1999 Budget which would significantly 
alter the tax treatment of life insurance and annuity products. 
We appreciate the opportunity to offer testimony with respect 
to these critical areas of concern.

        Exchanges Involving Variable Life and Annuity Contracts

    The President's Budget proposals would tax any exchange of 
contracts involving either a variable life insurance policy or 
a variable annuity contract. In addition, the President's 
proposals would treat as a taxable exchange the internal 
reallocation of values among the different funds offered under 
a variable insurance or annuity contract. Currently, a 
policyholder can avoid tax on the surrender of a life insurance 
or annuity contract by exchanging it for a new contract in 
accordance with the limitations of Section 1035 of the Internal 
Revenue Code. On a Section 1035 exchange, the contract gain is 
deferred until it is withdrawn or otherwise distributed from 
the new policy.  The tax-deferral offered by Section 1035 is 
available for all cash value life insurance and annuity 
contracts, whether fixed, traditional policies or variable 
contracts.
    Variable life insurance and annuity contracts represent an 
increasing percentage of MassMutual's business. The Company has 
over 74,000 individual variable life insurance policies in 
force, with approximately $14 billion of death benefits. 
Variable contracts represent the preponderance of the Company's 
annuity sales with $10.9 billion of assets under all of its 
variable annuities. The average account balance for our non-
tax-qualified variable annuity contracts is $45,000.
    Variable insurance and annuity products give policyholders 
an effective means to tailor long-term financial plans to their 
own specific needs and those of their families. By taxing 
exchanges that involve variable contracts or the transfer of 
funds within a variable contract, the Administration would gut 
the usefulness of these products for most taxpayers. A 
policyholder would be bound to his or her initial investment 
decision regardless of the subsequent performance of the 
insurance or annuity contract or the funds underlying the 
contract.
    The Administration has indicated that current taxation of 
exchanges or fund reallocations would place variable contracts 
on a par with other investments. This is simply not correct. 
Federal tax law already subjects variable insurance and annuity 
contracts to numerous stringent requirements that do not apply 
to other assets. For instance, a life policy that is overly 
investment-oriented will fail the definition of life insurance 
set out in Code Section 7702. Even if a life policy meets that 
definition, too rapid premium payments will cause it to become 
a modified endowment contract, subjecting loans and other 
distributions during the life of the insured to harsh income 
tax rules. A ten percent distribution penalty tax also applies 
to modified endowment contracts and annuities.
    Furthermore, the underlying investments of variable life 
and annuity contracts must meet specific diversification 
requirements under Code Section 817 and its regulations, and 
must comply with the investor control rules articulated by the 
Internal Revenue Service. However long the owner holds a 
variable contract, any gain distributed is always taxed as 
ordinary income not as capital gains. In contrast to other 
assets, the gift transfer of an annuity contract is taxable as 
income to the original owner and may trigger the additional 10% 
penalty tax. Moreover, there is no step-up in the cost basis of 
an insurance or annuity contract when the policyholder dies. In 
fact, while the tax laws do not mandate liquidation of other 
investments on the owner's death, annuity contracts must begin 
distributions when the policyholder dies.
    The Administration's proposal is in direct conflict with 
its stated commitment to private savings and personal 
responsibility for retirement income. Within the restrictions 
already imposed by the tax laws, life insurance and annuity 
contracts provide a valuable means for achieving those goals. 
There is no justifiable basis for penalizing exchanges that 
involve variable contracts or transfers of funds among the 
investment options offered within a variable contract. Code 
Section 1035 was enacted for the express purpose of enabling 
policyholders to replace, without tax liability, those 
insurance and annuity contracts that no longer met their 
particular needs. Congress long ago recognized the validity and 
merit of variable life and annuity contracts as integral 
components to prudent survivor and retirement planning. The 
Administration's proposal would penalize variable contract 
owners who tried to protect their insurance and retirement 
income.

                     Business Owned Life Insurance

    In the past two years, Congress created appropriate 
limitations on a business' ability to deduct interest on debt 
when it has cash value life insurance. Following amendments 
enacted in 1996, federal law allows a business to take an 
interest deduction for loans against only those insurance 
policies covering the life of either a 20% owner of the 
business or another key person. No more than 20 individuals may 
qualify as key persons and the business can deduct interest on 
no more than $50,000 of policy debt per insured life. A special 
rule grandfathers policies issued before June 21, 1986. The 
1997 tax act limited the interest a business can deduct on 
general debt if the business also has cash value life insurance 
on a person other than its employee, officer, director and 20% 
owner (or a 20% owner and spouse). To determine its allowable 
interest deductions, a business must reduce its general debt by 
the unborrowed cash value in policies covering insureds who do 
not come within these exceptions. This ``pro to policies issued 
or materially changed after June 8, 1997.
    The President's Budget proposals would destroy the 
carefully crafted limitations set by the 1996 and 1997 
amendments. First, the proposals would eliminate the ability of 
a business to deduct interest on loans against a policy 
insuring any person other than an individual who owned at least 
20% of the business. Second, the Administration would extend 
the pro rata disallowance rule to all business owned life 
insurance policies except those covering a 20% owner. Further, 
the proposals apparently would not grandfather policies 
purchased under prior laws.
    The proposals would make cash value life insurance 
prohibitively expensive for all businesses. By excepting only 
policies that insure 20% owners, the Administration proposals 
ignore the fact that business life insurance serves many 
legitimate, non-tax purposes. Clearly, life insurance provides 
a means for businesses to survive the death of an owner, 
offering immediate liquidity for day-to-day maintenance or the 
funds for co-owners to purchase the decedent's interest from 
heirs who are unwilling or incapable of continuing the 
business. However, although insurance to fund business buy-outs 
serves an important function, businesses use life insurance for 
many other equally meritorious purposes.
    A business must protect itself from the economic drain and 
instability caused by the loss of any major asset. More than 
any machinery, realty or tangible goods, the particular talents 
of its key personnel sustain a business as a viable force. Life 
insurance provides businesses with the means to protect the 
workplace by replacing revenues lost on the death of a key 
person and by offsetting the costs of locating and training a 
suitable successor. Businesses also use life insurance to 
provide survivor and post-retirement benefits to their 
employees, officers and directors. As part of a supplemental 
compensation package, these benefits help attract and retain 
talented and loyal personnel, the very individuals who are 
crucial to the ongoing success of any business.
    In 1996, Congress revised the rules for deducting for 
deducting interest on policy loans to impose sharp limits on 
the number of insureds and policy debt. The new rules 
successfully curtailed the abusive sale of life insurance for 
tax leverage and there is no reason to change the rules yet 
again. However, businesses need to retain the ability to borrow 
against policies on key persons without incurring a tax 
penalty. Although buying key person insurance makes sound 
business sense, the decision to do so requires a long-term 
commitment of capital. The business must have the flexibility 
to borrow against such policies in times of need without 
adverse tax consequences. The current key person exception is 
especially important to smaller businesses that have less 
access to alternative sources of borrowing.
    Last year, Congress examined the tax treatment of unrelated 
debt where a business also happened to hold cash value life 
insurance. Based on this review, it created a tax penalty for 
companies that hold life insurance on their debtors, customers 
or any insureds other than their own employees, officers, 
directors or 20% owners. The Administration would now set aside 
this careful analysis and overturn a provision approved by the 
President only a few months ago. The legitimate needs for 
workplace protection insurance have not altered in that short 
span of time. The business need for life insurance will not 
disappear if Congress extends the pro rata disallowance rule to 
policies covering any insured other than 20% owners, but the 
resulting costs for businesses will increase. Generally, term 
insurance does not provide businesses with a reasonable 
alternative to cash value life insurance. While often 
appropriate for temporary arrangements, term insurance is both 
costly and unsuitable for long-range needs. The loss of 
interest deductions on unrelated borrowing is an exceedingly 
harsh punishment to impose on a business for taking prudent 
financial measures to protect its valuable human assets or to 
provide benefits for its employees and retirees.

                        Reduction in Cost Basis

    The Administration's proposals would reduce a 
policyholder's cost basis in any life insurance or annuity 
contract by the total mortality and expense charges 
attributable to the protection offered under the contract. With 
respect to annuity contracts, the Administration would assume 
annual charges equal to 1.25% of the contract's average cash 
value for the year, regardless of the actual charges imposed by 
the insurer. The proposed reductions in a contract's cost basis 
would create phantom income for all policyholders. Although a 
policyholder would receive no more cash on any distribution 
from a contract, a larger portion would be taxable as income.
    Reducing a policy's cost basis would unfairly penalize one 
particular form of asset and would greatly increase the cost of 
annuities and cash value life insurance. There is no similar 
cutback in a taxpayer's basis to reflect the use and enjoyment 
of other assets. Thus, homeowners do not reduce their cost 
basis by the annual value of their residence on the property. 
Moreover, many other assets qualify for an automatic increase 
in cost basis when their owner dies. This ``step-up'' rule can 
raise cost basis to the value of the asset on the date of the 
owner's death; if the heirs or the estate subsequently sell the 
property, only the sale proceeds in excess of the stepped-up 
basis would be taxed as income. No step-up in basis is 
available when the owner of a life insurance or annuity 
contract dies before the insured. Indeed, as opposed to its 
treatment of other assets, the tax law, with limited 
exceptions, actually requires liquidation of an annuity 
contract to begin after the owner's death.
    While the proposal to reduce cost basis would adversely 
affect all policyholders, it would most severely hit those 
policies insuring older individuals and those policies 
maintained for the longest periods of time. As an insured ages, 
mortality charges associated with his coverage necessarily 
increase. The cumulative adjustments to reflect mortality and 
expense charges could deplete a policy's cost basis simply 
because the insured lived too long. Since mortality charges can 
also vary with the insured's gender and health, the charges for 
many insureds will consume cost basis more rapidly than for 
others. Income taxes should not punish taxpayers for their age, 
gender or state of health.
    The proposal to deduct mortality and expense charges from 
the cost basis of an annuity contract is in direct opposition 
to the Administration's rhetorical commitment to encourage 
private savings and funding for retirement. The longer a 
policyholder kept an annuity contract in force, the less basis 
there would be to recover when the contract began 
distributions. With an automatic annual reduction equal to 
1.25% of the annuity contract's average cash value for the 
year, the proposal would also effectively dock the 
policyholder's basis by a portion of the earnings on the 
contract. For no other asset does the tax law require a 
reduction in basis to reflect its appreciation in value.
    With the proposed reduction in basis, a policyholder who in 
fact held an annuity contract as a long-term retirement vehicle 
would find a larger portion of his distributions includible in 
gross income than if he had withdrawn the same amount at an 
earlier date. The Internal Revenue Code already imposes a 10% 
penalty tax on early withdrawals from annuity contracts as a 
disincentive to using them as short-term investments. The new 
proposal would also penalize a policyowner for holding an 
annuity contract too long. The proposal would allow a taxpayer 
to recover the lost basis only by annuitizing the contract over 
life, a limited exception that would force individuals to lock 
into an arrangement that may not best suit their private needs. 
In any effort to revitalize personal savings for future income 
needs, a rule that increases tax on such savings and dictates 
the form of payout will at best be counterproductive.

                 Taxation of Annuity Contract Reserves

    An insurance company is allowed a federal tax deduction for 
its annuity reserves, which are the amounts it must set aside 
to pay its policyowners in the future. To protect 
policyholders, state insurance regulators set guidelines for an 
insurer to compute the minimum reserves it must hold. The 
Internal Revenue Code specifies how an insurer would compute 
its tax deduction for annuity reserves, using as a base the 
state method of calculation that produces the minimum amount of 
reserves (called CARVM) and making certain adjustments. Under 
current tax law, an annuity contract's net surrender value is 
the least amount that can be taken as a reserve deduction.
    The President's Budget proposals would limit an insurer's 
reserve deduction for annuity contracts to the lesser of (1) 
the CARVM reserve (again, the minimum reserve amount required 
under state law), or (2) the contract's net surrender value 
plus a declining percentage of net surrender value phased out 
over seven years. The Administration would effectively limit 
the reserve deduction to a contract's net surrender value, 
regardless of the minimum reserve required under state law.
    State reserve requirements are designed specifically to 
protect policyholders by providing some safeguard that the 
insurer will be able to meet its long-term obligations. Given 
the increases in longevity, the National Association of 
Insurance Commissioners (NAIC) is reviewing an update of the 
mortality tables used to determine annuity reserves. The longer 
an annuitant is expected to live, the greater the insurer's 
financial commitment and the larger the reserve it must set 
aside to meet that commitment. With updated mortality tables, 
state laws would then require insurers to increase their 
annuity reserves. However, the Administration proposal would 
restrict the insurer's tax deduction to only that portion of 
the reserves equal to an annuity contract's net surrender 
value. It is inappropriate to limit the deduction to an 
annuity's net surrender value, a measure that does not take 
into account the risks that reserves are intended to meet.
    State insurance regulators are better able than the federal 
tax authorities to determine the reserves needed to satisfy 
obligations to policyholders. The states do not set their 
reserve requirements in order to provide insurers with 
excessive federal tax deductions. The federal government should 
not use the tax laws to usurp the states' authority to 
prescribe appropriate financial guidelines to protect their 
policyholders.
    The Administration has characterized this proposal as an 
increase in the income tax burden for insurers, not for annuity 
policyholders. Nevertheless, insurers will ultimately pass the 
tax cost on to their policyholders, making annuities more 
expensive for the many individuals who try to save for their 
personal retirement needs. As with the other tax proposals for 
insurance and annuity products, the increased tax on annuity 
reserves is completely at odds with the Administration's stated 
goals of fostering private savings and financial 
responsibility.

                        Crummey Withdrawal Right

    Under the combined federal estate and gift tax laws, a 
single donor can make annual gifts of up to $10,000 per 
recipient without triggering a tax liability; married donors 
may give up tts made through a trust qualify for the gift tax 
exclusion if the trust agreement grants the beneficiary what is 
called a ``Crummey'' withdrawal right, essentially the right to 
withdraw gifts made into a trust on his behalf. Since the trust 
beneficiary could demand immediate distribution, a gift in 
trust is treated as an outright gift eligible for the gift tax 
exclusion.
    The Administration's Budget proposal would disqualify gifts 
in trust from the gift tax exclusion, whether or not the trust 
agreement granted the beneficiaries any withdrawal rights. Only 
outright gifts would remain eligible for the exclusion. 
Effective for gifts made after 1998, the proposal would not 
grandfather any existing trust arrangements.
    Given the fact that federal gift and estate taxes are 
inter-linked, a change in the treatment of lifetime gifts 
increases the donor's ultimate estate tax burden. The 
Administration proposal would effectively raise federal death 
taxes at a time when many members of Congress have indicated 
that the tax is already too onerous.
    There is no sound reason for taxing gifts to a Crummey 
trust differently from outright gifts. The Internal Revenue 
service and the courts have established strict guidelines to 
ensure that Crummey rights have substance and are not mere 
``legal fictions,'' as described by the Administration. The 
trust agreement must require the trustee to provide prompt 
written notice to a beneficiary that a gift has been made on 
his behalf; the trust must grant the beneficiary a reasonable 
period to request a withdrawal; and, the trustee must maintain 
sufficient liquidity to satisfy any such requests made during 
the withdrawal period. As a result, there is no material 
difference between a gift made to a Crummey trust and an 
outright gift.
    For thirty years, the law has recognized contributions to a 
Crummey trust as eligible for the gift tax exclusion. Virtually 
all irrevocable trusts grant beneficiaries Crummey withdrawal 
rights. A change in the tax treatment of gifts to such trusts 
would disrupt the long-term estate plans of many American 
families. Since the trusts are irrevocable, their provisions 
cannot be revised to match a change in the tax law.
    Trusts created to hold life insurance policies almost 
universally rely on Crummey provisions to avoid tax on the 
annual gifts in trust to pay premiums. Over 30,000 MassMutual 
life insurance policies are currently held in such trusts. If 
those gifts no longer qualify for the exclusion, families would 
have to choose between paying the tax or lapsing the policy. As 
a practical matter, life insurance trusts are designed to 
provide liquidity on the insured's death, including funds to 
meet estate taxes. The proposal to tax gifts in trust would 
thus inflate the cost of making prudent arrangements to pay 
estate taxes.

                               Conclusion

    The revenue provisions contained in the President's Budget 
proposed for fiscal year 1999 would unduly increase the tax 
burden on holders of life insurance and annuity contracts. The 
proposals would effectively penalize taxpayers who try to 
provide for their future financial needs, as well as those of 
their families and their businesses. By radically altering 
well-established tax laws, the Administration proposals would 
disrupt the long-term plans of individuals and businesses. The 
proposals are particularly unsettling at a time when both 
Congress and the Administration agree that there should be a 
significant increase in the amount Americans save for their 
future financial needs.
      

                                

Statement of Merrill Lynch & Co., Inc.

    Merrill Lynch is pleased to provide this written statement 
for the record of the February 25, 1998 hearing of the 
Committee on Ways & Means on ``Revenue Provisions in the 
President's Fiscal Year 1999 Budget Proposal.'' \1\
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    \1\ Merrill Lynch also endorses the comments submitted to the 
Committee on these provisions by the Securities Industry Association 
and The Bond Market Association.
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                            I. Introduction

    Merrill Lynch believes that a strong, healthy economy will 
provide for increases in the standard of living that will 
benefit all Americans as we enter the challenges of the 21st 
Century. Investments in our nations future through capital 
formation will increase productivity enabling the economy to 
grow at a healthy rate. Merrill Lynch is, therefore, extremely 
supportive of fiscal policies that raise the United States 
savings and investment rates. For this reason, Merrill Lynch 
has been a strong and vocal advocate of policies aimed to 
balance the federal budget. Merrill Lynch applauds the efforts 
of this Congress to finally reach the commendable goal of 
balancing the budget.
    While Merrill Lynch applauds the efforts of many to balance 
the federal budget, it is unfortunate that some of the tax 
changes proposed by the Administration in its FY 1999 Budget 
would raise the costs of capital and discourage capital 
investment--policies contradictory to the objective of a 
balanced budget. The Administration's FY 1999 Budget contains a 
number of revenue-raising proposals that would raise the cost 
of financing new investments in plant, equipment, research, and 
other job-creating assets. This will have an adverse effect on 
the economy.
    Moreover, many of these proposals have previously been 
fully considered and rejected out-of-hand by this same 
Congress. On many prior occasions, Merrill Lynch has spoken out 
against the negative impact such proposals would have on our 
Nation.
    Merrill Lynch agrees with comments by Chairman Bill Archer 
in announcing these hearings, where he stated:
    ``Given the public reaction to the numerous tax increase 
proposals in the budget, including proposals which have been 
rejected previously and new proposals increasing the tax burden 
on savings and investment, the Administration has a very heavy 
burden to carry.''
    These remarks are consistent with Chairman Archer's prior 
statement to President Clinton when many of these same 
proposals were being considered for inclusion in prior budgets. 
On a broad basis, Chairman Archer stated that he is ``deeply 
troubled and believe(s) that the impact of your plan is 
fundamentally anti-business, anti-growth and . . . further 
concerned that the manner in which you have arrived at these 
proposals appears to be based on how much revenue you can raise 
from tax increases rather than how to improve the current tax 
code based on sound policy changes.'' See, Letter from Chairman 
Bill Archer to President Clinton (dated December 11, 1995). 
Chairman Archer also stated that:
    ``you have proposed numerous new tax increases on business 
which reflect anti-business bias that I fear will diminish 
capital formation, economic growth, and job creation. For 
example, I don't understand why you would want to exacerbate 
the current problem of multiple taxation of corporate income by 
reducing the intercorporate dividends received deduction and 
denying legitimate business interest deductions. . . . it will 
not only be America's businesses that pay the tab; hard-
working, middle income Americans whose nest-eggs are invested 
in the stock market will pay for these tax hikes.''
    Based on these and other serious concerns by Congress, many 
of the capital market proposals which the Administration is now 
reproposing were rejected outright in prior years. We see no 
legitimate reason to now reconsider these unsound policies.
    The U.S. enjoys the world's broadest and most dynamic 
capital markets. These markets allow businesses to access the 
capital needed for growth, while providing investment vehicles 
individuals can rely on to secure their own futures. Our 
preeminent capital markets have long created a competitive 
advantage for the United States, helping our nation play its 
leading role in the global economy.
    Merrill Lynch remains seriously concerned about the damage 
the Administration's proposals could cause to the capital-
raising activities of American business and the investments 
these companies are making for future growth. Merrill Lynch 
believes these proposals are anti-investment and anti-capital 
formation. If enacted, they would increase the cost of capital 
for American companies, thereby harming investment activities 
and job growth.
    Unfortunately, the Administration's proposals would serve 
to limit the financing alternatives available to businesses, 
harming both industry and the individuals who invest in these 
products. Merrill Lynch believes this move by the 
Administration to curtail the creation of new financial options 
runs directly counter to the long-run interests of our economy 
and our country.
    While Merrill Lynch is opposed to all such proposals in the 
Administration's FY 1998 Budget,\2\ our comments in this 
written statement will be limited to the proposals that:
---------------------------------------------------------------------------
    \2\ Other anti-business, anti-growth proposals include the tax on 
certain exchanges of insurance contracts (the ``annuities'' proposal), 
the increase in the proration percentage for property & casualty (P&C) 
insurance companies, and the real estate investment trust (``REIT'') 
proposals. There is no inference of support for proposals not mentioned 
in this written statement.
---------------------------------------------------------------------------
     Defer original issue discount deduction on 
convertible debt. This proposal would place additional 
restrictions on the use of hybrid preferred instruments and 
convertible original issue discount (``OID'') bonds and would 
defer the deduction for OID and interest on convertible debt 
until payment in cash (conversion into the stock of the issuer 
or a related party would not be treated as a ``payment'' of 
accrued OID). This proposal is nearly identical to ones 
proposed by the Administration in its FY '97 and FY '98 budget 
plans, which were rejected by Congress.
     Eliminate the dividends-received deduction 
(``DRD'') for certain preferred stock. This proposal would deny 
the 70-and 80-percent DRD for certain types of preferred stock. 
The proposal would deny the DRD for such ``nonqualified 
preferred stock'' where: (1) the instrument is putable; (2) the 
issuer is required to redeem the securities; (3) it is likely 
that the issuer will exercise a right to redeem the securities; 
or (4) the dividend on the securities is tied to an index, 
interest rate, commodity price or similar benchmark. This 
proposal is also nearly identical to ones proposed in previous 
budgets, which were rejected by Congress.
    Hereinafter these proposals will be referred to as the 
``Administration's proposals.''
    To be clear, these proposals are not ``loopholes'' or 
``corporate welfare.'' They are fundamental changes in the tax 
law that will increase taxes on savings and investment. They do 
little more than penalize middle-class Americans who try to 
save through their retirement plans and mutual funds. Rather 
than being a hit to Wall Street, as some claim, these proposals 
are a tax on Main Street--a tax on those who use capital to 
create jobs all across America and on millions of middle-class 
individual savers and investors.
    It is unfortunate that the Treasury has chosen to 
characterize these proposals as ``unwarranted corporate tax 
subsidies'' and ``tax loopholes.'' The fact is, the existing 
tax debt/equity rules in issue here have been carefully 
reviewed--some for decades--by Treasury and Internal Revenue 
Service (``IRS'') officials, and have been deemed to be sound 
tax policy by the courts. Far from being ``unwarranted'' or 
``tax loopholes,'' the transactions in issue are based on well 
established rules and are undertaken by a wide range of the 
most innovative, respected, and tax compliant manufacturing and 
service companies in the U.S. economy, who collectively employ 
millions of American workers.
    Merrill Lynch urges Congress to get past misleading 
``labels'' and weigh the proposals against long standing tax 
policy. Under such analysis, these proposals will be exposed 
for what they really are--nothing more than tax increases on 
Americans.
    Merrill Lynch believes that these proposals are ill-
advised, for four primary reasons:
     They Will Increase The Cost of Capital, 
Undermining Savings, Investments, and Economic Growth. While 
Treasury officials have stated their tax proposals will 
primarily affect the financial sector, this is simply not so. 
In reality, the burden will fall on issuers of, and investors 
in, these securities--that is, American businesses and 
individuals. Without any persuasive policy justification, the 
Administration's proposals would force companies to abandon 
efficient and cost-effective means of financing now available 
and turn to higher-cost alternatives, and thus, limit 
productive investment. Efficient markets and productive 
investment are cornerstones to economic growth.
     They Violate Established Tax Policy Rules. These 
proposals are nothing more than ad hoc tax increases that 
violate established rules of tax policy. In some cases, the 
proposals discard tax symmetry and deny interest deductions on 
issuers of debt instruments, while forcing holders of such 
instruments to include the same interest in income. 
Disregarding well-established tax rules for the treatment of 
debt and equity only when there is a need to raise revenue is a 
dangerous and slippery slope that can lead to harmful tax 
policy consequences.
     They Will Disrupt Capital Markets. Arbitrary and 
capricious tax law changes have a chilling effect on business 
investment and capital formation. Indeed, the Administration's 
proposals have already caused significant disruption in 
capital-raising activities, as companies reevaluate their 
options.
     They Will Fail to Generate Promised Revenue. The 
Administration's proposals are unlikely to raise the promised 
revenue, and could even lose revenue. Treasury's revenue 
estimates appear to assume that the elimination of the tax 
advantage of certain forms of debt would cause companies to 
issue equity instead. To the contrary, most companies would 
likely move to other forms of debt issuance--ones that carry 
higher coupons and therefore involve higher interest deductions 
for the issuer.
    At a time when the budget is balanced and the private 
sector and the federal government should join to pursue ways to 
strength the U.S. economy, the Administration has proposed tax 
law changes that would weaken the economy by disrupting 
capital-raising activities across the country. Merrill Lynch 
strongly urges the Administration and Congress to set aside 
these proposals. Looking forward, Merrill Lynch would be 
delighted to participate in full and open discussions on the 
Administration's proposals, so that their ramifications can be 
explored in depth.
    The following are detailed responses and reaction to three 
of the Administration's proposals that would directly affect 
capital-raising and investment activities in the U.S.

        II. Proposal To Defer OID Deduction on Convertible Debt

    The Administration's FY 1999 Budget contains proposals that 
would defer the deduction for original issue discount (``OID'') 
until payment and deny an interest deduction if the instrument 
is converted to the stock of the issuer or a related party. 
These proposed changes to fundamental tax policy rules relating 
to debt and equity come under two separate (but related) 
proposals. Similar proposals were proposed and rejected by 
Congress a number of times in the past two years.
    One proposal, among other things, defers OID on convertible 
debt. The only stated ``Reasons for Change'' relating 
specifically to this proposal is contained in the Treasury 
Department's ``General Explanations of the Administration's 
Revenue Proposals'' (February 1998) (the ``Green Book''):
    In many cases, the issuance of convertible debt with OID is 
viewed by market participants as a de facto purchase of equity. 
Allowing issuers to deduct accrued interest and OID is 
inconsistent with this market view.''
    This is the same justification used in Treasury's February 
1997 Green Book and rejected by Congress.
    Merrill Lynch strongly opposes the Administration's 
proposal to defer deductions for OID on Original Issue Discount 
Convertible Debentures (``OIDCDs'') for a number of reasons 
more fully described below. To summarize:
     The Treasury's conclusion that the marketplace 
treats OIDCD as de facto equity is erroneous and inconsistent 
with clearly observable facts;
     In an attempt to draw a distinction between OIDCDs 
and traditional convertible debt, Treasury has in prior years 
misstated current law with regard to the deduction of accrued 
but unpaid interest on traditional convertible debentures, and 
apparently continues to rely on such misstatements;
     The proposal ignores established authority that 
treats OIDCDs as debt, including guidance from the IRS in the 
form of a private letter ruling;
     The proposed elimination of deductions for OID 
paid in stock is at odds with the tax law's general treatment 
of expenses paid in stock;
     The proposal would destroy the symmetry between 
issuers and holders of debt with OID. This symmetry has been 
the pillar of tax policy regarding OID. The Administration 
offers no rationale for repealing this principle;
     The proposal disregards regulations adopted after 
nearly a decade of careful study by the Treasury and the 
Internal Revenue Service. Consequently, the Administration's 
proposal would hastily reverse the results of years of careful 
study; and
     While billed as a revenue raiser, it is clear that 
adoption of the Administration's proposal would in fact reduce 
tax revenue.
     Finally, this proposal has been fully considered 
by this same Congress and rejected in prior years.
A. Treasury's Conclusion That The Market Treats OIDCD As De 
Facto Equity Is Erroneous And Inconsistent With Clearly 
Observable Facts.

    The proposal is based on demonstrably false assumptions 
about market behavior, which assumptions are also inconsistent 
with clearly observable facts. There is no uncertainty in the 
marketplace regarding the status of OIDCDs as debt. These 
securities are booked on the issuers' balance sheets as debt, 
are viewed as debt by the credit rating agencies, and are 
treated as debt for many other legal purposes, including 
priority in bankruptcies. In addition, zero coupon convertible 
debentures are typically sold to risk averse investors who seek 
the downside protection afforded by the debentures. Thus, both 
issuers and investors treat convertible bonds with OID as debt, 
not equity. Accordingly, it is clear that the market's ``view'' 
supports the treatment of OIDCD as true debt for tax purposes.
    Treasury makes clear that its proposal would not affect 
``typical'' convertible debt on the grounds that the 
``typical'' convertible debentures are not certain to convert. 
Because OIDCDs have been available in the market place in 
substantial volume for over ten years, it is possible to 
compare the conversion experience of so-called ``typical'' 
convertible debentures with the conversion experience of 
OIDCDs, nearly all of which have been zero coupon convertible 
debt. The data shows that ``typical'' convertible debentures 
are much more likely to convert to equity, that is, to be paid 
off in stock, than zero coupon convertible debentures.
    The instruments in question are truly debt rather than 
equity. An analysis of all 97 liquid yield option notes 
(``LYONs'') sold in the public market since 1985, shows that 57 
of those issued had already been retired (as of December 1997). 
Of those 57, only 15 were finally paid in stock. The other 42 
were paid in cash. The remaining 40 of the 97 issues were still 
outstanding as of December 31, 1997. If those 40 securities 
were called, only 19 of them would have converted to stock and 
the other 21 would have been paid in cash. In other words, the 
conversion features of only 19 of the 40 issues remaining 
outstanding are ``in the money.'' Overall, only 35% of the 
public issuances of LYONs had been (or would be if called) paid 
in stock. Thus, in only 35% of these OIDCD issuances had the 
conversion feature ultimately controlled.
    On the other hand, an analysis of 669 domestic issues of 
``typical'' convertible debt retired since 1985 shows just the 
opposite result (as of December 1997). Seventy-three percent 
(73%) of these offerings converted to the issuer's common 
stock. Accordingly, based on historical data, typical 
convertible debt is significantly more likely to be retired 
with equity than cash, as compared to LYONs.
    The Treasury's proposal is clearly without demonstrable 
logic. It makes no sense to say that an instrument that has 
approximately a 30% probability of converting into common stock 
is ``viewed by market participants as a de facto purchase of 
equity,'' and therefore, the deduction for OID on that 
instrument should be deferred (or denied), while an instrument 
that has over a 70% probability of conversion should be treated 
for tax purposes as debt.\3\ We would be happy to provide this 
data, and any other relevant information, to the Administration 
and Congress.
---------------------------------------------------------------------------
    \3\ Given this data, even if one accepted the Treasury's assertion 
that probability of conversion in some way governed appropriate tax 
treatment, the proposal obviously addresses the wrong convertible 
security.

B. Prior Misstatements of Current Law Continue to Be Relied 
---------------------------------------------------------------------------
Upon

    In prior year's Budget proposals, Treasury's has made 
statements of ``Current Law,'' which apparently continue to be 
relied upon in the FY 1999 Budget plan. These statements 
misstate the law regarding interest that is accrued but unpaid 
at the time of the conversion. The Treasury has in the past 
suggested that the law regarding ``typical'' convertible debt 
is different from the law for convertible debt with OID. This 
is clearly not the case. Both the Treasury's own regulations 
and case law require that stated interest on a convertible bond 
be treated the same as OID without regard to whether the 
bondholder converts.
    When the Treasury finalized the general OID regulations in 
January, 1994 (T.D. 8517), the Treasury also finalized Treasury 
Regulations section 1.446-2 dealing with the method of 
accounting for the interest. The regulations state:
    ``Qualified stated interest (as defined in section 1.1273-
1(c)) accrues ratably over the accrual period (or periods) to 
which it is attributable and accrues at the stated rate for the 
period (or periods). See, Treas. Reg. Section 1.446-2(b).
    All interest on a debt obligation that is not OID is 
``qualified stated interest.'' Treasury regulations define 
``qualified stated interest'' under Treas. Reg. Section 1.1273-
1(c) as follows:
    (i) In general, qualified stated interest is stated 
interest that is unconditionally payable in cash or in property 
. . . or that will be constructively received under section 
451, at least annually at a single fixed rate . . .
    (ii) Unconditionally payable . . . For purposes of 
determining whether interest is unconditionally payable, the 
possibility of a nonpayment due to default, insolvency or 
similar circumstances, or due to the exercise of a conversion 
option described in section 1272-1(e) is ignored. This applies 
to debt instruments issued on or after August 13, 1996 
(emphasis added).
    Thus, according to the Treasury's own regulations, fixed 
interest on a convertible bond is deductible as it accrues 
without regard to the exercise of a conversion option. The 
Treasury's suggestion to the contrary in the description of the 
Administration's proposal contradicts the Treasury's own 
recently published regulations.
    In addition, case law from the pre-daily accrual era 
established that whether interest or OID that is accrued but 
unpaid at the time an instrument converts is an allowable 
deduction depends on the wording of the indenture. In Bethlehem 
Steel Corporation v. United States, 434 F.2nd 1357 (Ct. Cl. 
1971), the Court of Claims interpreted the indenture setting 
forth the terms of convertible bonds and ruled that the 
borrower did not owe interest if the bond converted between 
interest payment dates. The Court merely interpreted the 
indenture language and concluded that no deduction for accrued 
but unpaid interest was allowed because no interest was owing 
pursuant to the indenture. The Court stated that if the 
indenture had provided that interest was accrued and owing, and 
that part of the stock issued on conversion paid that accrued 
interest, a deduction would have been allowed. The indentures 
controlling all of the public issues of zero coupon convertible 
debt were written to comply with the Bethlehem Steel court's 
opinion and thus, the indentures for all of these offerings 
provide that if the debentures convert, part of the stock 
issued on conversion is issued in consideration for accrued but 
unpaid OID.
    Thus, there is no tax law principle that requires a 
difference between ``typical'' convertible bonds and zero 
coupon convertible deductions. The only difference is a matter 
of indenture provisions and that difference has been overridden 
by the Treasury's own regulations.

C. Proposal Ignores Established Authority That Treats OIDCDs As 
Debt, Including Guidance From The IRS In The Form Of A Private 
Letter Ruling.

    Under current law, well-established authority treats OIDCDs 
as debt for tax purposes, including guidance from the IRS in 
the form of a private letter ruling. The IRS has formally 
reviewed all the issues concerning OIDCDs and issued a private 
letter ruling confirming that the issuer of such securities may 
deduct OID as it accrues. See, PLR 9211047 (December 18, 1991). 
Obviously rather than having not exploited [a] lack of guidance 
from the IRS, issuers of OIDCDs have relied on official IRS 
guidance in the form of a private letter ruling. That the IRS 
issued a ruling on this topic confirms that OIDCDs do not 
exploit any ambiguity between debt and equity. If any such 
ambiguity existed the IRS would not have issued its ruling.

D. Proposal Is Inconsistent With The Fundamental Principle That 
Payment In Stock Is Equivalent To Payment In Cash.

    We would now like to focus not on the timing of the 
deduction but on the portion of the Administration's proposal 
that would deny the issuer a deduction for accrued OID if 
ultimately paid in stock. The proposal is inconsistent with the 
general policy of the tax law that treats a payment in stock 
the same as a payment in cash. A corporation that issues stock 
to purchase an asset gets a basis in that asset equal to the 
fair market value of the stock issued. There is no difference 
between stock and cash. A corporation that issues stock to pay 
rent, interest or any other deductible item may take a 
deduction for the item paid just as if it had paid in cash.
    More precisely on point, the 1982 Tax Act added section 
108(e)(8) \4\ to repeal case law that allowed a corporate 
issuer to escape cancellation of indebtedness income if the 
issuer retired corporate debt with stock worth less than the 
principal amount of the corporate debt being retired. The 
policy of that change was to make a payment with stock 
equivalent to a payment with cash. Section 108(e)(8) clearly 
defines the tax result of retiring debt for stock. As long as 
the market value on the stock issued exceeds the amortized 
value of the debt retired, there is no cancellation of 
indebtedness income. The Administration's proposal to treat 
payment of accrued OID on convertible debt differently if the 
payment is made with stock rather than cash is inconsistent 
with the fundamental rule that payment with stock is the same 
as payment with cash. The Administration's proposal would 
create an inconsistency without any reasoned basis.
---------------------------------------------------------------------------
    \4\ All section references are to the Internal Revenue Code of 
1986, as amended.

E. Treasury's Proposal Removes The Long Established Principle 
---------------------------------------------------------------------------
Of Tax Symmetry Between Issuers And Holders Of Debt With OID.

    As discussed above, the current law is clear that an issuer 
of a convertible debenture with OID is allowed to deduct that 
OID as it accrues. The Service's private letter ruling, cited 
above, confirms this result. It is important to note that the 
OID rules were originally enacted to ensure proper timing and 
symmetry between income recognition and tax deductions for tax 
purposes. Proposals that disrupt this symmetry violate this 
fundamental goal of tax law.
    The Administration's proposal reverses the policy of 
symmetry between issuers and holders of OID obligations. Since 
1969, when the tax law first addressed the treatment of OID, 
the fundamental policy of the tax law has been that holders 
should report OID income at the same time that the issuer takes 
a deduction. The Administration's proposal removes this 
symmetry for convertible debt with OID. Not only would the 
holders report taxable income before the issuer takes a 
deduction, but if the debt is converted, the holders would have 
already reported OID income and the issuer would never have an 
offsetting deduction. The Administration does not offer any 
justification for this unfairness.

F. Treasury's Proposal Is An Arbitrary Attempt To Reverse Tax 
Policies That Were Adopted After Nearly A Decade Of Careful 
Study.

    The manner in which this legislative proposal was offered 
is a significant reason to doubt the wisdom of enacting a rule 
to defer or deny deductions for OID on convertible debentures. 
When the Treasury issued proposed regulations interpreting 1982 
and 1984 changes in the Internal Revenue Code regarding OID, 
the Treasury asked for comments from the public regarding 
whether special treatment was necessary for convertible 
debentures. See, 51 Federal Register 12022 (April 18, 1986).
    This issue was studied by the Internal Revenue Service and 
the Treasury through the Reagan, Bush and Clinton 
Administrations. Comments from the public were studied and 
hearings were held by the current administration on February 
16, 1993. When the current Treasury Department adopted final 
OID regulations in January of 1994, the final regulations did 
not exclude convertible debentures from the general OID rules. 
After nearly nine years of study under three Administrations 
and after opportunity for public comment, the Treasury decided 
that it was not appropriate to provide special treatment for 
OID relating to convertible debentures. Merrill Lynch suggests 
that it is not wise policy to reverse a tax policy that 
Treasury had adopted after nearly a decade of study and replace 
it with a policy previously rejected by Congress on a number of 
occasions.

G. Proposal Regarding OID Convertible Debentures Would Reduce 
Tax Revenue.

    While billed as a ``revenue raiser,'' adoption of the 
Administration's proposal with respect to OIDCDs would in fact 
reduce tax revenue for the following reasons:
     Issuers of OIDCDs view them as a debt security 
with an increasing strike price option imbedded to achieve a 
lower interest rate. This a priori view is supported by the 
historical analysis of OIDCDs indicating that over 70% have 
been, or if called would be, paid off in cash.
     If OIDCDs were no longer economically viable, 
issuers would issue straight debt.
     Straight debt rates are typically 200 to 300 basis 
points higher than comparable rates. Therefore, issuers' 
interest deductions would be significantly greater.
     According to the Federal Reserve Board data, at 
June 30, 1995 over 60% of straight corporate debt is held by 
tax deferred accounts versus less that 30% of OIDCDs held by 
such accounts.
    Consequently, the empirical data suggests that if OIDCDs 
are not viable, issuers will issue straight debt with higher 
interest rates being deducted by issuers and paid to a 
significantly less taxed holder base. The Administration's 
proposal would therefore reduce tax revenue while at the same 
time interfering with the efficient operation of the capital 
markets.
    Giving full consideration to the above data, Merrill Lynch 
believe rejection of the proposal with respect to OIDCDs is 
warranted and the reasons for doing so compelling.

  III. Proposal To Reduce the DRD, Modify the DRD Holding Period, and 
          Eliminate the DRD on Certain Limited Preferred Stock

    The Administration has proposed to deny the 70- and 80-
percent DRD for certain types of preferred stock. The proposal 
would deny the DRD for such ``nonqualified preferred stock'' 
where: (1) the instrument is putable; (2) the issuer is 
required to redeem the securities; (3) it is likely that the 
issuer will exercise a right to redeem the securities; or (4) 
the dividend on the securities is tied to an index, interest 
rate, commodity price or similar benchmark. A similar proposal 
was proposed and rejected by Congress a number of times in the 
past two years.
    It has long been recognized that the ``double taxation'' of 
dividends under the U.S. tax system tends to limit savings, 
investment, and growth in our economy. The DRD was designed to 
mitigate this multiple taxation, by excluding some dividends 
from taxation at the corporate level.
    Unfortunately, the Administration's proposal eliminate the 
DRD on certain stock would significantly undermine this policy. 
In the process, it would further increase the cost of equity 
capital and negatively affect capital formation.
    From an economic standpoint, Merrill Lynch believes that in 
addition to exacerbating multiple taxation of corporate income, 
the Administration's proposal is troubling for a number of 
reasons and would have a number of distinct negative impacts:
     Dampen Economic Growth. If the DRD elimination 
were enacted, issuers would react to the potentially higher 
cost of capital by: lowering capital expenditures, reducing 
working capital, moving capital raising and employment 
offshore, and otherwise slowing investments in future growth. 
In particular, American banks, which are dependent on the 
preferred stock market to raise regulatory core capital, would 
see a significant increase in their cost of capital and, hence, 
may slow their business-loan generation efforts.
     Limit Competitiveness of U.S. Business. The 
elimination of the DRD would also further disadvantage U.S. 
corporations in raising equity vis-a-vis our foreign 
competitors, especially in the UK, France, and Germany. In 
these countries, governments have adopted a single level of 
corporate taxation as a goal, and inter-corporate dividends are 
largely or completely tax free. As long as American firms 
compete in the global economy under the weight of a double- or 
triple-taxation regime, they will remain at a distinct 
competitive disadvantage.
     Discriminate Against Particular Business Sectors 
and Structures. The Administration's proposal may have a 
disproportionate impact on taxpayers in certain industries, 
such as the financial and public utility industries, that must 
meet certain capital requirements. Certain types of business 
structures also stand to be particularly affected. Personal 
holding companies, for example, are required to distribute 
their income on an annual basis (or pay a substantial penalty 
tax) and thus do not have the option to retain income to lessen 
the impact of multiple levels of taxation.
     Companies Should Not Be Penalized for Minimizing 
Risk of Loss. As a result of the Administration's proposal, the 
prudent operation of corporate liability and risk management 
programs could result in disallowance of the DRD. Faced with 
loss of the DRD, companies may well choose to curtail these 
risk management programs.
     No Tax Abuse. In describing the DRD proposal, the 
Administration suggests that some taxpayers ``have taken 
advantage of the benefit of the dividends received deduction 
for payments on instruments that, while treated as stock for 
tax purposes, economically perform as debt instruments.'' To 
the extent Treasury can demonstrate that the deduction may be 
subject to misuse, targeted anti-avoidance rules can be 
provided. The indiscriminate approach of eliminating the DRD 
goes beyond addressing inappropriate transactions and 
unnecessarily penalizes legitimate corporate investment 
activity.
    While the overall revenue impact of the DRD proposal may be 
positive, Merrill Lynch believes the revenue gains will not be 
nearly as large as projected, due to anticipated changes in the 
behavior of preferred-stock issuers and investors.
     Issuers of Preferred Stock. Eliminating the DRD 
will increase the cost of preferred-stock financing and cause 
U.S. corporations to issue debt instead of preferred stock 
because of interest deductibility. This overall increase in 
deductible interest would result in a net revenue loss to 
Treasury.
     Secondary Market for Preferred Stock. Currently, 
the market for outstanding preferred stock is divided into two 
segments:
    (1) A multi-billion dollar variable-rate preferred stock 
market where dividends are set via Dutch auctions. The dividend 
rate on these securities will necessarily increase to adjust 
for the elimination of the DRD, and may cause some of these 
issuers to call these preferred securities at par and replace 
them with debt. This will result in a revenue loss to Treasury.
    (2) A multi-billion dollar fixed-rate preferred stock 
market where the issuing corporations cannot immediately call 
the securities. Retail investors, who comprise 80% of this 
market cannot utilize the DRD and therefore pay full taxes on 
dividends. Hence, there will be no meaningful revenue gains to 
Treasury from this market segment.
    This proposal may also create losses for individual 
investors. Institutions, which own approximately 20% of all 
fixed-rate preferred stock, may sell their holdings given the 
increased taxation. Individual investors will bear the brunt of 
any price decline, because they currently account for about 80% 
of the fixed-rate preferred market. These capital losses, when 
taken, will offset any capital gains and result in a revenue 
loss to Treasury.
    At a time when U.S. tax policy should be moving toward 
fewer instances of ``double taxation,'' Merrill Lynch believes 
it would be a mistake to eliminate the DRD on certain limited-
term preferred stock. Any such action will make ``triple 
taxation'' even more pronounced in, and burdensome on, our 
economy.

                             V. Conclusion

    Based on the discussion set forth above, Congress should 
reject the Administration's proposals out of hand. These 
proposals which include the deferral of legitimate interest 
deductions and the elimination of the DRD are nothing more than 
tax increases which raise the cost of financing new 
investments, plant, equipment, research, and other job-creating 
assets. These tax increases hurt the ability of American 
companies to compete against foreign counterparts and are born 
by the millions of middle-class Americans who try to work and 
save through their retirement plans and mutual fund 
investments. These impediments to investment and savings would 
hurt America's economic growth and continued leadership in the 
global economy.
    Moreover, from a tax policy perspective, the 
Administration's proposals are ill-advised, arbitrary and 
capricious tax law changes that have a chilling effect on 
business investment and capital formation. Indeed, the 
Administration's proposals are nothing more than ad hoc tax 
increases that violate established rules of tax policy. In some 
cases, the proposals discard tax symmetry and deny interest 
deductions on issuers of certain debt instruments, while 
forcing holders of such instruments to include the same 
interest in income. Disregarding well-established tax rules for 
the treatment of debt and equity only when there is a need to 
raise revenue is a dangerous and slippery slope that can lead 
to harmful tax policy consequences.
    The Administration's proposals also are unlikely to raise 
the promised revenue, and could even lose revenue. Treasury's 
revenue estimates appear to assume that the elimination of the 
tax advantage of certain forms of debt would cause companies to 
issue equity instead. To the contrary, most companies would 
likely move to other forms of debt issuance--ones that carry 
higher coupons and therefore involve higher interest deductions 
for the issuer.
    Far from being ``unwarranted'' or ``tax loopholes,'' the 
transactions in issue are based on well established rules and 
are undertaken by a wide range of the most innovative, 
respected, and tax compliant manufacturing and service 
companies in the U.S. economy, who collectively employ millions 
of American workers.
    Merrill Lynch urges Congress to get past misleading 
``labels'' and weigh the proposals against long standing tax 
policy. Under such analysis, these proposals will be exposed 
for what they really are--nothing more than tax increases on 
Americans.
    For all the reasons stated above, the Administration's 
proposals should AGAIN be rejected in total.
      

                                

Statement of the Price Waterhouse LLP Multinational Tax Coalition

    The Multinational Tax Coalition (``MTC''), a coalition of 
U.S. companies in a wide range of industries competing in world 
markets, appreciates the opportunity to respond to the 
Chairman's request for testimony to the Committee on Ways and 
Means on the revenue-raising provisions of President Clinton's 
FY 1999 budget plan.
    Specifically, we are testifying in opposition to the 
Administration's proposal to expand the Treasury Department's 
regulatory authority to address the tax consequences of 
``hybrid'' transactions. This proposal is the latest in a 
series of international tax initiatives undertaken by the 
Clinton Administration that would penalize cross-border 
business operations that support U.S. exports and American 
jobs.
    In our testimony, we explain our chief tax policy concerns 
over the Administration's proposal and related Treasury 
pronouncements (IRS Notices 98-11 and 98-5). We also weigh 
these initiatives from an economic viewpoint, taking into 
account their impact on U.S. competitiveness. We conclude that 
these initiatives, taken together, represent fundamental 
changes in U.S. international tax policy that properly should 
be considered by Congress.
    MTC members include AES Corporation, Caterpillar Inc., 
Chrysler Corporation, Citicorp, The Clorox Company, Coty Inc., 
DuPont, Emerson Electric Co., General Electric, General Mills, 
Inc., Hallmark Cards, Inc., Hewlett-Packard Company, IBM 
Corporation, J.P. Morgan, Morgan Stanley, Dean Witter & Co., 
NationsBank Corporation, PepsiCo, Inc., Philip Morris 
Companies, Inc., and Tupperware Corporation. Price Waterhouse 
LLP serves as consultant to the group.

                               Background

    The Administration's FY 1999 budget, submitted to Congress 
on February 2, includes a proposal to direct the Treasury 
Department to prescribe regulations clarifying the tax 
treatment of hybrid transactions, effective on the date of 
enactment. Treasury's ``Green Book'' description of the 
proposal defines ``hybrid transactions'' generally as 
transactions that utilize ``hybrid entities'' (i.e., entities 
that are treated as corporations in one jurisdiction and as 
branches or partnerships in another jurisdiction), ``hybrid 
securities'' (e.g., securities that are treated as debt or 
royalty rights for U.S. tax purposes and as equity interests 
for foreign purposes), or other types of hybrid structures.
    The Treasury proposal states that the regulations ``would 
set forth the appropriate tax results under hybrid transactions 
in which the taxpayer's intended results are not consistent 
with the purposes of U.S. law.'' Treasury anticipates that this 
regulatory authority would be used, in part, to ``deny tax 
benefits or results arising in connection with various types of 
tax arbitrage transactions, including transactions that 
circumvent the purposes of the U.S. Subpart F rules, U.S. tax 
treaty provisions, and the U.S. foreign tax credit rules.'' The 
Green Book describes some of the broad areas in which the 
expanded regulatory authority might be used:
     ``use of hybrid entities and hybrid securities 
that, contrary to the purposes of the Subpart F rules, result 
in deductions for foreign tax purposes with respect to certain 
cross-border payments that do not generate Subpart F income.''
     ``use of hybrid securities and other hybrid 
transactions in order to achieve results that can not be 
achieved through the use of hybrid entities'' because of 
section 894(c) and the regulations thereunder.\1\
---------------------------------------------------------------------------
    \1\ Section 894(c) denies treaty benefits for certain payments 
through hybrid entities.
---------------------------------------------------------------------------
     ``inappropriate foreign tax credits that arise in 
connection with certain hybrid transactions.''
    The Green Book notes that the extent of Treasury's current 
authority to issue regulations in these areas is unclear in 
some instances.
    The Treasury proposal comes on the heels of two Internal 
Revenue Service pronouncements (Notice 98-11 \2\ and Notice 98-
5 \3\) that discuss similar issues. In Notice 98-11, the IRS 
announced that Treasury regulations will be issued to prevent 
the use of certain ``hybrid branch'' arrangements deemed 
contrary to the policies and rules of Subpart F. Notice 98-11 
states that the regulations would apply to hybrid branch 
arrangements entered into (or substantially modified, 
including, for example, by acceleration of payments or 
increases in principal) on or after January 16, 1998.
---------------------------------------------------------------------------
    \2\ 1998-6 Internal Revenue Bulletin, February 9, 1998.
    \3\ 1998-3 Internal Revenue Bulletin, January 20, 1998.
---------------------------------------------------------------------------
    At issue, Notice 98-11 states, are hybrid branch 
arrangements generally involving the use of deductible payments 
to reduce the taxable income of a CFC and the creation in a 
hybrid branch of low-taxed, passive income that is not taxed 
under Subpart F. Notice 98-11 states that the creation of 
hybrid branches in these arrangements has been facilitated by 
recent entity classification (``check-the-box'') regulations.
    Notice 98-11 also states that Treasury and the IRS are 
aware that the Subpart F issues raised by hybrid branches also 
may be raised by certain partnership or trust arrangements. 
Notice 98-11 states that Treasury and the IRS intend to address 
these issues in separate ``ongoing'' regulations projects.
    In Notice 98-5, the IRS has announced that regulations will 
be issued to disallow U.S. foreign tax credits for taxes 
generated in certain ``abusive arrangements.'' According to the 
Notice, arrangements generally will be considered abusive where 
the ``reasonably expected economic profit is insubstantial 
compared to the value of the foreign tax credits'' claimed. 
Five examples of these arrangements are provided. The Notice 
states that the regulations will be effective with respect to 
taxes paid or accrued on or after December 23, 1997.
    In addition, Notice 98-5 indicates that the IRS will begin 
scrutinizing foreign tax credit claims in connection with the 
types of transactions described by the notice as abusive and 
may disallow credits under ``existing law,'' independently of 
the regulations to be issued. The Notice suggests that such 
challenges based on existing law may seek to deny credits for 
taxes paid or accrued before the effective date of the notice.
    Finally, Notice 98-5 identifies several other areas in 
which Treasury and IRS are considering guidance to limit the 
availability of foreign tax credits. These include situations 
involving high withholding taxes, ``mismatches'' between the 
timing of payment of foreign taxes and recognition of foreign 
source income, and portfolio hedging strategies.

                          Tax Policy Concerns

    The MTC is seriously concerned about the application of 
Notices 98-11 and 98-5 to legitimate business transactions and 
about the breadth of the regulatory authority requested by 
Treasury in its FY 1999 budget proposal. The stated goal of 
these initiatives is to prevent certain transactions that 
Treasury and the IRS consider to be ``inconsistent with the 
purposes of U.S. tax law (including tax treaties).'' Apart from 
a few examples, however, neither the budget proposal nor the 
Notices specify which transactions will be affected, or how and 
when this determination will be made. These open-ended 
initiatives have created significant uncertainty for taxpayers 
and already have had a chilling effect on normal business 
operations.
    We also are troubled by the retroactive impact of Notices 
98-5 and 98-11. The regulations contemplated by these Notices 
would fundamentally alter the treatment of existing 
arrangements entered into by taxpayers in reliance on current 
law. Notice 98-5 was issued on December 23, 1997, to deny 
foreign tax credits for amounts due to accrue eight days later 
under binding contracts. It remains unclear, after almost three 
months, precisely which transactions would be affected by this 
measure. Similarly, in circumstances yet to be specified, 
Notice 98-11 would prohibit the adoption of certain business 
structures as of January 16, 1998, the date on which it was 
issued. In addition, Notice 98-11 would require many 
businesses, including businesses that relied on the recent 
``check-the-box'' regulations, to complete major restructuring 
by June 30, 1998, again without any guidance to date regarding 
its exact reach. We believe these Notices represent a 
questionable use of the limited exceptions to the general 
prohibition on retroactive regulations enacted by Congress in 
1996.
    In addition to these procedural fairness concerns, we have 
fundamental policy concerns regarding the new initiatives. At 
one level, Notice 98-5 and Notice 98-11 appear to be motivated 
by opposite concerns. Notice 98-5 expresses concern regarding 
reduction of U.S. tax, while Notice 98-11 is concerned about 
reduction of foreign tax. The common suggestion is, however, 
that the United States generally should impose tax where an 
adequate tax is not imposed by the foreign country. This 
thinking raises major tax policy issues that are not addressed 
by the stated rationales for these initiatives.
    Notice 98-11 targets ``hybrid branch'' arrangements on the 
grounds that such arrangements ``circumvent the purposes of 
Subpart F.'' Without citing specific statutory provisions or 
legislative history, Notice 98-11 presents a broad account of 
Congress' intent in enacting Subpart F in 1962. According to 
Notice 98-11, one of the purposes of Subpart F is to prevent 
controlled foreign corporations from earning ``low-or non-taxed 
income on which United States tax might be permanently 
deferred'' as a result of inconsistencies between U.S. and 
foreign tax systems.
    Subpart F clearly does not presume that U.S. tax should be 
imposed currently wherever a certain level of foreign tax is 
not. If Congress had meant to provide such a rule, it 
presumably would have enacted an effective tax rate test. 
Instead, Congress enacted a general deferral regime, and chose 
to impose U.S. tax currently only on specified types of income. 
Even under Subpart F, U.S. tax generally is deferred without 
regard to whether the income is earned in a high-tax or low-tax 
jurisdiction. It is clear that Congress considered the issue of 
foreign tax rates in this context, because Subpart F provides a 
broad exception for income subject to high foreign tax. 
Treasury and the IRS would now do the converse, by denying 
deferral for income subject to low foreign tax. But they would 
do so administratively, where Congress has declined to do so 
legislatively. And they seek to do so without indicating what 
they would consider to be an appropriate tax burden.
    Notice 98-11's account of the legislative intent underlying 
Subpart F diverges in important respects from the official 
legislative history provided by Congress. First, Subpart F does 
not focus on inconsistencies between U.S. and foreign law. In 
fact, neither the statute nor the legislative history even 
mentions such inconsistencies. Subpart F focuses solely on the 
issue of when U.S. tax should be imposed on certain types of 
income. Apart from the taxpayer-favorable exception noted 
above, Subpart F does not condition deferral on whether or how 
foreign tax is imposed on that income.
    Second, while the legislative history indicates that 
Congress sought to strike a balance in enacting Subpart F, it 
gave far more weight to competitiveness concerns than is 
suggested by the account provided by Treasury and the IRS. This 
is evidenced clearly by both the House and Senate reports, 
which cite preservation of the international competitiveness of 
U.S. business as the major reason for rejecting the 
Administration's bid to repeal deferral. It also is evidenced 
by the resulting statute, which clearly retains deferral as the 
general rule, not the exception.
    If anything, competitiveness concerns have become even more 
important since Subpart F was enacted in 1962. First, the Tax 
Reform Act of 1986 greatly expanded the reach of Subpart F to 
encompass more types of active business income and imposed 
numerous new limitations (``baskets'') on the foreign tax 
credit. Second, U.S. businesses face far more intense 
competition around the world than was the case in 1962. With 
the increasing globalization of the economy, it has become 
critical for businesses to compete internationally if they wish 
to remain competitive in their home markets. If U.S. businesses 
are to succeed in the global economy, they will need a U.S. tax 
system that permits them to compete effectively against 
foreign-based companies. This requires a system that permits 
broad deferral for active business income and provides a full 
foreign tax credit to prevent double taxation. The new Treasury 
and IRS initiatives would move in the opposite direction.
    Notice 98-5 similarly oversteps its statutory bounds. Like 
the budget proposal, it rests on a vision of the foreign tax 
credit regime that is not evidenced by--and, indeed, is 
inconsistent with--the statute.
    According to Notice 98-5, the purpose of the foreign tax 
credit is ``to preserve neutrality between U.S. and foreign 
investment and to minimize the effect of tax consequences on 
taxpayers' decisions about where to invest and conduct 
business.'' It objects that allowing a foreign tax credit in 
``abusive'' cases would serve ``no statutory purpose.'' Notice 
98-5 further contends that allowing a foreign tax credit in 
such cases would be incompatible with ``the existence of the 
detailed foreign tax credit provisions and cross-crediting 
limitations enacted by Congress.'' Notice 98-5 is premised, 
therefore, on a broad vision of the role of the foreign tax 
credit regime, coupled with a narrow reading of the cross-
crediting permitted by that regime.
    There is no evidence, however, that Congress ever intended 
the foreign tax credit to do anything other than remove a 
disincentive to foreign investment by U.S. companies, which 
would otherwise be subject to double taxation under our 
worldwide tax system. It is true that Congress has imposed some 
limitations on the use of the foreign tax credit, such as 
separate ``baskets'' for certain types of income, but those 
limitations are specified in great detail in the statute, as 
Notice 98-5 itself acknowledges.
    The cross-crediting to which Notice 98-5 objects is an 
integral part of our foreign tax credit regime. The Notice 
concedes that the U.S. foreign tax credit regime generally 
permits taxpayers to cross-credit by using foreign taxes 
imposed on high-taxed foreign source income to offset residual 
U.S. tax on low-taxed foreign source income. Indeed, the Notice 
acknowledges that such cross-crediting is allowed because it is 
viewed as ``consistent with the interrelated quality of 
multinational operations of U.S. persons.''
    In seeking to deny credits in cases they regard as 
``abusive,'' Treasury and the IRS would move the foreign tax 
credit regime carefully constructed by Congress away from a 
system that explicitly permits cross-crediting to average high-
and low-taxed foreign income towards an item-by-item limitation 
that would deny taxpayers the ability to cross-credit. It would 
accomplish this major change by administrative action--a 
significant and burdensome restriction on the foreign tax 
credit that Congress has declined to enact by statute. This 
would depart from the long-established procedure of having 
Congress consider fundamental changes to our foreign tax credit 
laws--a procedure acknowledged by Treasury only last year in 
its efforts to impose certain holding period requirements (see 
section 901(k)(4)).
    These concerns are exacerbated by the unacceptable 
vagueness of Notice 98-5 and the budget proposal. While Notice 
98-5 signals the view that certain transactions are 
``abusive,'' it provides no clear basis for distinguishing 
``abusive'' transactions from transactions for which a foreign 
tax credit should be allowed. According to the Notice, certain 
types of transactions will be considered abusive wherever the 
expected economic profit is ``insubstantial'' compared to the 
foreign tax credits involved. The Notice does not define the 
term ``insubstantial,'' and Treasury officials have publicly 
commented that the regulations to be issued under the Notice 
will not define the term.
    Compounding this uncertainty is the fact that a finding of 
``abuse'' would not require any demonstration of tax 
motivation. In this regard, Notice 98-5 and the budget proposal 
venture far beyond accepted anti-abuse principles. In fact, it 
is clear that they would reach even transactions entered into 
by a taxpayer in the ordinary course of conducting its 
business. For example, they would deny credits for foreign 
withholding taxes incurred by U.S. securities dealers in 
connection with routine hedging positions taken in the ordinary 
course of their business. This is contrary to the intent of 
legislation enacted by Congress only last year. In adding 
section 901(k)(4) to the Code, that legislation provided a 
broad ordinary-course exception to its general holding period 
requirements, which Treasury and the IRS would now simply 
disregard in many cases. As Congress recognized in enacting 
section 901(k)(4), ordinary-course exceptions are essential if 
U.S. business is to remain competitive in the world 
marketplace.
    In sum, it is clear that Notice 98-5 seeks to impose extra-
statutory limits on the foreign tax credit, while Notice 98-11 
seeks to limit deferral in a manner that Congress has declined 
to do. These initiatives would seriously undermine the 
competitiveness of U.S. businesses. However, Treasury and the 
IRS present the Notices and the budget proposal as measures 
designed to preserve the existing principles of the U.S. 
international tax regime. They take the view that the balance 
that has been established by Congress should be interpreted 
more restrictively than either the legislative history or the 
statute would require.
    The MTC respectfully suggests that, if anything, our 
Subpart F and foreign tax credit rules should be relaxed rather 
than tightened. They contain a number of restrictions that have 
become unworkable or outmoded. For example, unlike the law of 
other countries, Subpart F continues to deny deferral for 
active income earned by financial services companies. And the 
foreign tax credit system has reached a level of complexity 
that is daunting for taxpayers and tax administrators alike. 
While the basic framework of our law remains solid, it needs to 
be updated to ensure that U.S. businesses will remain able to 
compete in the 21st century. This role properly is that of 
Congress, however, not Treasury or the IRS.

              Initiatives Override Long-standing Doctrines

    The Administration's initiatives conflict with long-
standing U.S. tax law doctrines. First and foremost, Notice 98-
11 and the budget proposal are based on the premise that 
transactions are abusive if they allow U.S. multinationals to 
reduce their foreign tax burden in a manner perceived as 
inconsistent with Subpart F. As discussed above, we do not 
agree with the Treasury/IRS reading of Subpart F. In any event, 
however, the IRS and the courts have recognized that a 
reduction of foreign tax is a legitimate business purpose for a 
transaction. See, e.g., Rev. Rul. 89-101 and Betty M. Ellis v. 
Commissioner, 50 T.C.M. 1202 (1985). In fact, if U.S. 
multinationals pay less in foreign taxes, they can be expected 
over the long term to claim fewer foreign tax credits--and thus 
to pay more residual U.S. tax. In short, there does not appear 
to be any valid policy reason why the United States should 
insist that its multinationals pay more foreign taxes than 
their foreign competitors.
    Second, by making the Subpart F or other U.S. tax 
consequences depend on how the foreign taxing jurisdiction 
treats a transaction, Notice 98-11 and the budget proposal 
would overturn the principle that the foreign tax law treatment 
of a transaction should not dictate the U.S. tax results. See 
Biddle v. Commissioner, 302 U.S. 573 (1938); United States v. 
Goodyear Tire and Rubber Co. et al., 493 U.S. 132 (1989).
    Third, by preventing taxpayers from conducting their 
overseas operations in a form that will be considered a branch 
for all purposes of the Internal Revenue Code, Notice 98-11 and 
the budget proposal would overturn the principle that taxpayers 
are free to choose the form in which they will do business. See 
Higgins v. Smith, 308 U.S. 473 (1940) (``A taxpayer is free to 
adopt such organization for his affairs as he may choose.'').
    Fourth, Subpart F currently contains a branch rule that is 
set forth in the statute and that is limited to foreign base 
company sales income. In Notice 98-11, Treasury effectively 
seeks to create a new Subpart F branch rule, for foreign 
personal holding company income (and perhaps other categories 
of Subpart F income as well), despite a lack of similar 
statutory authority. Given that Congress saw fit to create only 
one branch rule, and to limit it to foreign base company sales 
income, it seems clear that Treasury lacks the authority to 
create additional branch rules.
    Finally, the branch rule that Treasury seeks to create is 
fundamentally different from the existing Subpart F branch 
rule. Whereas the existing branch rule merely recharacterizes 
income derived from transactions with other parties, Treasury's 
new branch rule would actually create income where the CFC has 
not entered into a transaction with another party (for example, 
by treating a remittance from the corporate home office to a 
branch as ``income,'' as in Example 2 of Notice 98-11). By 
creating income where none exists under general U.S. tax 
principles, this new rule would represent a radical departure, 
beyond the bounds of Subpart F. While allowing the 
recharacterization of existing income under certain 
circumstances, the rules of Subpart F do not give Treasury and 
the IRS the authority to create income.

                           Economic Concerns

Competitiveness

    From an income tax perspective, particularly since the Tax Reform 
Act of 1986, the United States currently has become one of the least 
attractive countries in which to locate the headquarters of a 
multinational corporation. As a result, U.S.-based multinationals tend 
to be disadvantaged relative to non-U.S. multinationals in competing 
around the world. The Administration's proposal would further burden 
U.S.-based multinationals.
    First, it should be noted that many of our major trading partners 
(12 of the 24 OECD countries as of 1990) operate under the principle of 
``territorial'' taxation, under which a parent company is not subject 
to tax on the active income earned by a foreign subsidiary.\4\ By 
contrast, the United States taxes income earned through foreign 
corporations when it is repatriated or deemed to be repatriated under 
various ``anti-deferral'' rules in the tax code.
---------------------------------------------------------------------------
    \4\ Organization for Economic Cooperation and Development, Taxing 
Profits in a Global Economy, 1991.
---------------------------------------------------------------------------
    Second, among countries that tax income on a worldwide basis, the 
active business income of a foreign subsidiary is generally not subject 
to tax before it is remitted to the parent.\5\ This differs from the 
U.S. treatment of foreign base company sales and service income and 
financial services income, and certain other types of active business 
income, which are subject to current U.S. tax even if reinvested 
abroad.
---------------------------------------------------------------------------
    \5\ Organization for Economic Cooperation and Development, 
Controlled Foreign Company Legislation, 1996.
---------------------------------------------------------------------------
    Third, other countries with worldwide tax systems generally have 
fewer restrictions on the use of foreign tax credits than the United 
States.\6\
---------------------------------------------------------------------------
    \6\ A variety of U.S. rules limit the crediting of foreign taxes 
against U.S. tax liability. These include multiple separate ``baskets'' 
for calculating tax credits, the apportionment of interest and certain 
other deductions against foreign source income, and the attribution to 
a foreign subsidiary of a larger measure of income for U.S. purposes 
(``Earnings and Profits'') than used by other countries. See Taxation 
of U.S. Corporations Doing Business Abroad: U.S. Rules and 
Competitiveness Issues, Price Waterhouse LLP (Financial Executives 
Research Foundation, 1996).
---------------------------------------------------------------------------
    Fourth, most of the major trading partners of the United States 
provide for some form of integration of the corporate and individual 
income tax systems, which reduces or eliminates the extent to which 
corporate income is double taxed--at both the corporate and shareholder 
level.\7\
---------------------------------------------------------------------------
    \7\ Organization for Economic Cooperation and Development, Taxing 
Profits in a Global Economy, 1991.
---------------------------------------------------------------------------
    The net effect of these tax differences is that a foreign 
subsidiary of a U.S. corporation frequently pays a greater share of its 
income in foreign and U.S. tax than a similar foreign subsidiary owned 
by a company headquartered outside of the United States.\8\ This makes 
it more expensive for U.S. companies to operate abroad than their 
foreign-based competitors.
---------------------------------------------------------------------------
    \8\ Organization for Economic Cooperation and Development, Taxing 
Profits in a Global Economy, 1991.
---------------------------------------------------------------------------
    A decline in activity of U.S. companies abroad can have important 
negative consequences for the U.S. economy. For example, foreign 
affiliates of U.S.-owned companies are responsible for a significant 
amount of exports from the United States.\9\ As another example, a 
reduction in foreign activity would reduce headquarter-based 
activities, such as research and development, that tend to provide high 
wages and enhance U.S. productivity.\10\
---------------------------------------------------------------------------
    \9\ Survey of Current Business, October 1997, p. 50.
    \10\ See Irving Kravis and Robert Lipsey, ``Sources of 
Competitiveness of the United States and of its Multinational Firms,'' 
Review of Economics and Statistics, May 1992, for a discussion of the 
relationship between R&D intensity and human capital intensity and 
worldwide trade shares of U.S. multinationals.

---------------------------------------------------------------------------
Equity

    One argument for the Administration's budget proposal is equity. 
For instance, if some taxpayers are able to reduce foreign taxes 
through the use of certain hybrid arrangements, while other taxpayers 
do not make use of these arrangements, then there may be an inequity.
    As the Joint Committee on Taxation notes in its analysis of the 
Administration's proposal, however: ``hybrid transactions are not 
inherently inequitable. Any business may choose to organize itself to 
take advantage of the benefits of these structures.'' \11\
---------------------------------------------------------------------------
    \11\ Joint Committee on Taxation, Description of Revenue Provisions 
Contained in the President's Fiscal Year 1999 Budget Proposal (JCS-4-
98), February 24, 1998, p. 197.
---------------------------------------------------------------------------
    Given the general applicability of hybrid arrangements, any concern 
about disparate treatment of similarly situated taxpayers appears to be 
unfounded.

Efficiency

    The JCT analysis of the Administration's proposal raises the 
possibility that hybrid arrangements may result in three types of 
economic inefficiencies.
    1. Potential misallocation of investment.--First, if some 
international activities can make use of hybrid arrangements while 
other international activities cannot, then there may be a concern that 
too much investment will be directed to the relatively tax-favored 
activity. However, since the opportunity to make use of hybrid 
arrangements is generally available, there is little reason to suggest 
that these structures create a misallocation of investment resources 
among alternative international activities.
    2. Potential for inefficient increase in administrative costs.--A 
second efficiency concern is that the use of hybrid arrangements causes 
real resources to be expended merely to achieve tax savings.
    In fact, the ``check the box'' regulations under which many hybrid 
arrangements operate were motivated by a concern for reducing 
administrative costs relative to the costs required to achieve similar 
tax effects through more complex legal structures. The recent notices 
issued by the IRS on a retroactive basis will cause taxpayers to incur 
substantial costs to modify structures adopted in reliance on present 
law. Moreover, the testing of individual transactions for economic 
substantiality, as contemplated in Notice 98-5, would be an enormous 
compliance burden on taxpayers that engage in large numbers of 
transactions.
    3. Potential for inefficient increase in foreign investment.--A 
third efficiency concern is that if hybrid arrangements facilitate the 
reduction of foreign taxes, there may be an incentive for U.S. 
multinationals to increase foreign investment relative to domestic 
investment. This would be inefficient if, on a pre-tax basis, domestic 
investment were more productive than foreign investment.
    Academic research and government data on the foreign direct 
investment of U.S. multinationals suggest that increased foreign 
investment is efficiency enhancing and results in important benefits to 
the U.S. economy.
    For example, research by Martin Feldstein concludes that an 
additional dollar of foreign direct investment by U.S. multinationals 
leads to an increase (in present value) of $1.72 in interest, dividend 
receipts, and tax payments to the United States, relative to $1 of such 
receipts on domestic investment.\12\
---------------------------------------------------------------------------
    \12\ Martin Feldstein, ``Tax Rules and the Effect of Foreign Direct 
Investment on U.S. National Income,'' in Taxing Multinational 
Corporations, eds. Martin Feldstein, James R. Hines, Jr., and R. Glenn 
Hubbard (University of Chicago Press, 1995).

---------------------------------------------------------------------------
Tax Revenue Effects

    The official revenue estimate by the Joint Committee on Taxation 
shows that enactment of the proposal would result in no change in 
revenues in any year over the fiscal year 1998-2008 period.
    Aspects of the Administration proposal can even be seen to reduce 
U.S. tax collections if the Treasury Department were to use its grant 
of regulatory authority to restrict the use of hybrid arrangements. 
Current use of hybrid arrangements often results in a reduction in 
foreign taxes paid. A reduction in foreign taxes increases the after-
tax return (in present value) to the United States from foreign 
investment. A reduction in foreign taxes also increases the amount of 
taxes paid to the U.S. government when the income is repatriated, since 
a smaller amount of foreign taxes would be creditable against U.S. tax 
liability.
    Treasury concerns about the creditability of withholding taxes 
levied by third countries with respect to financial instruments held 
abroad appears misplaced. Foreign governments generally allow these 
withholding taxes to be credited against their income taxes. In these 
cases, the withholding tax does not add to the total foreign tax burden 
borne by U.S. investors.
    The Administration's proposal can be seen to harm U.S. investors 
and ultimately reduce U.S. tax collections. Again, it should be noted 
that other countries do not tax the transactions that the 
Administration proposes to tax under this proposal.

Capital Export Neutrality

    One theoretical principle that is sometimes invoked in discussions 
of international tax policy is capital export neutrality (CEN). Under 
this principle, taxes would not affect the investment location 
decisions of multinational corporations.
    One way to achieve CEN would be to tax worldwide income on a 
current basis (whether or not repatriated) with an unlimited foreign 
tax credit. No country has adopted a pure CEN tax system. The U.S. tax 
system can be seen as a compromise: by providing only a limited foreign 
tax credit, total tax paid on certain foreign source income exceeds 
that paid on domestic source income, while deferral of U.S. taxation on 
certain unremitted active business income can result in a lower rate of 
tax.
    Many countries follow the principle of capital import neutrality 
(CIN) with respect to active business income. Under this principle, an 
investment in a foreign country is subject to the same amount of tax 
regardless of the nationality of the investor. CIN is obtained by 
exempting foreign source income from domestic tax.
    The Administration's proposal does not move the U.S. tax system 
closer to either location neutrality (CEN) or competitiveness (CIN). By 
restricting the use of hybrid arrangements, taxes on foreign source 
income are increased both by further limiting the use of foreign tax 
credits and by further restricting deferral on active foreign income.
    Of course, more important than adherence to an abstract principle 
is to evaluate directly whether U.S. living standards are increased by 
tax policies which encourage foreign direct investment by U.S. 
multinationals.\13\ As discussed earlier and in the next section, the 
evidence is quite strong that foreign direct investment by U.S. 
multinationals increases U.S. living standards in a number of different 
ways.
---------------------------------------------------------------------------
    \13\ Joint Committee on Taxation, Factors Affecting the 
International Competitiveness of the United States, JCS-6-91, May 30, 
1991.

---------------------------------------------------------------------------
Effects of Foreign Investment on the U.S. Economy

    The primary motivation for U.S. multinationals to operate abroad is 
to better compete in foreign markets, not domestic markets. A large 
body of research has documented that U.S. operations abroad on balance 
increase exports of goods and services from the United States. In 1995, 
U.S.-controlled foreign corporations contributed a net surplus of $27 
billion to the U.S. trade balance.\14\
---------------------------------------------------------------------------
    \14\ Survey of Current Business, October 1997, p.50.
---------------------------------------------------------------------------
    Foreign direct investment is one means by which U.S. multinationals 
can increase their return on firm-specific assets, including patents, 
skills, and technologies. As noted by Robert Lipsey, the ability to 
earn an enhanced return on these firm-specific assets through foreign 
direct investment provides an incentive to increase investment in the 
activities that generate these assets, such as research and 
development.\15\ These and other high-value activities are 
disproportionately undertaken by U.S. multinationals in the United 
States. For example, over the past 20 years, between 43% and 62% of 
total U.S. R&D was performed by or for U.S. multinationals.\16\
---------------------------------------------------------------------------
    \15\ Robert Lipsey, ``Outward Direct Investment and the U.S. 
Economy,'' in The Effects of Taxation on Multinational Corporations, 
eds. Martin Feldstein, James R. Hines, Jr., and R. Glenn Hubbard 
(University of Chicago Press, 1995).
    \16\ Bureau of Economic Analysis and National Science Foundation 
data.
---------------------------------------------------------------------------
    Other research has focused on the effect of foreign direct 
investment on U.S. employment and U.S. wages and salaries. This 
research finds little or no evidence of an adverse effect on the U.S. 
labor market.\17\ In 1995, approximately 80 percent of new foreign 
affiliate assets and employees of U.S. multinationals were located in 
high-wage foreign countries. These and other findings suggest that 
foreign investment is primarily undertaken to pursue market 
opportunities abroad rather than to substitute low-cost foreign labor 
for U.S. operations.
---------------------------------------------------------------------------
    \17\ See, e.g., S. Lael Brainard and David Riker, ``Are U.S. 
Multinationals Exporting U.S. Jobs?'' National Bureau of Economic 
Research Working Paper 5958, March 1997.
---------------------------------------------------------------------------

                               Conclusion

    Treasury's FY 1999 budget proposal and the issuance of 
Notice 98-11 and 98-5 are the latest in a series of Clinton 
Administration anti-competitive international tax initiatives 
that have been blocked by Congress. For example, Congress in 
1997 rejected Treasury proposals to eliminate the export sales 
source rules under section 863(b), which help support U.S. 
exports. In addition, Congress in 1996 repealed ill-conceived 
limitations on deferral, under section 956A, that had been 
proposed by the Administration in 1993. The MTC applauds the 
Congress for having provided a counterbalance with respect to 
these initiatives, and would urge Congress to continue its 
vigilance.
    We have two requests. First, in light of strong concerns 
and uncertainty over the regulatory authority requested by 
Treasury in the Administration's FY 1999 budget, we ask 
Congress not to adopt this proposal. Policy changes of the 
scope envisioned by Treasury should be made by the Congress 
after input from all interested constituencies, not by notice 
or regulation.
    Second, we respectfully ask the Congress to limit the 
Treasury's ability to take preemptive active in the areas 
discussed in Notice 98-11 and Notice 98-5. Specifically, we ask 
that Congress consider the possibility of a moratorium on 
regulations to be promulgated pursuant to Notices 98-11 and 98-
5 until Congress, with input from the Treasury and Commerce 
Department, has an appropriate opportunity to study the issues 
involved and the ramifications for the ability of American 
businesses to compete in world markets.
    The MTC stands ready to work with Congress and the Treasury 
Department to reach a resolution of these issues.
      

                                

[GRAPHIC] [TIFF OMITTED] T1685.005

      

                                

Statement of National Association of Manufacturers

                              Introduction

    The National Association of Manufacturers (NAM) wishes to 
express its appreciation to the Committee's chairman, Mr. 
Archer, for holding a hearing on the revenue provisions in the 
Administration's FY 1999 budget proposal. The NAM is the 
nation's oldest and largest broad-based industrial trade 
association. Its more than 14,000 member companies and 
subsidiaries, including approximately 10,000 small 
manufacturers, are in every state and produce about 85 percent 
of U.S. manufactured goods. Through its member companies and 
affiliated associations, the NAM represents every industrial 
sector and the interests of more than 18 million employees.
    The Administration's FY 1999 Budget proposal jeopardizes 
last year's balanced-budget agreement and threatens to revive 
big government with proposals to increase new spending by $21 
billion financed by a $25 billion tax hike. The majority of the 
included tax proposals are anti-growth and bad tax policy, with 
a few notable exceptions. Overall, the proposals run counter to 
the NAM's goal of maintaining sustained economic growth to 
enhance living standards for all Americans. Although this is 
not an exhaustive list, following are the NAM's comments on 
some of the specific provisions.

                          Pro-Growth Proposals

Accelerating the Effective Date of Look-Through Treatment for 
10/50 Companies

    This proposal would accelerate the effective date of a tax 
change made in the 1997 Tax Relief Act affecting foreign joint 
ventures owned between 10 and 50 percent by U.S. parents (so-
called ``10/50 companies''). This change will allow 10/50 
companies to be treated similarly to controlled foreign 
corporations by allowing ``look-through'' treatment for foreign 
tax credit purposes for dividends from such joint ventures. 
Under the 1997 Act, the change is effective only for dividends 
received after the year 2003 and, even then, two sets of rules 
are required to be applied: one for dividends from earnings and 
profits (E&P) generated before 2003 and another for dividends 
from E&P accumulated after 2002. The Administration's proposal 
will instead apply the look-through rules to all dividends 
received in tax years after 1997, regardless of when the E&P 
constituting the dividend were accumulated.
    This change will result in a tremendous reduction in 
complexity and compliance burdens for U.S. multinationals doing 
business overseas through foreign joint ventures. It will also 
reduce the competitive bias against U.S. participation in such 
ventures by placing U.S. companies on a much more level playing 
field from a corporate tax standpoint. This proposal epitomizes 
the favored policy goal of simplicity in the tax laws and will 
go a long way toward helping the U.S. economy by strengthening 
the competitiveness of U.S.-based multinationals.

Extending the Research and Experimentation (R&E, commonly known 
as R&D) Tax Credit

    Technology progress accounts for nearly one-third of 
economic growth over the long run because of the direct 
correlation between technology progress and increased 
productivity. Although the credit's benefits are many, a 
principal benefit of the credit is its effect on lowering the 
cost of investing in technology. Thus, the NAM commends the 
President for recognizing the importance of the credit's 
contribution to sustaining our robust economic growth by 
including a one-year, seamless extension of the credit.
    NAM economic analysis shows that a perminant R&D tax credit 
would, over time, actually increase the rate of GDP growth over 
the long term, as opposed to a one-time shift in the level of 
GDP. This is an important distinction from most policy 
initiatives, which have no effect on the rate of long-term 
economic growth. Since manufacturers are the principal parties 
engaging in U.S.-based R&D activities and many of our nation's 
foreign trade competitors offer permanent tax and financial 
incentives for R&D, the credit helps mitigate this unfair 
competitive disadvantage to U.S. companies. The Congress and 
the President are urged to work together to end the continuing 
15-plus year saga of temporary lapses of the credit with 
extensions that may or may not be retroactive to the expiration 
date. Thus, the NAM strongly supports ending the uncertainty of 
credit extensions by making the R&D tax credit permanent.

``Global'' Interest Netting on Underpayments and Overpayments

    The NAM supports this long-overdue taxpayer simplification 
proposal and urges speedy enactment. Specifically, this 
proposal will allow global interest netting for income taxes by 
adding a new interest rate to Internal Revenue Code section 
6621. Thus, this proposal will allow netting an overpayment, or 
interest thereon, against a prior deficiency of tax or interest 
that has already been paid in full by the taxpayer, or 
conversely netting an underpayment against a prior refund (of 
tax or interest) that has already been paid by the IRS.

Tax Incentives To Promote Energy Efficiency and Improve the 
Environment

    In general, the NAM supports a voluntary approach to 
improving energy efficiency and the environment rather than 
federal mandates. While the NAM generally approves of the 
thrust of the Administration's tax incentive proposals 
pertaining to energy efficiency, the manufacturing community 
would prefer a general, permanent extension of the R&D tax 
credit to better allow the market to allocate limited 
resources.

                      Growth-Inhibiting Proposals

Repeal of the Export Source Rule

    The NAM strongly opposes the Administration's proposal to 
replace the current export source rule with an activity-based 
sourcing rule. Since 1922, tax regulations have contained the 
export source rule, which allows the income from goods that are 
manufactured in the United States and sold abroad to be treated 
as 50-percent U.S. source income and 50-percent foreign source 
income. As a result, the export source rule increases the 
ability of U.S. exporters to make use of foreign tax credits 
and thus avoid double taxation of foreign earnings.
    The Administration contends that the export source rule is 
not needed to alleviate double taxation because of our tax 
treaty network. We strongly disagree. The United States has tax 
treaties with fewer than a third of all jurisdictions. More 
significantly, double taxation is generally caused by the many 
restrictions in U.S. tax laws on crediting foreign taxes paid 
on the international operations that U.S. companies must have 
to compete in the global marketplace. Among these restrictions 
are the allocation rules for interest and R&D expenses, the 
many foreign tax credit ``baskets,'' and the treatment of 
domestic losses.
    By reducing double taxation, the export source rule 
encourages U.S.-based manufacturing and exports. A recent 
Hufbauer/DeRosa study estimates that, for the year 1999 alone, 
the export source rule will account for an additional $30.8 
billion in exports, support 360,000 jobs and add $1.7 billion 
to worker payrolls in the form of export-related wage premiums. 
(This study is an analysis of the economic impact of the export 
source rule, a document submitted as part of Gary Hufbauer's 
testimony on March 12, 1997.) The Administration's proposal 
would essentially eliminate this WTO-consistent (World Trade 
Organization) export incentive. Such action would be harmful to 
U.S. economic growth and high-paying, export-related jobs. This 
proposal would also take away the administrative simplicity of 
the export source rule and require enormously complex factual 
determinations that would add administrative burdens and create 
controversies. The NAM strongly urges Congress to retain the 
current export source rule.

Estate and Gift Tax Provisions

    In the area of estate and gift taxes, the Administration 
proposes to scrap the techniques that allow a business owner to 
move illiquid assets out of the estate first. Forcing business 
owners to delay transfer of business ownership until death will 
result in an even higher failure rate for family-owned 
businesses.
    The best example of this is the Administration's proposal 
to eliminate the ``Crummey'' rule. The Crummey rule allows 
transfer of ownership in an orderly fashion during the donor's 
lifetime. Since the case was decided nearly 30 years ago, 
thousands of estate plans have been built on the decision. The 
revenue gains from its elimination are small because gifting 
can and will continue. This change would make it harder to give 
business assets to children in the business and non-business 
assets to children outside the business. The Crummey rule 
allows movement of illiquid assets outside of the estate; 
without it, the estate will most likely be drained of its 
liquid assets first, leaving the family business to face the 
maximum tax with the minimum of resources.
    The Qualified Terminable Interest Property Trust (QTIP) was 
designed by Congress to allow both spouses to use their full 
individual unified credits. QTIPs were expressly set up to 
prevent the estate tax from impoverishing a surviving spouse. 
Disallowing QTIPs would force an estate to choose between 
losing the unified credit, breaking up the business, or 
divesting the surviving spouse of cash, leaving the ``second to 
die'' holding the illiquid assets.
    Personal Residence Trusts are significant tools for estate 
planners only because the family home is another illiquid 
asset. Allowing parents to give the family home to their 
children at a future date while retaining the parent's right to 
live in the house for as long as they desire permits a planner 
to give the estate the maximum liquidity to deal with the death 
tax bill.
    Finally, the rules on minority valuation again produce 
little revenue gain, but they allow the IRS to decide whether 
the cash or cash equivalents of an active business exceed the 
``reasonable working capital needs of the business.'' This test 
is already defined under the accumulated earnings tax, and it 
has been the subject of much litigation already. Courts often 
side with the corporations, but too many companies are already 
in court fighting the IRS's unrealistic formula.
    Fewer than one-third of family businesses survive to the 
second generation. These proposals offer minimal revenue and 
would drive down the survival rate even further. The Treasury 
Department derides these estate-planning tools as legal 
fictions. But estate and gift taxes themselves are bad. Family-
owned businesses should not need to resort to legal fictions to 
stay in business. Federal estate and gift taxes should be 
abolished, not raised.

Repeal Tax-Free Conversions of Large C-Corporations to S-
Corporations

    This proposal would repeal Internal Revenue Code Section 
1374 that governs the tax treatment of C-corporations that 
convert to S-corporation status. Specifically, these 
conversions would be treated as taxable liquidations by 
repealing the method of taxing built-in gains such that it 
would be harmful to small and medium-size companies. Small and 
medium-size companies, many of which are S-corporations (4000 
of which are NAM members), are central to the growth of our 
economy. About one-fourth of our national income is generated 
by small and medium-size companies. The Congress has recognized 
the integral and productive contribution of S-corporations to 
our economy, as evidenced by the Small Business Job Protection 
Act of 1996 that encouraged the formation of new S-corporation 
entities. If passed, this proposal would be a barrier to many 
businesses desiring to operate as S-corporations. Thus, the NAM 
opposes this ill-conceived provision that has been proposed 
repeatedly without success. S-corporation rate-relief 
legislation, introduced by Representative Phil Crane (R-IL-8) 
(H.R. 2884) would help mitigate some of the remaining 
deterrents for companies to convert to S-corporation status.

Limiting Use of ``Hybrid'' Entities

    The NAM is very concerned about the Administration's 
request for congressional authority to issue potentially 
sweeping legislative regulations to implement non-specific tax 
guidance. If the Administration feels that a specific abuse is 
being perpetrated, it should be addressed through relevant 
legislation. This would permit normal congressional 
consideration, including hearings on such legislation.
    One specific Administration proposal would limit the 
ability of certain foreign and U.S. persons to enter into 
transactions that use so-called ``hybrid entities,'' which are 
entities that are treated as corporations in one jurisdiction 
but as branches or partnerships in another. Although most 
hybrid transactions do not attempt to generate tax results that 
are ``inconsistent with the purposes of U.S. tax law,'' the 
Administration feels that there are enough taxpayers taking 
unfair advantage of the current rules that it is necessary to 
codify and extend the earlier government issued tax guidance 
(Notices 98-5 and 98-11) on this subject.
    U.S. multinationals compete in an environment wherein 
foreign competitors use tax-planning techniques to reduce 
foreign taxes without incurring home country tax. The use of 
``hybrid entities'' allows U.S. multinationals to compete on a 
level playing field and promotes additional U.S. exports. The 
use of hybrids is consistent with the initial balance between 
competitiveness and export neutrality that was intended by 
Congress in enacting the ``Subpart F'' rules. Although Congress 
specifically enacted a branch rule for foreign base company 
sales under Code section 954(d)(3), similar rules were not 
enacted for foreign personal holding company income. If 
enacted, these proposals would represent an unwarranted 
extension of legislative authority by Congress to the executive 
branch to circumvent congressional debate by imposing new rules 
through regulation.
    Notices 98-5 and 98-11 have a chilling effect on the 
ability of U.S. companies to structure their foreign operations 
consistently with the commercial objective of regionalizing 
their businesses. They also adversely impact companies' 
abilities to effectively reduce their overall costs by reducing 
local taxes in their overseas operations. The notices are 
drafted so broadly and so vaguely that they confuse U.S. 
taxpayers and their advisors, and introduce a compelling need 
to seek clarification as to whether taxpayers can continue to 
rely on the simple ``check-the-box'' regulations issued just 
last year. All these effects are exacerbated by the notices' 
immediate effective dates.
    The world has changed dramatically since enactment of the 
Subpart F rules in 1962. The NAM feels it would be more 
appropriate for Congress to request a study regarding the trade 
and tax policy issues associated with Notices 98-5 and 98-11. 
In this regard, a moratorium on further regulatory action by 
the Treasury Department should be imposed until enactment of 
specific legislative proposals resulting from well-reasoned 
analysis and debate.

Foreign Built-in Losses

    Another proposal would require the Treasury Department to 
issue regulations to prevent taxpayers from ``importing built-
in losses incurred outside U.S. taxing jurisdictions to offset 
income or gain that would otherwise be subject to U.S. tax.'' 
The Administration argues that, although there are rules in the 
Code that limit a U.S. taxpayer's ability to avoid paying U.S. 
tax on built-in gain (e.g. Code 367(a), 864(c)(7), and 877), 
similar rules do not exist that prevent built-in losses from 
being used to shelter income otherwise subject to U.S. tax, 
and, as a result, taxpayers are avoiding Subpart F income 
inclusions or capital gains tax. We believe that this 
directive, which is written extremely broadly, is unnecessary 
due to the existence of rules already available in the Code. 
Both this proposal and the one immediately above regarding the 
use of hybrid entities would severely impact the ability of 
U.S. multinationals to compete on an equal footing against 
foreign-based companies.

Superfund Taxes

    The Superfund program has historically been funded by the 
following taxes--the corporate environmental income tax and 
excise taxes on petroleum, chemical feed stock, and imported 
chemical substances--all of which expired as of Dec. 31, 1995. 
The Administration's budget proposal would reinstate the excise 
taxes at their previous levels for the period after the date of 
enactment until Oct. 1, 2008. The corporate environmental 
income tax would be reinstated at its previous level for 
taxable years beginning after Dec. 31, 1997 and before Jan. 1, 
2009.
    Under the ``pay-go'' rules of the federal budget laws, any 
Superfund reauthorization bill that includes spending 
provisions must also include provisions to reinstate the former 
Superfund taxes or provide equivalent revenues ``within the 
four corners of the bill'' to keep it revenue neutral. Thus, as 
a practical matter, if Congress were to extend the Superfund 
taxes separate from a Superfund reauthorization bill, then such 
action would end the prospects for major legislative reform of 
the Superfund program during the period for which the taxes are 
re-enacted. Furthermore, an additional revenue offset would be 
needed because the taxes collected would be scored for general 
revenues to balance the budget. The use of such tax revenues 
for deficit-reduction purposes should be rejected. The NAM 
urges that the decision to reinstate these taxes dedicated to 
financing Superfund should instead be made only as part of 
comprehensive programmatic changes to a Superfund reform bill. 
The Administration's proposal to reinstate the Superfund taxes 
without Superfund reform is merely an attempt to raise revenue 
for new spending programs.

Foreign Oil and Gas Income Tax Credits

    The President's budget proposal dealing with foreign oil 
and gas income moves in the opposite direction by limiting use 
of the foreign tax credit on such income. This selective attack 
on a single industry's use of the foreign tax credit is not 
justified. U.S.-based oil companies are already at a 
competitive disadvantage under current law, since most of their 
foreign-based competition pay little or no home country tax on 
foreign oil and gas income. The proposal increases the risk of 
foreign oil and gas income being subject double taxation, which 
will severely hinder U.S. oil companies in the global oil and 
gas exploration, production, refining, and marketing arena. The 
NAM is particularly opposed to this provision because it 
undermines the entire foreign tax credit system and sets a very 
bad tax-policy precedent by making the recoupment of double 
taxation costs contingent on the industry in which a company is 
engaged.

Payments to 80/20 Companies

    Currently, a portion of interest or dividends paid by a 
domestic corporation to a foreign entity may be exempt from 
U.S. withholding tax, provided the payor corporation is a so-
called ``80/20 company,'' i.e., at least 80 percent of its 
gross income for the preceding three years is foreign-source 
income attributable to the active conduct of a foreign trade or 
business. The Administration believes that the testing period 
is subject to manipulation and allows certain companies to 
improperly avoid U.S. withholding tax on certain distributions 
attributable to a U.S. subsidiary's U.S. source earnings. As a 
result, it proposes to arbitrarily change the 80/20 rules by 
applying the test on a group-wide (as opposed to individual 
company) basis. However, there is little evidence that these 
rules have been manipulated on a broad scale in the past and we 
do not believe such a drastic change is needed at this time.

Dividends-Received Deduction for Certain Preferred Stock

    The dividends-received deduction (DRD) was designed to 
alleviate the impact of multiple layers of corporate taxation. 
Without the DRD, income would be taxed three times: 1) when it 
is earned by a corporation; 2) when the income is paid as a 
dividend to a corporate shareholder; and 3) when the income of 
the receiving corporation is paid as a dividend to an 
individual shareholder. The DRD was enacted to provide for full 
deductibility of intercorporate dividends.
    The Administration's revenue-raising proposal would result 
in asymmetrical tax treatment between a payor and payee of what 
purports to be a dividend is not appropriate tax policy. Thus, 
the NAM objects to this provision.

Limiting Mark-to-Market Accounting

    Certain trade receivables would no longer be eligible for 
treatment under the mark-to-market accounting rules. Under 
those rules, certain taxpayers who purchase and sell their own 
trade receivables are exempt from the mark-to-market method of 
accounting unless they elect to be included. If they make the 
election, those taxpayers can currently write-off certain non-
interest bearing receivables, and account, note, and trade 
receivables unrelated to the active business of a securities 
dealer. There appear to be no tax policy reasons for 
prohibiting taxpayers from accelerating their bad debt 
deductions for these trade receivables, only government revenue 
considerations.

Lower of Cost or Market Inventory Accounting Method

    A taxpayer that sells goods in the active conduct of its 
trade or business generally must maintain inventory records in 
order to determine the cost of goods it sold during the taxable 
period. Cost of goods sold generally is determined by adding 
the taxpayer's inventory at the beginning of the period to 
purchases made during the period and subtracting from that sum 
the taxpayer's inventory at the end of the period. Because of 
the difficulty of applying the specific identification method 
of accounting, taxpayers often use methods such as ``first-in, 
first-out'' (FIFO) and ``last-in, first-out'' (LIFO). Taxpayers 
not using a LIFO method are allowed to determine the carrying 
values of their inventories by applying the lower of cost or 
market (LCM) method and by writing down the cost of goods that 
are unsalable at normal prices or unusable in the normal way 
because of damage, imperfection or other causes (the 
``subnormal goods'' method).
    The Administration's proposal would repeal the LCM method. 
The NAM is opposed to repeal of LCM because, particularly in a 
time of rapid technological advance, the value of items 
accounted for in inventory is often diminished due to external 
factors. LCM allows this loss of value to be accounted for in 
the period in which it occurs. To retain the historic cost 
basis in such instances would be both unfair and fail to 
achieve a proper matching of costs and revenue, resulting in a 
failure to clearly reflect income. The NAM strongly urges the 
retention of the LCM method.

Deferral of Original Issue Discount (OID) on Convertible Debt

    The Administration has included a number of past proposals 
aimed at financial instruments and the capital markets, which 
were fully rejected during the last session of Congress. These 
reintroduced proposals should again be rejected. One proposal 
would defer deductions by corporate issuers for interest 
accrued on convertible debt instruments with original issue 
discount (OID) until interest is paid in cash. The proposal 
would completely deny the corporation an interest deduction 
unless the investors are paid in cash (e.g. no deduction would 
be allowed if the investors convert their bonds into stock). 
Investors in such instruments would still be required to pay 
income tax currently on the accrued interest. In effect, the 
proposal defers or denies an interest deduction to the issuer, 
while requiring the holder to pay tax on the interest 
currently.
    The NAM opposes this proposal because it is contrary to 
sound tax policy and symmetry that matches accrual of interest 
income by holders of OID instruments with the ability of 
issuers to deduct accrued interest. There is no justifiable 
reason for treating the securities as debt for one side of the 
transaction and as equity for the other side. There is also no 
reason, economic or otherwise, to distinguish a settlement in 
cash from a settlement in stock.
    Moreover, the instruments in question are truly debt rather 
than equity. Recent statistics show that more than 70 percent 
of all zero-coupon convertible-debt instruments were retired 
with cash, while only 30 percent of these instruments were 
convertible to common stock. Recharacterizing these instruments 
as equity for some purposes is fundamentally incorrect and will 
put American companies at a distinct disadvantage to their 
foreign competitors, who are not bound by such restrictions. 
These hybrid instruments and convertible OID bond instruments 
have allowed many U.S. companies to raise tens of billions of 
dollars of investment capital used to stimulate the economy. 
Introducing this imbalance and complexity into the tax code 
will discourage the use of such instruments, limit capital 
raising options, and increase borrowing costs for corporations.

Modifying Corporate-Owned Life Insurance (COLI) Rules

    The Administration proposes to substantially change the 
taxation of business-owned life insurance by disallowing a pro-
rata portion of a business' general deduction for interest 
expense. Moreover, the Administration has proposed retroactive 
application of the new tax to existing life insurance 
contracts. This proposal should not be adopted.
    Life insurance has long been used by businesses to protect 
against financial loss caused by the death of key employees and 
to finance the cost of employee benefits, especially post-
retirement health benefits. Life insurance provides a secure 
and stable source of financing for such employee benefits, and 
it is particularly well suited to this purpose because its 
long-term nature matches the correspondingly long-term nature 
of the liabilities. The Administration's proposal would have a 
devastating effect on key-person protection by effectively 
taxing life insurance contracts out of existence. Businesses 
should not be discouraged from providing employee health 
benefits or from seeking to protect themselves from key-person 
losses.
    Moreover, the Administration's proposal would apply 
retroactively to existing life insurance contracts that were 
purchased by businesses in good faith, based on existing law. 
There can be no question of abuse: business use of life 
insurance is well known and the taxation of insurance contracts 
has been settled for many years. In addition, Congress has 
reviewed the taxation of business-owned life insurance in each 
of the last two years and, in each case, has carefully 
preserved the existing taxation of business-owned life 
insurance on the lives of employees. The Administration's 
proposal represents the worst kind of retroactive tax--it would 
not only cause the termination of most or all existing 
contracts but would also have the effect of taxing past 
earnings under those contracts.

Tax Insurance Contract Exchanges or Reallocate Assets with 
Variable Insurance Contracts

    Annuity contract investments are a valuable retirement and 
investment tool. Currently, owners of variable annuity 
contracts can allocate their investments in a contract among 
different investment options (e.g. a bond fund, a stock fund, 
and a balanced fund). Owners may reallocate their account 
values within the contract among the various options without 
incurring a current tax, so long as the investment remains 
committed to a retirement annuity. This flexibility provides an 
important savings incentive for retirement. A taxable event 
occurs when funds are taken out of an annuity. Regardless, the 
Administration proposes to tax any exchange of a life 
insurance, endowment, or annuity contract, for a variable 
contract, or vice versa. In addition, any reallocation among 
accounts within the same variable life or annuity contract 
would result in a taxable event, even though no funds were 
taken out of the contract. An exchange of contracts, without 
tax liability, is a long-standing proviso of the Code.
    The NAM opposes this provision as a tax increase on middle-
class Americans and retirement savers. Moreover, the proposal 
completely contradicts the President's recent statements to 
``save Social Security first.'' Any new tax on private 
retirement savings puts further strain on the overall private 
and public retirement system. Variable life and annuity 
contracts are used respectively to insure against premature 
death and for long-term retirement savings. Like other 
retirement-saving vehicles, including defined contribution and 
defined benefit plans, annuities allow savings to grow tax-free 
until they are needed for retirement. All retirement savers 
periodically shift their savings among different options as 
they grown older and more conservatives, or as the market 
changes. Under this proposal, annuity owners who shift accounts 
would be taxed immediately, thereby forcing them to keep bad 
investments or pay a tax on undistributed funds.
    Recent surveys have shown that more than 80 percent of the 
owners of deferred annuity contracts have total annual 
household incomes of under $75,000. Such middle income savers 
rely on these well-designed products to encourage them to 
commit funds to retirement. At a time when Congress and the 
President are concerned about saving social security, the last 
thing that they should do is tax private retirement savings 
options.

Reduction in Basis (Investment in the Contract) for Mortality-
Related Charges

    The Administration's proposal would reduce a policy-
holder's tax basis in an insurance or annuity contract for 
certain charges under the contract by subtracting these charges 
include the cost of the insurance and related expenses. For 
deferred annuity contracts, the assumed mortality and expenses 
charges, which must be subtracted, are deemed to equal the 
contract's average cash value during the year multiplied by 
1.25 percent. This proposal is nothing but a tax on private 
retirement savings. Increasing the cost of such savings 
vehicles by reducing a product's tax basis creates a 
disincentive to use these important savings tools. Life 
insurance and annuity contracts are designed to both accumulate 
retirement savings and insure against premature death (e.g. 
mortality-related risks). Taxes on income from the savings 
element of such contracts should not be increased just because 
those contracts also provide insurance protection.
    This provision will likewise result in a tax increase on 
middle-class Americans and retirement savers. In addition, the 
proposal is inconsistent with general tax rules relating to the 
determination of tax basis and will further increase the 
complexity of the tax code with no recognizable benefit. Under 
the proposal, life insurance companies would be required to 
maintain additional records to keep track of two different 
basis amounts for annuity contracts. This will undoubtedly 
result in increased administrative burdens and compliance 
costs, which most likely will be passed on to Americans trying 
to save for retirement.

Tightening the Substantial Understatement Penalty for Large 
Corporations

    The NAM opposes this anti-business proposal because the 
percent test of 10 percent is appropriate for all size 
companies. This proposal would treat a corporation's deficiency 
of more than $10 million as substantial for purposes of the 
substantial understatement penalty, regardless of whether it 
exceeds 10 percent of the taxpayer's total tax liability. There 
is no need to discriminate against large, multinational, and 
publicly-held companies by inserting into the tax code an 
absolute dollar amount based on their proportionately higher 
tax liabilities and greater tax ambiguities faced by these 
companies.

Effective Dates

    Finally, certain proposed revenue raising provisions 
contained in the Administration's FY 1999 budget proposal would 
have retroactive effective dates. The NAM believes that the 
effective dates of any new revenue raising proposals should not 
disrupt market activities and normal business transactions. In 
this regard, the completion of many contractually binding 
business transactions can be subject to delays or 
contingencies, such as shareholder approval or government 
antitrust or tax clearances. Nevertheless, these bona fide 
transactions would fail the Administration's effective date 
rule if final closing were to occur after the effective date, 
even though the transactions were contractually bound prior to 
that time. This disrupts on-going commercial activities and 
ultimately amounts to a retroactive tax increase on pending but 
not completed transactions.
    The NAM believes it would be highly inappropriate to 
adversely affect pending business transactions in this way. 
Accordingly, the NAM urges that if Congress adopts any revenue 
raisers, whatever effective date it chooses, it should include 
an exception for pending transactions that are publicly 
announced, subject to binding contracts or contingent upon 
necessary third party approvals.

                               Conclusion

    The NAM fully supports a balanced federal budget and, in 
fact, believes it is necessary to the economic health of the 
country. However, we believe that the revenue raisers discussed 
above would provide disincentives to savings and investment and 
raise the cost of capital for manufacturers. The NAM not only 
doesn't support these and other tax increases in the 
Administration's budget, but we believe that pro-growth 
policies, such as corporate alternative minimum tax (AMT) 
reform, estate tax repeal, permanent extension of the R&D tax 
credit, and S-corporation rate relief, combined with 
substantive social security reform and spending reductions, 
would help maintain robust economic growth concurrent with a 
low rate of inflation.
      

                                

Statement of Steven J. Guttman, NAREIT Chair and Chairman and Chief 
Executive Officer, Federal Realty Investment Trust; on behalf of 
National Association of Real Estate Investment Trusts

    As requested in Press Release No. FC-11 (February 18, 
1998), the National Association of Real Estate Investment 
Trusts (``NAREIT'') respectfully submits these 
comments in connection with the Ways and Means Committee's 
review of certain revenue provisions presented to the Committee 
as part of the Administration's Fiscal Year 1999 Budget.
    NAREIT's comments will address the Administration proposals 
to (1) amend section 1374 of the Internal Revenue Code to treat 
an ``S'' election by a large C corporation as a taxable 
liquidation of that C corporation; (2) restrict real estate 
investment trusts (``REITs'') from owning more than 10 percent 
of the value of so-called ``subsidiary service corporations;'' 
(3) modify treatment of closely held REITs; and (4) freeze the 
grandfather status of stapled (or paired-share) REITs. We 
appreciate the opportunity to present these comments.
    NAREIT is the national trade association for real estate 
companies. Members are REITs and other public businesses that 
own, operate and finance income-producing real estate, as well 
as those firms and individuals who advise, study and service 
these businesses. REITs are companies whose income and assets 
are mainly connected to income-producing real estate. By law, 
REITs regularly distribute most of their taxable income to 
shareholders as dividends. NAREIT represents over 250 REITs or 
other public real estate companies, as well as over 2,000 
investment bankers, analysts, accountants, lawyers and other 
professionals who provide services to REITs.

                          Background on REITs

    A REIT is essentially a corporation or business trust 
combining the capital of many investors to own and, in most 
cases, operate income-producing real estate, such as 
apartments, shopping centers, offices and warehouses. Other 
REITs also are engaged in financing real estate. REITs must 
comply with a number of requirements, some of which are 
discussed in detail in this statement, but the most fundamental 
of these are as follows: (1) REITs must pay at least 95 percent 
of their taxable income to shareholders; (2) REITs must derive 
most of their income from real estate held for the long term; 
and (3) REITs must be widely held. In exchange for satisfying 
these requirements, REITs (like mutual funds) benefit from a 
dividends paid deduction so that most, if not all, of a REIT's 
earnings are taxed only at the shareholder level. On the other 
hand, REITs pay the price of not having retained earnings 
available to expand their business. Instead, capital for growth 
must come from new money raised in the investment marketplace 
from investors who have confidence in the REIT's future 
prospects and business plan.
    Congress created the REIT structure in 1960 to make 
investments in large-scale, significant income-producing real 
estate accessible to the smaller investor. Based in part on the 
rationale for mutual funds, Congress decided that the only way 
for the average investor to access investments in larger-scale 
commercial properties was through pooling arrangements. In much 
the same ways as shareholders benefit by owning a portfolio of 
securities in a mutual fund, the shareholders of REITs can 
unite their capital into a single economic pursuit geared to 
the production of income through commercial real estate 
ownership. REITs offer distinct advantages for smaller 
investors: greater diversification by investing in a portfolio 
of properties rather than a single building and expert 
management by experienced real estate professionals.
    Despite the advantages of the REIT structure, the industry 
experienced very little growth for over 30 years mainly for two 
reasons. First, at the beginning REITs were handcuffed. REITs 
were basically passive portfolios of real estate. REITs were 
permitted only to own real estate, not to operate or manage it. 
This meant that REITs needed to use third party independent 
contractors, whose economic interests might diverge from those 
of the REIT's owners, to operate and manage the properties. 
This was an arrangement the investment marketplace did not 
accept warmly.
    Second, during these years the real estate investment 
landscape was colored by tax shelter-oriented characteristics. 
Through the use of high debt levels and aggressive depreciation 
schedules, interest and depreciation deductions significantly 
reduced taxable income--in many cases leading to so-called 
``paper losses'' used to shelter a taxpayer's other income. 
Since a REIT is geared specifically to create ``taxable'' 
income on a regular basis and a REIT is not permitted to pass 
``losses'' through to shareholders like a partnership, the REIT 
industry could not compete effectively for capital against tax 
shelters.
    In the Tax Reform Act of 1986 (the ``1986 Act''), Congress 
changed the real estate investment landscape in two important 
ways. First, by limiting the deductibility of interest, 
lengthening depreciation periods and restricting the use of 
``passive losses,'' the 1986 Act drastically reduced the 
potential for real estate investment to generate tax shelter 
opportunities. This meant, going forward, real estate 
investment needed to be on a more economic and income-oriented 
footing.
    In addition, as part of the 1986 Act, Congress took the 
handcuffs off REITs. The Act permitted REITs to operate and 
manage--in addition to owning--most types of income-producing 
commercial properties by providing ``customary'' services 
associated with real estate ownership. Finally, for most types 
of real estate (other than hotels, health care facilities and 
some other activities that consist of a higher degree of 
personal services), the economic interests of the REIT's 
shareholders could be merged with those of the REIT's operators 
and managers.
    Despite Congress' actions in 1986, significant REIT growth 
did not begin until 1992. One reason was the real estate 
recession in the early 1990s. During the late 1980s banks and 
insurance companies kept up real estate lending at a 
significant pace. Foreign investment, particularly from Japan, 
also helped buoy the marketplace. But by 1990 the combined 
impact of the Savings and Loan crisis, the 1986 Act, 
overbuilding during the 1980s by non-REITs and regulatory 
pressures on bank and insurance lenders, led to a depression in 
the real estate economy. During the early 1990s commercial 
property values dropped between 30 and 50 percent. Credit and 
capital for commercial real estate became largely unavailable. 
As a result of this capital crunch, many building owners 
defaulted on loans, resulting in huge losses by financial 
institutions. The Resolution Trust Corporation took over the 
real estate assets of insolvent financial institutions.
    Against this backdrop, starting in 1992, many private real 
estate companies realized that the best and most efficient way 
to access capital was from the public marketplace through 
REITs. At the same time, many investors decided that it was a 
good time to invest in commercial real estate--assuming 
recovering real estate markets were just over the horizon. They 
were right.
    Since 1992, the REIT industry has attained astounding 
growth as new publicly traded REITs infused much needed equity 
capital into the over-leveraged real estate industry. Today 
there are over 200 publicly traded REITs with an equity market 
capitalization exceeding $150 billion. These REITs are owned 
primarily by individuals, with 49 percent of REIT shares owned 
directly by individual investors and 37 percent owned by mutual 
funds, which are owned mostly by individuals. Today's REITs 
offer smaller real estate investors three important qualities 
never accessible and available before: liquidity, security and 
performance.
    Liquidity. REITs have helped turn real estate liquid. 
Through the public REIT marketplace of over 200 real estate 
companies, investors can buy and sell interests in portfolios 
of properties and mortgages--as well as the management 
associated with them--on an instantaneous basis. Illiquidity, 
the bane of real estate investors, is gone.
    Security. Because real estate is a physical asset with a 
long life during which it has the potential to produce income, 
investors always have viewed real estate as an investment 
option with security. But now through REITs small investors 
have an added level of security never available before in real 
estate investment. Today's security comes from information. 
Through the advent of the public REIT industry (which is 
governed by SEC and securities exchange-mandated information 
disclosure and reporting), the flow of available information 
about the company and its properties, the management and its 
business plan, and the property markets and their prospects are 
available to the public. As a result, REIT investors are 
provided a level of security never available before in the real 
estate investment marketplace.
    Performance. Since their inception, REITs have provided 
competitive investment performance. Both over the past two 
years and the past twenty years, REIT market performance has 
been comparable to that of the S&P 500 and has greatly exceeded 
the returns from fixed income and direct real estate 
investments. Because REITs annually pay out almost all of their 
taxable income, a significant component of total return on 
investment reliably comes from dividends. In 1997, REITs paid 
out over $8 billion in dividends to their shareholders. Just as 
Congress intended, today through REITs small investors have 
access to large-scale, income producing real estate on a basis 
competitive with large institutions and wealthy individuals.
    But REITs don't just benefit investors. The lower debt 
levels associated with REITs compared to real estate investment 
overall has a positive effect on the overall economy. Average 
debt levels for REITs are 35 percent of market capitalization, 
compared to leverage of 80 percent and higher used by privately 
owned real estate (which have the effect of minimizing tax 
liabilities). The higher equity capital cushions REITs from the 
severe effects of fluctuations in the real estate market that 
have traditionally occurred. The ability of REITs to better 
withstand market downturns has a stabilizing effect on the real 
estate industry and lenders, resulting in fewer bankruptcies 
and work-outs. The general economy benefits from lower real 
estate losses by federally insured financial institutions.
    NAREIT believes the future of the REIT industry will see an 
acceleration in the shift from private to public ownership of 
U.S. real estate. At the same time, future growth may be 
limited by the competitive pressures for REITs to be able to 
provide more services to their tenants than they are currently 
allowed to perform. Although the 1986 Act took off the 
handcuffs and the Taxpayer Relief Act of 1997 included 
additional helpful REIT reforms, REITs still must operate under 
significant, unnecessary restrictions. NAREIT looks forward to 
working with Congress and the Administration to further 
modernize and improve the REIT rules so that REITs can continue 
to offer smaller investors opportunities for rewarding 
investments in income-producing real estate.

                            I. Section 1374

    The Administration's Fiscal Year 1999 Budget proposes to 
amend section 1374 to treat an ``S'' election by a C 
corporation valued at $5 million or more as a taxable 
liquidation of that C corporation followed by a distribution to 
its shareholders. This proposal was also included in the 
Administration's Fiscal Year 1997 and 1998 proposed budgets.

A. Background and Current Law

    Prior to its repeal as part of the Tax Reform Act of 1986, 
the holding in a court case named General Utilities permitted a 
C corporation to elect S corporation, REIT or mutual fund 
status (or transfer assets to an S corporation, REIT or mutual 
fund in a carryover basis transaction) without incurring a 
corporate-level tax. With the repeal of the General Utilities 
doctrine in 1986, such transactions arguably would have been 
subject to tax but for Congress' enactment of Internal Revenue 
Code section 1374.\1\ Under section 1374, a C corporation 
making an S corporation election can elect to have the S 
corporation pay any tax that otherwise would have been due on 
the ``built-in gain'' of the C corporation's assets, but only 
if those assets were sold or otherwise disposed of during a 10-
year ``recognition period.'' The application of the tax upon 
the disposition of the assets, as opposed to the election of S 
status, worked to distinguish legitimate conversions to S 
status from those made for purposes of tax avoidance.
---------------------------------------------------------------------------
    \1\ Hereinafter all references to ``section'' are to the Internal 
Revenue Code of 1986 (as amended).
---------------------------------------------------------------------------
    In Notice 88-19, 1988-1 C.B. 486 (the ``Notice''), the 
Internal Revenue Service (the ``IRS'') announced that it 
intended to issue regulations under section 337(d)(1) that in 
part would address the avoidance of the repeal of General 
Utilities through the use of REITs and regulated investment 
companies (``RICs,'' i.e. mutual funds). In addition, the IRS 
noted that those regulations would permit the REIT or RIC to be 
subject to rules similar to the principles of section 1374. 
Thus, C corporations can elect REIT status and incur a 
corporate-level tax only if the REIT sells assets during the 
10-year ``recognition period.''
    In a release issued February 18, 1998, the Treasury 
Department announced that it intends to revise Notice 88-19 to 
conform to the Administration's proposed amendment to limit 
section 1374 to corporations worth less than $5 million, with 
an effective date similar to the statutory proposal. This 
proposal would result in a double layer of tax: once to the 
shareholders of the C corporation in a deemed liquidation and 
again to the C corporation itself upon such deemed liquidation.
    Because of the Treasury Department's intent to extend the 
proposed amendment of section 1374 to REITs, these comments 
address the proposed amendment as if it applied to both S 
corporations and REITs.

B. Statement in Support of the Current Application of Section 
1374 to REITs

    As stated above, the Administration proposal would limit 
the use of the 10-year election to REITs valued at $5 million 
or less. NAREIT believes that this proposal would contravene 
Congress' original intent regarding the formation of REITs, 
would be both inappropriate and unnecessary in light of the 
statutory requirements governing REITs, would impede the 
recapitalization of commercial real estate, likely would result 
in lower tax revenues, and ignores the basic distinction 
between REITs and partnerships.
    A fundamental reason for a continuation of the current 
rules regarding a C corporation's decision to elect REIT status 
is that the primary rationale for the creation of REITs was to 
permit small investors to make investments in real estate 
without incurring an entity level tax, and thereby placing 
those persons in a comparable position to larger investors. 
H.R. Rep. No. 2020, 86th Cong., 2d. Sess. 3-4 (1960).
    By placing a toll charge on a C corporation's REIT 
election, the proposed amendment would directly contravene this 
Congressional intent, as C corporations with low tax bases in 
assets (and therefore a potential for a large built-in gains 
tax) would be practically precluded from making a REIT 
election. As previously noted, the purpose of the 10-year 
election was to continue to allow C corporations to make S 
corporation and REIT elections when those elections were 
supported by non-tax business reasons (e.g., access to the 
public capital markets), while protecting the Treasury from the 
use of such entities for tax avoidance.
    Additionally, REITs, unlike S corporations, have several 
characteristics that support a continuation of the current 
section 1374 principles. First, there are statutory 
requirements that make REITs long-term holders of real estate. 
The 100 percent REIT prohibited transactions tax \2\ 
complements the 10-year election mechanism.
---------------------------------------------------------------------------
    \2\ I.R.C. Sec. 857(b)(6).
---------------------------------------------------------------------------
    Second, while S corporations may have no more than 75 
shareholders, a REIT faces no statutory limit on the number of 
shareholders it may have, is required to have at least 100 
shareholders, and in fact some REITs have hundreds of thousands 
of beneficial shareholders. NAREIT believes that the large 
number of shareholders in a REIT and management's 
responsibility to each of those shareholders preclude the use 
of a REIT as a vehicle to be used primarily in the 
circumvention of the repeal of General Utilities. Any attempt 
to benefit a small number of investors in a C corporation 
through the conversion of that corporation to a REIT is impeded 
by the REIT widely-held ownership requirements.
    The consequence of the Administration proposal would be to 
preclude C corporations in the business of managing and 
operating income-producing real estate from accessing the 
substantial capital markets' infrastructure comprised of 
investment banking specialists, analysts, and investors that 
has been established for REITs. In addition, other C 
corporations that are not primarily in the business of 
operating commercial real estate would be precluded from 
recognizing the value of those assets by placing them in a 
professionally managed REIT. In both such scenarios, the 
hundreds of thousands of shareholders owning REIT stock would 
be denied the opportunity to become owners of quality 
commercial real estate assets.
    Furthermore, the $5 million dollar threshold that would 
limit the use of the current principles of section 1374 is 
unreasonable for REITs. While many S corporations are small or 
engaged in businesses that require minimal capitalization, 
REITs as owners of commercial real estate have significant 
capital requirements. As previously mentioned, it was Congress' 
recognition of the significant capital required to acquire and 
operate commercial real estate that led to the creation of the 
REIT as a vehicle for small investors to become owners of such 
properties. The capital intensive nature of REIT's makes the $5 
million threshold essentially meaningless for REITs.
    It should be noted that this proposed amendment is unlikely 
to raise any substantial revenue with respect to REITs, and may 
in fact result in a loss of revenues. Due to the high cost that 
would be associated with making a REIT election if this 
amendment were to be enacted, it is unlikely that any C 
corporations would make the election and incur the associated 
double level of tax without the benefit of any cash to pay the 
taxes. In addition, by remaining C corporations, those entities 
would not be subject to the REIT requirement that they make a 
taxable distribution of 95% of their income each tax year. 
While the REIT is a single-level of tax vehicle, it does result 
in a level of tax on nearly all of the REIT's income each year.
    Last, but far from least, the Administration justifies its 
de facto repeal of section 1374 by stating that ``[t]he tax 
treatment of the conversion of a C corporation to an S 
corporation generally should be consistent with the treatment 
of its [sic] conversion of a C corporation to a partnership.'' 
Regardless of whether this stated reason for change is 
justifiable for S corporations, in any event it should not 
apply to REITs because of the differences between REITs and 
partnerships.
    Unlike partnerships, REITs cannot (and have never been able 
to) pass through losses to their investors. Further, REITs can 
and do pay corporate level income and excise taxes. Simply put, 
REITs are C corporations. Thus, REITs are not susceptible to 
the tax avoidance concerns raised by the 1986 repeal of the 
General Utilities doctrine.

C. Summary

    The 10-year recognition period of section 1374 currently 
requires a REIT to pay a corporate-level tax on assets acquired 
from a C corporation with a built-in gain, if those assets are 
disposed of within a 10-year period. Combined with the 
statutory requirements that a REIT be a long-term holder of 
assets and be widely-held, current law assures that the REIT is 
not a vehicle for tax avoidance. The proposal's two level tax 
would frustrate Congress' intent to allow the REIT to permit 
small investors to benefit from the capital-intensive real 
estate industry in a tax efficient manner.
    Accordingly, NAREIT believes that tax policy considerations 
are better served if the Administration's section 1374 proposal 
is not enacted.

                  II. Subsidiary Service Corporations

    As part of the asset diversification tests applied to 
REITs, a REIT may not own more than 10 percent of the 
outstanding voting securities of a non-REIT corporation 
pursuant to section 856 (c)(5)(B). The shares of a wholly-owned 
``qualified REIT subsidiary'' (``QRS'') of the REIT are ignored 
for this test. The Administration's Fiscal Year 1999 Budget 
proposes to amend section 856(c)(5)(B) to prohibit REITs from 
holding stock possessing more than 10 percent of the vote or 
value of all classes of stock of a non-REIT corporation (other 
than a wholly owned QRS).

A. Background and Current Law

    The activities of REITs are strictly limited by a number of 
requirements that are designed to ensure that REITs serve as a 
vehicle for public investment in real estate. First, a REIT 
must comply with several income tests. At least 75 percent of 
the REIT's gross income must be derived from real estate, such 
as rents from real property, mortgage interest and gains from 
sales of real property (not including dealer sales).\3\ In 
addition, at least 95 percent of a REIT's gross income must 
come from the above real estate sources, dividends, interest 
and sales of securities.\4\
---------------------------------------------------------------------------
    \3\ I.R.C. Sec. 856(c)(3).
    \4\ I.R.C. Sec. 856(c)(2).
---------------------------------------------------------------------------
    Second, a REIT must satisfy several asset tests. On the 
last day of each quarter, at least 75 percent of a REIT's 
assets must be real estate assets, cash and government 
securities. Real estate assets include interests in real 
property and mortgages on real property. As mentioned above, 
the asset diversification rules require that a REIT not own 
more than 10 percent of the outstanding voting securities of an 
issuer (other than a QRS). In addition, no more than 5 percent 
of a REIT's assets can be represented by securities of a single 
issuer (other than a QRS).
    REITs have been so successful in operating their properties 
and providing permissible services to their tenants that they 
have been asked to provide these services to non-tenants, 
building off of expertise and capabilities associated with the 
REIT's real estate activities. The asset and income tests, 
however, restrict how REITs can engage in these activities. A 
REIT can earn only up to 5 percent of its income from sources 
other than rents, mortgage interest, capital gains, dividends 
and interest. However, many REITs have had the opportunity to 
maximize shareholder value by earning more than 5 percent from 
third party service income.
    Starting in 1988, the Internal Revenue Service issued 
private letter rulings to REITs approving a structure to 
facilitate a REIT providing a limited amount of services to 
third parties.\5\ These rulings sanctioned a structure under 
which a REIT owns no more than 10 percent of the voting stock 
and up to 99 percent of the value of a non-REIT corporation 
through nonvoting stock. Usually, managers or shareholders of 
the REIT own the voting stock of the ``Third Party Service 
Subsidiary'' (``TPSS,'' also known as a ``Preferred Stock 
Subsidiary''). The TPSS typically provides unrelated parties 
services already being delivered to a REIT's tenants, such as 
landscaping and managing a shopping mall in which the REIT owns 
a joint venture interest. The REIT receives dividends from the 
TPSS that are treated as qualifying income under the 95 percent 
income test, but not the 75 percent income test.\6\ 
Accordingly, a REIT continues to be principally devoted to real 
estate operations. In addition, while the IRS has approved 
using TPSSs for services to third parties and ``customary'' 
services to tenants the REIT could otherwise provide, the IRS 
has not permitted the use of these subsidiaries to provide 
impermissible, non-customary real estate services to REIT 
tenants.\7\
---------------------------------------------------------------------------
    \5\ PLRs 9440026, 9436025, 9431005, 9428033, 9340056, 8825112. See 
also PLRs 9507007, 9510030, 9640007, 9733011, 9734011, 9801012.
    \6\ The REIT does not qualify for a dividends received deduction 
with respect to TRSS dividends. I.R.C. Sec. 857(b)(2)(A).
    \7\ But see PLR 9804022.
---------------------------------------------------------------------------
    The Administration proposes to change the asset 
diversification tests to prevent a REIT from owning securities 
in a C corporation that represent either 10 percent of the 
corporation's vote or value. The proposal would apply with 
respect to stock acquired on or after the date of first 
committee action. In addition, to the extent that a REIT's 
ownership of TPSS stock is grandfathered by virtue of the 
effective date, the grandfather status would terminate if the 
TPSS engages in a new trade or business or acquires substantial 
new assets on or after the date of first committee action. This 
proposal is only expected to raise $19 million over five years.

B. Statement Against Administration Proposal to Limit REIT 
Investments in Service Subsidiaries

    The REIT industry has grown significantly during the 1990s, 
from an equity market capitalization under $10 billion to a 
level exceeding $150 billion. The TPSS structure is used 
extensively by today's REITs and has been a small, but 
important, part of recent industry growth. These subsidiaries 
help ensure that the small investors who own REITs are able to 
maximize the return on their capital by taking full economic 
advantage of core business competencies developed by REITs in 
owning and operating the REIT's real estate. By halting the 
expansion of TPSSs, the Administration proposal would curtail 
REIT growth at a time when the industry is just realizing 
Congress' vision of making publicly owned, income-producing 
real estate accessible for small investors. Since the profits 
of the TPSS are taxable at the corporate level today, NAREIT 
sees no reason to restrain their future use and growth.
    The REIT asset rules are patterned loosely after the asset 
diversification rules applicable to mutual funds, with the REIT 
rules being significantly more restrictive.\8\ In contrast to 
the REIT rules, a mutual fund can own 100 percent of any one 
issuer so long as not more than 25 percent of the value of the 
fund's total assets are invested in that issuer. The REIT 
provisions do not provide the same flexibility. A REIT cannot 
own more than 10% of the voting securities of a non-REIT 
corporation, and securities of a non-REIT corporation cannot be 
worth more than 5 percent of the REIT's assets. The 
Administration proposal would further restrict REIT investment, 
in contrast with the flexibility afforded to mutual funds.
---------------------------------------------------------------------------
    \8\ Compare I.R.C. Sec. Sec. 851(b)(3) and 856(c)(4).
---------------------------------------------------------------------------
    Over the years, Congress has modified and refined the REIT 
rules several times to ensure that REITs can continue to 
effectively fulfill their mission to promote investment by 
individuals in income-producing real estate. These 
modifications helped shift the focus of real estate investment 
generally from the tax loss orientation of the 1970s and 1980s 
to the taxable, income-oriented REIT environment today. Most 
recently, Congress reviewed the REIT rules and enacted the 
constructive REIT Simplification Act of 1997.
    NAREIT believes strongly that the Administration proposal 
limiting REIT investment in TPSSs is a noticeable step 
backwards in thinking at a time when policymakers should 
seriously consider additional forward-thinking steps to make 
income-based real estate investments easily and economically 
accessible to small investors everywhere. To ensure REITs 
remain competitive in the real estate marketplace, an important 
step forward in this area is to enable REITs in the future to 
provide more services to both tenants and customers under 
appropriate tax rules.
    While NAREIT strongly disagrees with the Administration 
proposal, we do believe that the TPSS approach is not an ideal 
solution to making certain that REITs can provide competitive 
services in the real estate marketplace. NAREIT looks forward 
to working with the Administration and Congress to formulate 
appropriate rules to enable REITs to serve their tenants and 
customers and thereby effectively compete with other real 
estate companies.

C. Summary

    NAREIT strongly opposes the Administration proposal as it 
will only further restrict REITs from fulfilling their mission 
of making investment in large-scale, income-producing real 
estate accessible to small investors. NAREIT encourages 
Congress and the Administration to work towards a solution that 
will enable REITs to better serve their tenants and customers, 
thereby maximizing returns to REIT shareholders. For REITs to 
compete effectively with other real estate investors, they must 
be able to manage and operate their properties, including 
providing a wide range of customer services. There is no reason 
why REITs should not be able to provide noncustomary services 
to tenants as well as services to non-tenant customers on a 
basis taxable at the corporate level.

                        III. Closely Held REITs

    The Administration's Fiscal Year 1999 Budget proposes to 
add a new rule, creating a limit of 50 percent on the vote or 
value of stock any entity could own in any REIT.

A. Background and Current Law

    As discussed above, Congress created REITs to make real 
estate investments easily and economically accessible to the 
small investor. To carry out this purpose, Congress mandated 
two rules to ensure that REITs are widely held. First, five or 
fewer individuals cannot own more than 50% of a REIT's 
stock.\9\ In applying this test, most entities owning REIT 
stock are ``looked through'' to determine the ultimate 
ownership by individuals of the stock. Second, at least 100 
persons (including corporations and partnerships) must be REIT 
shareholders.\10\ Both tests do not apply during a REIT's first 
taxable year, and the ``five or fewer'' test only applies in 
the last half of all taxable years.\11\
---------------------------------------------------------------------------
    \9\ I.R.C. Sec. 856(h)(1).
    \10\ I.R.C. Sec. 856(a)(5).
    \11\ I.R.C. Sec. Sec. 542(a)(2) and 856(h)(2).
---------------------------------------------------------------------------
    The Administration appears to be concerned about non-REITs 
establishing ``captive REITs'' and REITs doing ``step-down 
preferred'' transactions used for various tax planning purposes 
it finds abusive. The Administration proposes changing the 
``five or fewer'' test by imposing an additional requirement. 
The proposed new rule would prevent any ``person'' (i.e., a 
corporation, partnership or trust) from owning stock of a REIT 
possessing more than 50 percent of the total combined voting 
power of all classes of voting stock or more than 50 percent of 
the total value of shares of all classes of stock. Certain 
existing REIT attribution rules would apply in determining such 
ownership, and the proposal would be effective for entities 
electing REIT status for taxable years beginning on or after 
the date of first committee action.

B. Statement Providing Limited Support for Administration 
Proposal on Closely Held REITs

    NAREIT shares the Administration's concern that the REIT 
structure not be used for abusive tax avoidance purposes, and 
therefore NAREIT welcomes the intent of the proposal. We are 
concerned, however, that the Administration proposal casts too 
broad a net, prohibiting legitimate and necessary use of 
``closely held'' REITs. A limited number of exceptions are 
necessary to allow certain entities to own a majority of a 
REIT's stock. NAREIT would like to work with Congress and the 
Administration to ensure that any action to curb abuses does 
not disallow legitimate and necessary transactions.
    First, an exception needs to be made so that a REIT may own 
more than 50 percent of another REIT's stock. For example, in 
the course of an acquisition, a REIT may need to own more than 
50 percent of another REIT's stock while conducting a tender 
offer for the target REIT's shares. Also, in structuring a 
joint venture a REIT may desire to own a majority, controlling 
interest in another REIT. Neither of these situations raises 
abuse concerns. After all, the ``control'' REIT must comply 
with the full panoply of REIT rules--including any new ones--to 
ensure the private REIT is truly widely held.
    Second, an exception should be allowed to enable a REIT's 
organizers to have a single large investor for a temporary 
period, such as in preparation for a public offering of the 
REIT's shares. Such ``incubator REITs'' sometimes are majority 
owned by its sponsor to allow the REIT to accumulate a track 
record that will allow it to go public. The Administration 
proposal would prohibit this important approach which, in turn, 
could curb the emergence of new public REITs in which small 
investors may invest.
    In addition, there is no reason why a partnership, mutual 
fund or other pass-through entity should be counted as one 
entity in determining whether any ``person'' owns 50 percent of 
the vote or value of a REIT. A partnership, mutual fund or 
other pass-through entity is usually ignored for tax purposes. 
The partners in a partnership and the shareholders of a mutual 
fund or other pass-through entity should be considered the 
``persons'' owning a REIT for purposes of any limits on 
investor ownership.

C. Summary

    NAREIT supports a change in the REIT rules to prevent 
abusive use of closely held REITs, but is concerned that the 
Administration proposal is overly broad. NAREIT looks forward 
to working with Congress and the Administration to craft a 
solution that will prevent such abuses without impeding 
legitimate and necessary transactions, such as those mentioned 
above.

                         IV. Paired Share REITs

    The Administration's Fiscal Year 1999 Budget proposes to 
freeze the ``grandfathered'' status of the existing paired 
share REITs.

A. Background and Current Law

    In order to actively manage their properties within the 
strictures of the REIT rules, in the 1970s and early 1980s a 
handful of REITs sought and received permission from the IRS to 
establish a ``paired'' relationship with other companies that 
would manage the REIT-owned properties. A ``paired-share'' 
company is actually two companies the stock of which is 
``paired'' or ``stapled'' such that they trade as a single 
unit. As a result, the two companies are owned by the same 
shareholders. One company, the REIT, owns real estate and, in 
some cases, may lease it to the second operating company. The 
operating company is typically organized as a C corporation 
with the accompanying corporate level tax. The operating 
company is unrestricted in the businesses it may operate, 
meaning it may operate those businesses, such as hotels or golf 
courses, which require a high level of services be provided to 
customers.
    In 1984, Congress adopted section 269B in the Deficit 
Reduction Act of 1984 (``the Act'') which requires that in 
applying the tests for REIT status, all stapled entities are 
treated as one entity.\12\ In connection with considering and 
restricting the use of ``paired share'' entities by non-REIT 
U.S. corporations operating overseas, Congress decided in 1984 
to ``grandfather,'' or apply prior law to, a very limited 
number of REITs that earlier had received IRS permission to 
adopt a ``paired share'' structure.\13\ Congress crafted this 
exception for the paired share REITs out of a concern for 
fairness to these companies and their shareholders who made 
their investments on the basis of existing law. No doubt the 
same fairness issues apply today.
---------------------------------------------------------------------------
    \12\ I.R.C. Sec. 269B(a)(3).
    \13\ Over 200 publicly traded REITs are active in today's real 
estate marketplace. Of these, four are so-called ``paired share'' 
REITs.
---------------------------------------------------------------------------
    The Administration proposes to limit the tax benefits of 
the existing paired share REITs that qualify under the 1984 
Act's grandfather rules. Pursuant to the proposal, the general 
rules treating the REIT and the stapled C corporation as a 
single entity for purposes of the REIT qualification tests 
would be applied to properties acquired by grandfathered 
entities on or after the effective date and activities or 
services relating to such properties performed on or after the 
effective date.

B. Statement Concerning Freezing the Grandfathered Status of 
Stapled REITs

    NAREIT does not support the Administration proposal out of 
concern for the shareholders who reasonably relied on existing 
law when investments were made.
    If enacted, the Administration proposal would cause 
investors in some of these entities to experience adverse 
consequences. The shareholders reasonably relied on Congress' 
grandfathering of the stapled REITs and the previous IRS 
rulings approving of their status. This authority should not be 
reversed without careful consideration of the extent to which 
the REITs, their investors and others have made long-term 
financial commitments in reasonable reliance on such authority.

C. Summary

    NAREIT does not support the Administration proposal out of 
concern for fairness to the stapled REITs and their 
shareholders who made their investments on the basis of 
existing law.
      

                                
Statement of Fred F. Murray, Vice President For Tax Policy, National 
Foreign Trade Council, Inc.

    Mr. Chairman, and Members of the Committee:
    The National Foreign Trade Council, Inc. (the ``NFTC'' or 
the ``Council'') is appreciative of the opportunity to present 
its views on the impact on international competitiveness of 
certain of the revenue raising foreign provisions in the 
administration's fiscal year 1999 budget proposals.
    The NFTC is an association of businesses with some 550 
members, founded in 1914. It is the oldest and largest U.S. 
association of businesses devoted exclusively to international 
trade matters. Its membership consists primarily of U.S. firms 
engaged in all aspects of international business, trade, and 
investment. Most of the largest U.S. manufacturing companies 
and most of the 50 largest U.S. banks are Council members. 
Council members account for at least 70% of all U.S. non-
agricultural exports and 70% of U.S. private foreign 
investment. The NFTC's emphasis is to encourage policies that 
will expand U.S. exports and enhance the competitiveness of 
U.S. companies by eliminating major tax inequities in the 
treatment of U.S. companies operating abroad.
    The founding of the Council was in recognition of the 
growing importance of foreign trade to the health of the 
national economy. Since that time, expanding U.S. foreign trade 
and incorporating the United States into an increasingly 
integrated world economy has become an even more vital concern 
of our nation's leaders. The value of U.S. international trade 
(imports plus exports) as a percentage of GDP has more than 
doubled in recent decades: from 7 percent in the 1960's to 17 
percent in the 1990's. The share of U.S. corporate earnings 
attributable to foreign operations among many of our largest 
corporations now exceeds 50 percent of their total earnings. 
Direct investment by U.S. companies in foreign jurisdictions 
continues to exceed foreign direct investment in the United 
States (in spite of the net debtor status of the U.S.) by some 
$180 billion in 1994. In 1995, U.S. exports of goods and 
services totaled $805 billion--11.1 percent of GDP.\1\ In 1993, 
58 percent of the $465 billion of merchandise exports from the 
U.S. were associated with U.S. multinational corporations: $110 
billion of the exports went to foreign affiliates of the U.S. 
companies, and another $139 billion of the exports were shipped 
directly to unrelated foreign buyers.\2\ Even these numbers in 
and of themselves do not convey the full importance of exports 
to our economy and to American-based jobs, because they do not 
address the additional fact that many of our smaller and 
medium-sized businesses do not consider themselves to be 
exporters although much of their product is supplied as 
inventory or components to other U.S.-based companies who do 
export.
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    \1\ U.S. Department of Commerce, ``Survey of Current Business,'' 
April 1996.
    \2\ U.S. Department of Commerce, ``U.S. Multinational Companies: 
Operations in 1993,'' June 1995, at 39.
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    Foreign trade is fundamental to our economic growth and our 
future standard of living.\3\ Although the U.S. economy is 
still the largest economy in the world, its growth rate 
represents a mature market for many of our companies. As such, 
U.S. employers must export in order to expand the U.S. economy 
by taking full advantage of the opportunities in overseas 
markets. Today, some 96% of U.S. firms' potential customers are 
outside the United States, and in the 1990's 86% of the gains 
in worldwide economic activity occurred outside the United 
States. Over the past three years, exports have accounted for 
about one-third of total U.S. economic growth; and, projected 
exports of manufactured goods reached a record level in 1996 of 
$653 billion.\4\
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    \3\ ``Continued robust exports by U.S. firms in a wide variety of 
manufactures and especially advanced technological products--such as 
sophisticated computing and electronic products and cutting-edge 
pharmaceuticals--are critical for maintaining satisfactory rates of GDP 
growth and the international competitiveness of the U.S. economy. 
Indeed, it is widely acknowledged that strong export performance ranks 
among the primary forces behind the economic well-being that U.S. 
workers and their families enjoy today, and expect to continue to enjoy 
in the years ahead.'' Gary Hufbauer (Reginald Jones Senior Fellow, 
Institute for International Economics) and Dean DeRosa (Principal 
Economist, ADR International, Ltd.), ``Costs and Benefits of the Export 
Source Rule, 1998-2002,'' A Report Prepared for the Export Source 
Coalition, February 19, 1997.
    \4\ See, Fourth Annual Report of the Trade Promotion Coordinating 
Committee (TPCC) on the National Export Strategy: ``Toward the Next 
Century: A U.S. Strategic Response to Foreign Competitive Practices,'' 
October 1996, U.S. Department of commerce, ISBN 0-16-048825-7; J. David 
Richardson and Karin Rindal, ``Why Exports Matter: More!,'' Institute 
for International Economics and the Manufacturing Institute, 
Washington, D.C., February 1996.
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                  The Council's Comments and Concerns

    The NFTC believes that certain of the President's proposals 
related to international business are beneficial to the 
nation's export sector and to its economy; but, it also 
believes that certain of the proposals are not in the nation's 
interest. For example, the NFTC supports extension of the tax 
credit for research, as well as accelerating the effective date 
of the rules regarding look-through treatment for dividends 
received from ``10/50 Companies.'' These provisions will serve 
to improve the competitive position of U.S. multinational 
companies.
    However, in devising many of its other tax proposals, the 
Administration replaced sound tax policy with a short sighted 
call for more revenue. The NFTC is concerned that this and 
previous Administrations, as well as previous Congresses, have 
often turned to the international provisions of the Internal 
Revenue Code to find revenues to fund domestic priorities, in 
spite of the pernicious effects of such changes on the 
competitiveness of United States businesses in world markets. 
The Council is further concerned that such initiatives may have 
resulted in satisfaction of other short-term goals to the 
serious detriment of longer-term growth of the U.S. economy and 
U.S. jobs through foreign trade policies long consistent in 
both Republican and Democratic Administrations, including the 
present one.
    United States policy in regard to trade matters has been 
broadly expansionist for many years, but its tax policy has not 
followed suit. The provisions of Subchapter N of the Internal 
Revenue Code of 1986 (Title 26 of the United States Code is 
hereafter referred to as the ``Code'') impose rules on the 
operations of American business operating in the international 
context that are much different in important respects than 
those imposed by many other nations upon their companies. Some 
of these differences, described in more detail in the sections 
that follow, may make American business interests less 
competitive in foreign markets when compared to those from our 
most significant trading partners: \5\
---------------------------------------------------------------------------
    \5\ See, Financial Executives Research Foundation, Taxation of U.S. 
Corporations Doing Business Abroad: U.S. Rules and Competitiveness 
Issues, 1996, Ch. 9.
---------------------------------------------------------------------------
     The United States taxes worldwide income of its 
citizens and corporations who do business and derive income 
outside the territorial limits of the United States. Although 
other important trading countries also tax the worldwide income 
of their nationals and companies doing business outside their 
territories, such systems generally impose less tax on foreign 
source income and are less complex than their U.S. 
counterparts.
     The United States has more complex rules for the 
limitation of ``deferral'' than any other major industrialized 
country. Although the United States taxes the worldwide income 
of its companies, it permits deferral of the tax on 
unrepatriated foreign earnings of controlled foreign 
corporations, except where one of six complex, overlapping 
series of ``anti-deferral'' provisions of the Code apply. In 
addition, the anti-deferral provisions of most countries do not 
tax active business foreign income of their companies, while 
those of the U.S. inappropriately impose current U.S. tax on 
some active business foreign income as well as on passive 
foreign income.
     The current U.S. Alternative Minimum Tax (AMT) 
system imposes numerous rules on U.S. taxpayers that seriously 
impede the competitiveness of U.S. based companies. For 
example, the U.S. AMT provides a cost recovery system that is 
inferior to that enjoyed by companies investing in our major 
competitor countries; additionally, the current AMT 90-percent 
limitation on foreign tax credit utilization imposes an unfair 
double tax on profits earned by U.S. multinational companies--
in some cases resulting in a U.S. tax on income that has been 
taxed in a foreign jurisdiction at a higher rate than the U.S. 
tax.
     The U.S. foreign tax credit system is very 
complex, particularly in the computation of limitations under 
the provisions of section 904 of the Code. While the theoretic 
purity of the computations may be debatable, the significant 
administrative costs of applying and enforcing the rules by 
taxpayers and the government is not. Systems imposed by other 
countries are in all cases less complex.
     The United States has more complex rules for the 
determination of U.S. and foreign source net income than any 
other major industrialized country. In particular, this is true 
with respect to the detailed rules for the allocation and 
apportionment of deductions and expenses. In many cases, these 
rules are in conflict with those of other countries, and where 
this conflict occurs, there is significant risk of double 
taxation.
    As noted above, the United States system for the taxation 
of the foreign business of its citizens and companies is more 
complex than that of any of our trading partners, and perhaps 
more complex than that of any other country.
    That result is not without some merit. The United States 
has long believed in the rule of law and the self-assessment of 
taxes, and some of the complexity of its income tax results 
from efforts to more clearly define the law in order for its 
citizens and companies to apply it. Other countries may rely to 
a greater degree on government assessment and negotiation 
between taxpayer and government--traits which may lead to more 
government intervention in the affairs of its citizens, less 
even and fair application of the law among all affected 
citizens and companies, and less certainty and predictability 
of results in a given transaction. In some other cases, the 
complexity of the U.S. system is simply ahead of development 
along similar lines in other countries--many other countries 
have adopted an income tax similar to that of the United 
States, and a number of these systems have eventually adopted 
one or more of the significant features of the U.S. system of 
taxing transnational transactions: taxation of foreign income, 
anti-deferral regimes, foreign tax credits, and so on. However, 
while difficult to predict the ultimate evolution, none of 
these other country systems seems prone to the same level of 
complexity that affects the United States system. This 
reluctance may be attributable in part to recognition that the 
U.S. system has required very significant compliance costs of 
both taxpayer and the Internal Revenue Service, particularly in 
the international area where the costs of compliance burdens 
are disproportionately higher relative to U.S. taxation of 
domestic income and to the taxation of international income by 
other countries. \6\
---------------------------------------------------------------------------
    \6\ See Marsha Blumenthal and Joel B. Slemrod, ``The Compliance 
Cost of Taxing Foreign-Source Income: Its Magnitude, Determinants, and 
Policy Implications,'' in National Tax Policy in an International 
Economy: Summary of Conference Papers, (International Tax Policy Forum: 
Washington, D.C., 1994).
---------------------------------------------------------------------------
    Many foreign companies do not appear to face the same level 
of costs in their operations. The European Community Ruding 
Committee survey of 965 European firms found no evidence that 
compliance costs were higher for foreign source income than for 
domestic source income.\7\ Lower compliance costs and simpler 
systems that often produce a more favorable result in a given 
situation are competitive advantages afforded these foreign 
firms relative to their American counterparts.
---------------------------------------------------------------------------
    \7\ Id.
---------------------------------------------------------------------------
    Short of fundamental reform--a reform in which the United 
States federal income tax system is eliminated in favor of some 
other sort of system--there are many aspects of the current 
system that could be reformed and greatly improved. These 
reforms could significantly lower the cost of capital, the cost 
of administration, and therefore the cost of doing business for 
American firms. For example, the NFTC strongly supported the 
International Tax Simplification for American Competitiveness 
Act of 1997, H.R. 1783, introduced by Mr. Houghton (R-NY) and 
Mr. Levin (D-MI) of this Committee, and many of the provisions 
of which were enacted in the Taxpayer Relief Act of 1997. The 
NFTC continues to strongly support similar efforts in this 
session of the 105th Congress.
    In the light of this background, the NFTC would today like 
to specifically address some of the President's Fiscal Year 
1999 proposals as follows: (1) Accelerating the effective date 
of the ``look-through'' rules relating to noncontrolled section 
902 corporations (``10/50 Companies''); (2) Extension of the 
Research Tax Credit; (3) Modification of the Export Source Rule 
(also known as the ``Inventory Sales Source Rule,'' and 
sometimes as the ``Title Passage Rule''); (4) Modification of 
foreign tax credits applicable to to foreign oil and gas 
income; (5) Certain others of the foreign proposals affecting 
foreign operations. We would also comment on a proposal from 
last year's budget submission that is being separately 
considered in the Senate that relates to a modification of the 
rules relating to foreign tax credit carrybacks and carryovers.

                          Proposals Supported

Accelerating the Effective Date of the ``Look-Through'' Rules 
Relating to 10/50 Companies

    Description of Current Law.--U.S. companies may credit 
foreign taxes against U.S. tax on foreign source income. The 
foreign tax credit is a fundamental requirement of the U.S. 
system of worldwide taxation because it eliminates double 
taxation of income. The amount of foreign tax credits that can 
be claimed in a year is subject to a limitation that prevents 
taxpayers from using foreign tax credits to offset U.S. tax on 
U.S. source income. Separate limitations are applied to 
specific categories of income under section 904.
    ``Look-through'' treatment provides that income is 
apportioned to a foreign tax credit limitation category in 
proportion to the ratio of the earnings and profits 
attributable to income in such foreign tax credit limitation 
category to the total earnings and profits.
    Under changes made by the Taxpayer Relief Act of 1997, U.S. 
parent corporations that own at least 10 percent but not more 
than 50 percent of the stock of a corporation will be able to 
use ``look-through'' treatment in computing indirect foreign 
tax credits under section 902 for the taxes paid by the owned 
corporation and attributable to the parent's ownership. Prior 
to such change, a separate limitation applied to each 10/50 
Company owned by the parent corporation, irrespective of the 
amount and source of income of the subsidiary.
    This structure is important to U.S. multinational groups 
because many foreign joint ventures are structured in this 
way--the parent has less than a majority interest and is not 
therefore subject to the controlled foreign corporation rules 
that apply look-through treatment--and in many cases 
multinationals own many hundreds of these ventures. The 
Taxpayer Relief Act of 1997 changed these rules to allow 10/50 
Companies to be treated like controlled foreign corporations by 
allowing ``look-through'' treatment for foreign tax credit 
purposes for dividends from such joint ventures. The 1997 Act, 
however, did not make the change effective for such dividends 
unless they were received after the year 2002: Dividends paid 
by a 10/50 Company in taxable years beginning after December 
31, 2002, from earning and profits (``E&P'') accumulated in 
taxable years beginning before January 1, 2003, are subject to 
a single foreign tax credit limitation for all 10/50 companies. 
Dividends paid by a 10/50 company in taxable years beginning 
after December 31, 2002, from E&P accumulated in taxable years 
beginning after December 31, 2002, are treated as income in a 
foreign tax credit limitation category under look through 
treatment. Therefore, two different sets of rules apply for 
dividends from E&P generated before the year 2003 and dividends 
from E&P accumulated after the year 2002. Dividends paid by a 
10/50 Company in taxable years beginning before January 1, 
2003, are subject to a separate foreign tax credit limitation 
for each 10/50 Company (prior law).
    The 1997 provision effects a significant simplification 
over current law, but is delayed in effective date and is still 
overly complex.
    The Administration's Proposal.--The proposal would 
accelerate the effective date of the 1997 changes affecting 
foreign joint ventures owned between ten and fifty percent by 
U.S. parents (so-called ``10/50 Companies''). This change will, 
instead, apply the look-through rules to all dividends received 
in tax years after 1997, no matter when the E&P constituting 
the makeup of the dividend was accumulated.
    This change will result in a tremendous reduction in 
complexity and compliance burdens for U.S. multinationals doing 
business overseas through foreign joint ventures. It will also 
reduce the competitive bias against U.S. participation in such 
ventures (the minority position in such ventures is many times 
dictated by local law) by placing U.S. companies on a more 
level playing field.
    The NFTC supports even further simplification of these 
rules by extension of them beyond the Administration's proposal 
to income other than dividends, including interest, rents, 
royalties, and gains from the sale of interests in partnerships 
and lower-tier subsidiary companies.

Extending the R&E Tax Credit

    Description of Current Law.--The research credit generally 
applies on an incremental basis to a taxpayer's ``qualified 
research'' expenses for a taxable year. The credit is equal to 
20 percent of the amount by which the taxpayer's qualified 
research expenses for the taxable year exceed a base amount. 
The Small Business Job Protection Act of 1996 provided an 
alternative incremental research credit.
    The research credit expired on June 30, 1995. In the 1996 
Act, the research credit was extended in modified form for 
eleven months to May 31, 1997. The credit was subsequently 
extended by the 1997 Act to apply to expenses incurred from 
June 1, 1997 to June 30, 1998. The 1997 Act also modified the 
alternative incremental research credit regime to permit 
taxpayers to elect the regime for any taxable year beginning 
after June 30, 1996.
    The Administration's Proposal.--The research tax credit 
would be extended for twelve months, from July 1, 1998, through 
June 30, 1999 under the Administration's proposal. The NFTC 
supports this proposal to extend the research tax credit for 
another year. The credit has served to promote research that 
otherwise may never have occurred. The buildup of ``knowledge 
capital'' is absolutely essential to enhance the competitive 
position of the U.S. in international markets. Encouraging 
private sector research work through a tax credit has the 
decided advantage of keeping the government out of the business 
of picking specific winners or losers in providing direct 
research incentives. The NFTC encourages both the 
Administration and the Congress to make the research tax credit 
permanent.

                   Proposals Not Supported or Opposed

Modification of the Export Source Rule

    Description of the Rule.\8\--The ``Export Source Rule,'' as 
it is commonly called, is but one of a number of sales source 
rules found in sections 861, 862, and 863 of the Internal 
Revenue Code of 1986 (the ``Code''), and the Treasury 
regulations thereunder. In fact, the Export Source Rule is not 
in the statute, but is instead found in Treasury Regulations 
Sec. 1.863-3(b), and has been there or in its predecessor 
provisions for more than 70 years.
---------------------------------------------------------------------------
    \8\ Parts of the following discussion of the rule were abstracted 
from material prepared for the Export Source Coalition.
---------------------------------------------------------------------------
    As noted above, the United States taxes U.S. citizens and 
residents and U.S. corporations on their worldwide income. That 
is, a U.S.-based enterprise is taxed by the United States not 
only on the income from its operations and sales in the United 
States, but also on the income from its operations and sales in 
other countries. This worldwide taxation creates ``double 
taxation'' when that same foreign income is taxed in the other 
country where it is derived. Each of the affected countries has 
its own internal tax rules to determine the ``source'' of the 
income involved, the application of which rules may determine 
whether the income in question may be taxed under its laws and 
to what extent.
    To mitigate double taxation of income earned abroad, the 
United States, like many other countries, has since 1918 
allowed a credit for income taxes paid to foreign countries 
with respect to foreign source income--the ``foreign tax 
credit.'' That is, in cases where it applies, the United States 
cedes its jurisdiction in favor of the foreign country where 
the income is sourced, (i.e., the source country taxes the 
income and the U.S. does not).
    Since 1921, foreign tax credits have been subject to a 
limitation in some form. Generally, the limitation is intended 
to allow a credit to be claimed only to the extent that the 
credit does not exceed the amount of U.S. income tax that would 
be due on the foreign-source income absent the credit. In other 
words, the United States does not allow a credit for the entire 
amount of foreign tax imposed--only that amount that would have 
been the U.S. tax if it had chosen to impose its tax on the 
income. For example, a U.S. company paying a tax at a 40% rate 
in a foreign country would only receive a foreign tax credit up 
to the maximum 35% U.S. rate. The general limitation can be 
expressed in an algebraic equation:

    U.S. tax (pre-credit) on worldwide income   
foreign source taxable income/worldwide taxable income

    Under the formula, as foreign source taxable income 
increases (e.g., by operation of the Export Source Rule), the 
limitation on foreign tax credits available to offset U.S. tax 
increases (and therefore the foreign tax credit that can be 
utilized in most cases increases, up to the full amount of 
foreign taxes paid or accrued).
    To the extent that the foreign income tax is less than the 
limitation, the United States collects a residual tax on the 
foreign source income. If the foreign income tax exceeds the 
limitation, the taxpayer pays tax, in the current year, on 
foreign source income at the effective foreign tax rate (rather 
than the lower U.S. tax rate). This results in foreign tax 
credits in excess of the general limitation in the current year 
(an ``excess foreign tax credit position''). These excess 
credits may, under current law, be ``carried back'' for up to 
two years and ``carried forward'' for up to five years, subject 
to the general limitation in each of those years.\9\
---------------------------------------------------------------------------
    \9\ In other words, the return for the second preceding tax year is 
recomputed with the newly available credit carryback, and to the extent 
that the foreign tax credits previously available in that year plus the 
foreign tax credits carried back to that year do not exceed the general 
limitation, the taxes carried back may be utilized in that year to 
reduce the U.S. tax paid in that year. If excess credits remain, the 
same procedures are followed for the first preceding tax year, and then 
the first succeeding tax year, the second succeeding tax year, and so 
on, until they are used up, or until the five year limitation causes 
them to ``expire.''
---------------------------------------------------------------------------
    Higher foreign tax rates are only one reason many companies 
are in an excess foreign tax credit position. A multitude of 
other U.S. tax rules place restrictions on crediting foreign 
taxes.
    As noted above, the amount of the credit is dependent on 
the amount of income designated as ``foreign source'' under 
U.S. tax law. For example, under restrictions in U.S. law, a 
portion of U.S. interest, as well as research and development 
costs, must be allocated to and reduce foreign source taxable 
income (even though no deduction may actually be allowed for 
these amounts in the foreign country). On the other hand, if a 
company incurs a loss in its domestic operations, it is never 
able to use foreign source earnings from that year to claim 
foreign tax credits.
    The system is further complicated by other rules, such as 
the ``basket'' limitation rules of section 904 of the Code. 
Under these provisions, foreign source income is divided into 
separate baskets for various situations and types of income to 
each of which the limitation is applied. These rules may result 
in hundreds of separate limitations being applied to the 
credits. (Thus, a U.S. company might nevertheless end up with 
excess foreign tax credits, even though without such rules the 
company would have been able to fully utilize its foreign tax 
credits.)
    These U.S. rules are orders of magnitude more complex than 
the similar limitation systems of any of our foreign trading 
partners. Lost credits and the cost of compliance only add to 
the disparity in tax burden between U.S.-based and foreign-
based multinationals, mitigated in part by the Export Source 
Rule.
    The Code contains two source rules for the sale of 
inventory property that are of particular importance to U.S. 
exporters. One rule is for inventory property that the exporter 
produces and sells; and, the other is for inventory property 
that the exporter purchases and sells.\10\
---------------------------------------------------------------------------
    \10\ The source of gross income derived from inventory property 
that is purchased by an exporter in the U.S. and sold outside the U.S. 
is determined under the ``title-passage'' rule of section 862(a)(6), 
which treats such income as derived entirely from the country in which 
the sale occurs. That is, such property sales generally produce foreign 
source income.
---------------------------------------------------------------------------
    The source of income derived from the sale of property 
produced \11\ in the U.S. and sold outside the U.S. (or vice 
versa) is determined under section 863 of the Code. Treasury 
Regulations promulgated in 1996, following regulations that 
date back to 1922, and which implement section 863 and its 
predecessor statutes, provide three rules for making the 
determination of the amount of income that is foreign source. 
The first and most commonly used of these is known as the ``50-
50 Method'' (also known as the ``Export Source Rule'').\12\
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    \11\ Section 864 of the Code provides that ``produced property'' 
includes property that is ``created, fabricated, manufactured, 
extracted, processed, cured, or aged.''
    \12\ The second method is the ``Independent Factory Price Method'' 
or ``IFP Method;'' and, the third permits a method based on use of the 
taxpayer's own method of allocation made in its books and records with 
the IRS District Director's consent.
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    Under the so-called ``50-50 Method,'' 50 percent of the 
income to be allocated between U.S. source and foreign source 
is allocated based on the location of the taxpayer's property 
used in the production of the inventory, and the source of the 
other 50 percent is based on the title-passage rule. Assuming 
title to the inventory passes outside the United States, this 
generally allows U.S. manufacturers to treat at least half of 
their export income from manufacture and sale of their products 
as derived from foreign sources, even though the manufacturer's 
production activity is located in the U.S.
    EXAMPLE: \13\
---------------------------------------------------------------------------
    \13\ For purposes of this example, a number of other U.S. tax 
rules, such as ``deferral'' and the ``subpart F'' rules, other credit 
limitations, and the like are ignored--they do not change the basic 
result, but serve to complicate the illustration.
---------------------------------------------------------------------------
    American Widget Company exports widgets to European markets 
and is in an excess foreign tax credit position. It costs 
American $90 to produce, sell, and transport a unit from one of 
its 14 U.S. plants, but only $88 to produce and sell a unit in 
the Czech Republic where it has located a plant to make widgets 
for the East European market. The U.S. made units sell for $100 
each in West European markets.
    Assume American produces a widget in the U.S. with U.S. 
jobs and manufacturing plant, and passes title to the widget in 
Romania, paying no tax in Romania on the sale. American has $10 
of pre-tax income, $5.00 of which is considered foreign source 
income. Assuming a 35% U.S. tax rate, it may utilize $1.75 
additional foreign tax credits, and therefore has $8.25 of 
after-tax income from the sale [($10.00  65%) + 
$1.75].
    As an alternative, American could produce a widget in the 
Czech Republic for sale in Romania. American would have $12.00 
of net income. Assume again that American would pay no Romanian 
tax and that the Czech tax rate is 35%. American would have 
$7.80 of after-tax income.
    With the Export Source Rule, American has an incentive to 
maintain production in the U.S. ($8.25 > $7.80). Without the 
Rule, American would have an incentive to increase its Czech 
production. ($7.80 > $6.50):


----------------------------------------------------------------------------------------------------------------
                                                                          U.S. Production
                                                                 --------------------------------      Czech
                                                                    With Export   Without Export    Production
                                                                    Source Rule     Source Rule
----------------------------------------------------------------------------------------------------------------
Sales Price.....................................................         $100.00         $100.00         $100.00
Cost of Goods Sold..............................................        ($90.00)        ($90.00)        ($88.00)
                                                                 -----------------------------------------------
Pre-tax Income..................................................          $10.00          $10.00          $12.00
                                                                 -----------------------------------------------
U.S. tax........................................................           $3.50           $3.50           $4.20
Czech tax.......................................................              --              --           $4.20
Foreign Tax Credit..............................................         ($1.75)              --         ($4.20)
                                                                 -----------------------------------------------
Net tax.........................................................           $1.75           $3.50           $4.20
                                                                 -----------------------------------------------
After-tax Income................................................           $8.25           $6.50           $7.80
----------------------------------------------------------------------------------------------------------------

    As another way to view the situation, if American requires 
an 8.25% Return On Sales to support its capital structure, 
without the Export Source Rule, American would have to raise 
its unit price at least $2.69 to obtain the same $8.25 return. 
If the market would not support this new price, it would have 
to shift production to a location where a lower cost structure 
can be found, or lose its market to lower cost competitors.
    For example, the following two structures result with and 
without the Export Source Rule:


------------------------------------------------------------------------
                                            With Export   Without Export
                                            Source Rule     Source Rule
------------------------------------------------------------------------
Sales Price.............................         $100.00         $102.69
Cost of Sales...........................           90.00           90.00
                                         -------------------------------
Profit..................................          $10.00          $12.69
                                         -------------------------------
Net tax.................................           $3.50           $4.44
Less: Foreign Tax Credit................         ($1.75)              --
                                         -------------------------------
Net tax.................................           $1.75           $4.44
                                         -------------------------------
After-tax profit........................           $8.25           $8.25
------------------------------------------------------------------------

    The Administration's Proposal.--The President's Fiscal Year 
1999 Budget contains a proposal to eliminate the ``50/50 Rule'' 
and replace it with an ``activities based'' test which would 
require exporters to allocate income from exports to foreign or 
domestic sources based upon how much of the activity producing 
the income takes place in the U.S. and how much takes place 
abroad.
    In addition to introducing considerable administrative 
complexity and cost into the system,\14\ this modification 
essentially eliminates the benefits of the rule. The 
justification given for eliminating the rule is essentially 
that it provides U.S. multinational exporters that also operate 
in high tax foreign countries a competitive advantage over U.S. 
exporters that conduct all their business activities in the 
U.S. In this regard, the Administration prefers the foreign 
sales corporation rules (FSC) which exempt a lesser portion of 
export income for all exporters that qualify. The 
Administration also notes that the U.S. tax treaty network 
protects export sales from foreign taxation in countries with 
which we have treaties. The NFTC believes that these arguments 
are flawed.
---------------------------------------------------------------------------
    \14\ ``Moreover, the 50/50 source rule of present law can be viewed 
as having the advantage of administrative simplicity; the proposal to 
apportion income between the taxpayer's production activities and its 
sales activities based on actual economic activity has the potential to 
raise complex factual issues similar to those raised under the section 
482 transfer pricing rules that apply in the case of transactions 
between related parties.'' Joint Committee on Taxation, ``Description 
and Analysis of Certain Revenue-Raising Provisions Contained in the 
President's Fiscal Year 1998 Budget Proposal,'' JCX-10-97, March 11, 
1997.
---------------------------------------------------------------------------
    The Export Source Rule does not provide a competitive 
advantage to multinational exporters vis-a-vis exporters who 
conduct all their operations in the United States. First, 
exporters with domestic only operations do not incur foreign 
taxes and therefore do not suffer double taxation. Also, 
domestic-only exporters are able to claim the full benefit of 
deductions for U.S. expenses for U.S. tax purposes (e.g., 
interest on borrowings and Research & Development costs) 
because they are also not subject to the rules applied to 
multinational operations that require allocation of a portion 
of these expenses against foreign source income. Absent the 
Export Source Rule, the current Code would have even more of a 
bias against foreign operations. Second, this is important 
because the Administration argument also ignores the fact that 
export operations ultimately lead to foreign operations for 
U.S. companies. Exporting companies conduct foreign operations 
to enter and serve foreign markets; marketing, technical and 
administrative services, and even specialized manufacturing 
activities are necessary to gain markets and to keep them--to 
compete with foreign-based companies. Further, and importantly, 
the Export Source Rule, by alleviating the cost of double 
taxation, encourages U.S. companies to locate production in the 
United States. Tax costs are like other costs (e.g., labor, 
material, and transportation) affecting the production and 
marketing of these products and services; a recent study 
suggests that these decisions are now much more tax-sensitive 
in fact than was previously the case.\15\
---------------------------------------------------------------------------
    \15\ ``A second key is the sensitivity of plant location to the tax 
environment. Not right away perhaps, but over a period of years a 
country that penalizes export production with high taxes will forfeit 
first investment and then export sales.'' Hufbauer, DeRosa, Id., at 15.
---------------------------------------------------------------------------
    Although the FSC regime of the Code \16\ is itself valuable 
to promoting U.S. exports, these provisions do not in 
themselves afford relief to U.S. exporters with foreign 
operations that face double taxation because of limited use of 
foreign tax credits. Further, because the FSC benefits are less 
than those attributable to the loss of foreign tax credits in a 
situation where the Export Source Rule may be applicable, they 
may be insufficient to keep an exporter from moving its 
production overseas to generate foreign source income.\17\
---------------------------------------------------------------------------
    \16\ The Foreign Sales Corporation (``FSC'') provisions of sections 
921 through 927 of the Code are one of the most important U.S. tax 
incentives for exports from the United States. These provisions were 
adopted to offset disadvantages to U.S. exporters in relation to more 
favorable tax schemes allowed their foreign competitors in the tax 
systems of our trading partners. These provisions encourage the 
development and manufacture of products in the United States and their 
export to foreign markets.
    \17\ U.S. firms with excess foreign tax credits that use the Export 
Source Rule pay a ``blended'' tax rate of 17.5 percent on their export 
earnings--zero percent on half and 35 percent on half. U.S. firms can 
conduct their export sales through a FSC and exclude a maximum of 15 
percent of their net export earnings from U.S. taxation. In this case, 
the ``blended'' rate is 29.75 percent--zero percent on 15 percent of 
export earnings and 35 percent on 85 percent of export earnings.
---------------------------------------------------------------------------
    Our tax treaty network, valuable as it is, is no substitute 
for the Export Source Rule. First, the countries with which the 
U.S. currently has double taxation agreements number 
approximately forty-nine.\18\ The current international 
consensus favoring income tax treaties is derived from sixty 
years of evolution, starting with the model income tax treaty 
drafted by the League of Nations in 1927, culminating in its 
``London Model'' treaty in 1946, and carried on later by the 
United Nations, and the Committee on Fiscal Affairs of the 
Organization for Economic Cooperation and Development 
(``OECD''). The U.S. first signed a bilateral tax treaty in 
1932 with France, which treaty never went into force. The first 
effective treaty, also with France, was signed July 25, 1939, 
and came into force on January 1, 1945.\19\ A hearing intended 
to be held in early September of this year is expected to deal 
with four new treaties, and the termination of an existing one. 
\20\ These nations tend to be our most developed trading 
partners, and relatively few developing nations are included. 
Much of the world is not yet covered by these treaties. 
Further, the treaties provide relief from double taxation in 
such cases only where the export income is solely allocable to 
the U.S.--i.e., where the U.S.-based exporter does not have a 
permanent establishment in the foreign jurisdiction to which 
income is allocable. These circumstances only occur where a 
U.S. company exports to a foreign treaty partner, and has no 
operations in that host country that have anything to do with 
its export sales.
---------------------------------------------------------------------------
    \18\ The United States has in force some forty-nine Conventions for 
the Avoidance of Double Taxation and the Prevention of Fiscal Evasion 
With Respect to Taxes on Income (``income tax treaties'') with various 
jurisdictions, not including other agreements affecting income taxes 
and tax administration (e.g., Exchange of Tax Information Agreements or 
Treaties of Friendship and Navigation that may include provisions that 
deal with tax matters). It has taken more than sixty years to 
negotiate, sign, and approve the treaties that form the current 
network.
    \19\ A number of new agreements are being negotiated by the 
Treasury Department.
    \20\ Nevertheless, the U.S. treaty network has never been as 
extensive as the treaty networks of our principal competitors. The U.S. 
treaty network covers only a relatively small percentage percent of the 
developing world, compared to coverage of 40 to 46 percent by the 
networks of Japan and leading European nations. This discrepancy has 
persisted for many years, even though the United States relies on the 
developing world to buy a far larger share of its exports than does 
Europe.
---------------------------------------------------------------------------
    To the contrary, the Export Source Rule supports 
significant additional U.S. exports and worker earnings. For 
example, in 1999, for an adjusted net tax revenue cost of $1.1 
billion, the U.S. will ship an additional $30.8 billion of 
exports and add $1.7 billion to worker payrolls in the form of 
the export earnings premium. The additional exports will 
support 360 thousand workers in export-related jobs who in a 
full employment economy would otherwise be working in lower 
paid sectors of the U.S. economy.\21\
---------------------------------------------------------------------------
    \21\ Hufbauer, DeRosa, Id., at 1.

Limitation of Foreign Tax Credits from Foreign Oil and Gas 
---------------------------------------------------------------------------
Income

    The Administration's Proposals.--The President's Fiscal 
Year 1999 Budget contains a proposal to modify the rules 
affecting foreign tax credits for all ``foreign oil and gas 
income.'' Such income would be trapped in a new separate FOGI 
basket under the separate basket foreign tax credit limitations 
of section 904. In situations where taxpayers are subject to a 
foreign tax and also receive an economic benefit from the 
foreign country (e.g., a royalty on production), taxpayers 
would be able to claim a foreign tax credit for such taxes 
under section 902 only if the country has a ``generally 
applicable income tax'' that has ``substantial application'' to 
all types of taxpayers and then only up to the level of 
taxation that would be imposed under the generally applicable 
income tax. Treaty provisions to the contrary (for foreign tax 
credit calculations) would be respected.
    The NFTC opposes these proposals. Potential abuses of the 
foreign tax credit have been addressed previously in sections 
901(f), 907(a) and (b) and (c), and 954(g) of the Code, and in 
the ``dual capacity'' income tax regulations under section 901 
of the Code.\22\ The Administration has not demonstrated that 
these provisions of law and regulation are not adequate and 
should be amended.
---------------------------------------------------------------------------
    \22\ Congress legislated changes in the treatment of oil and gas 
income, and related foreign tax credits, in the 1970's and 1980's. 
These changes reflected concerns about the relatively high tax rates in 
some foreign jurisdictions in which there was significant oil recovery, 
and also a concern over whether payments by the petroleum companies 
were in fact disguised royalties.
    Under section 907(a), the amount of taxes on foreign oil and gas 
extraction income (``FOGEI'') may not exceed 35% (i.e., the highest 
U.S. marginal rate) on such income. Excess credits may be carried over 
like excess foreign tax credits in the general limitation basket. 
(FOGEI is income derived from the extraction of oil and gas, or from 
the sale of exchange of assets used in extraction activities.) In 
addition, under section 907(b), the Treasury has regulatory authority 
to determine that a foreign tax on foreign oil related income 
(``FORI'') is not creditable to the extent that the foreign law 
imposing the tax is structured, or in fact operates, so that the tax 
that is generally imposed is materially greater than the amount of tax 
on income that is neither FORI nor FOGEI. (FORI is foreign source 
income from: (1) processing oil and gas into primary products; (2) 
transporting oil and gas or their primary products, (3) distributing or 
selling these products, or (4) disposing of assets used in the 
foregoing activities.) To date, the Treasury has not exercised this 
authority; however, see the discussion below of the safe harbor rule of 
Treas. Reg. Sec. 1.901-2A(e)(1).
    Under section 954(g), foreign base company oil related income (an 
element of subpart F income not eligible for deferral) generally 
includes FORI other than income derived from a source within a foreign 
country in connection with either (1) oil or gas which was extracted 
from a well located in that foreign country (FOGEI); or (2) oil, gas, 
or a primary product of oil or gas which is sold by the foreign 
corporation or a related person for use or consumption within that 
foreign country, or is loaded in that country on a vessel or aircraft 
as fuel for that vessel or aircraft.
    In addition, in 1983, the I.R.S. promulgated the ``dual capacity'' 
regulations (Treas. Reg. Sec. 1.901-2A). Since mineral rights in many 
countries vest in the sovereign, payments to the sovereign may take the 
form of royalties or other payments for the mineral or as taxes to the 
sovereign on the income represented by the production. To help resolve 
the possible controversy of whether such payment are royalties or 
creditable income taxes, the regulations provide that a taxpayer must 
establish under the facts and circumstances method the amount of the 
intended tax payment that otherwise qualifies as an income tax payment 
but is not paid in return for a specific economic benefit. The 
remainder is a deductible rather than creditable payment (in the case 
of oil and gas products, a royalty). A ``safe harbor'' method is 
available under Treas. Reg. Sec. 1.901-2A(e)(1), under which a formula 
is used to determine the tax portion of the payment to the foreign 
sovereign (e.g., the amount that the taxpayer would pay under the 
foreign country's general income tax law). Where there is no generally 
applicable income tax, the safe harbor rule of the regulation allows 
the use of the U.S. tax rate in a ``splitting'' computation (the U.S. 
tax rate is considered the country's generally applicable income tax 
rate).
---------------------------------------------------------------------------
    The proposals create significant new limitations on the 
foreign tax credits attributable to foreign oil and gas income, 
and represent significant limitations on the foreign tax 
credits available to this specific industry. This proposal will 
significantly increase the cost of capital in that industry and 
make U.S. companies even less competitive vis-a-vis their 
foreign competitors. U.S. based oil companies are already at a 
competitive disadvantage under current law since most of their 
foreign based competition pay little or no home country tax on 
foreign oil and gas income. The proposal increases the risk of 
foreign oil and gas income being subject to double taxation 
which will severely hinder U.S. oil companies in the global oil 
and gas exploration, production, refining and marketing arena.

Other Foreign Proposals: Amend 80/20 Company Rules; Prescribe 
Regulatory Directive to Address Tax Avoidance Involving 
Foreign-Built-In Losses; Prescribe Regulatory Directive to 
Address Tax Avoidance Through Use of Hybrids; Modify Foreign 
Office Material Participation Exception Applicable to Inventory 
Sales Attributable to Nonresident's U.S. Office

    In each of these proposals the Treasury seeks legislative 
or regulatory authority to address perceived abuses. The NFTC 
is also concerned that current law not be subject to 
unwarranted abuse of statutory provisions in ways that 
undermine Congressional intent.
    However, the General Explanations of the Administration's 
Revenue Proposals (the ``Green Book'' explanations) issued by 
the Treasury give little detail of the perceived abuses. 
Further, the changes to the statutes affected by the 
proposals--in some case statutes that have been settled law for 
many years--and the regulatory authority sought are very broad. 
Still further, recent notices issued by the Treasury that 
amplify certain of these proposals have created considerable 
uncertainty as to the intent of the Treasury in regard to its 
announced intent to issue legislative regulations in the very 
near future in these areas--given the breadth of the notices, 
and their application to a number of legitimate transactions 
that have been planned and in some cases implemented under 
current law and regulations. Lastly, NFTC is troubled by recent 
indications that Treasury is apparently seeking to broadly 
address efforts by U.S. taxpayers to legitimately reduce their 
foreign taxes under provisions of foreign law that do not 
affect U.S. tax receipts.
    Therefore, the NFTC does not support these changes until a 
better analysis of these issues and perceived abuses can be 
produced by the Treasury, and until more specific legislation 
is crafted that better serves the interests of the U.S. by 
separating legitimate transactions from those not favored by 
current U.S. law.
    Notice 98-5, and Notice 98-11 in particular, have had a 
chilling effect on the ability of U.S. companies to structure 
their foreign operations consistent with legitimate commercial 
objectives. They also adversely impact companies' abilities to 
effectively reduce their overall costs by reducing local taxes 
in their overseas operations. The Notices are drafted so 
broadly and so vaguely that they confuse U.S. taxpayers and 
their advisors, and introduce a compelling need to seek 
clarification as to whether taxpayers can continue to rely on 
the simple ``check-the-box'' regulations issued just last year. 
All these effects are exacerbated by the Notices' immediate 
effective dates.
    U.S. multinationals compete in an environment wherein 
foreign competitors use tax planning techniques to reduce 
foreign taxes without incurring home country tax. It would 
appear that at least some of the concerns sought to be 
addressed are not inconsistent with the balance between 
competitiveness and export neutrality that was intended by 
Congress in enacting the ``subpart F'' rules. NFTC believes 
that it would be more appropriate for Congress to request a 
study regarding the trade and tax policy issues associated with 
Notices 98-5 and 98-11. In this regard, a moratorium on further 
regulatory action by Treasury should be imposed until enactment 
of specific legislative proposals resulting from well reasoned 
analysis and debate.

Modification of the Rules for Foreign Tax Credit Carrybacks and 
Carryovers

    As noted above, if a foreign income tax exceeds the 
limitation, the taxpayer pays tax, in the current year, on 
foreign source income at the effective foreign tax rate (rather 
than the lower U.S. tax rate). This results in foreign tax 
credits in excess of the general limitation in the current year 
(an ``excess foreign tax credit position''). These excess 
credits may, under current law, be ``carried back'' for up to 
two years and ``carried forward'' for up to five years, subject 
to the general limitation in each of those years.\23\
---------------------------------------------------------------------------
    \23\ See footnote 9.
---------------------------------------------------------------------------
    The Administration's Proposal.--The President's Fiscal Year 
1998 Budget contained a proposal to reduce the carryback period 
for excess foreign tax credits from two years to one year. The 
proposal also would extend the excess foreign tax credit 
carryforward period from five years to seven years. This 
proposal is currently being considered in the Senate as a 
revenue raiser for one or more pending bills. The NFTC strongly 
opposes this proposal.
    As noted by the Joint Committee on Taxation,\24\ one of the 
purposes of the carryover of foreign tax credits is to address 
timing differences between U.S. tax rules and foreign tax 
rules. Income may be subject to tax in one year under U.S. 
rules and in another tax year under applicable foreign rules. 
The carryback and carryover of foreign tax credits helps to 
ensure that foreign taxes will be available to offset U.S. 
taxes on the income in the year in which the income is 
recognized for U.S. purposes. Shortening the carryback period 
and increasing the carryforward period also could have the 
effect of reducing the present value of foreign tax credits and 
therefore increasing the effective tax rate on foreign source 
income.
---------------------------------------------------------------------------
    \24\ JCX-10-97, Id., at 62.

---------------------------------------------------------------------------
In Conclusion

    Again, the Council applauds the Chairman and the Members of 
the Committee for giving careful consideration to the proposals 
raised by the Administration. The NFTC is appreciative of the 
opportunity to work with the Committee and the Congress in 
going forward into this process of consideration of various 
alternatives, and the Council would hope to make a contribution 
to this important business of the Committee.
      

                                

Statement of National Mining Association

    The National Mining Association (NMA) appreciates the 
opportunity to submit this statement for the Committee's record 
on the President's fiscal 1999 tax proposals. The NMA is an 
industry association representing most of the Nation's 
producers of coal, metals, industrial and agricultural 
minerals. Our membership also includes equipment manufacturing 
firms and other providers of products and services to the 
mining industry. The NMA has not received a federal grant, 
contract or subcontract in fiscal years 1998, 1997, 1996 or 
1995.
    Mining directly employs over 300,000 workers. Nearly five 
million Americans have jobs as a result of the mining 
industry's contribution to personal, business and government 
income throughout the nation. The headquarters of NMA member 
company operations are located in nearly every state of the 
Union and some form of mining represented by the NMA occurs in 
all 50 states.

                        The President's Proposal

    Of primary concern to our industry is the Administration's 
budget proposal to repeal the percentage depletion allowance 
for minerals mined on federal and former federal lands where 
mining rights were originally acquired under the Mining Law. 
The mining industry is adamantly opposed to this proposal. The 
President included this provision in his 1997 and 1998 budget 
proposals. It was a bad idea then, it is a bad idea now.
    Repeal of the allowance is a major tax increase on 
companies whose mines are located primarily in the western 
United States. As it is not uncommon for ownership of mineral 
deposits to change hands, the proposal would especially 
penalize mining companies who purchased their properties from 
original claimants or other intermediary mining concerns.
    The U.S. Department of Labor reports that the mining 
industry provides some of the highest paying nonsupervisory 
jobs in the United States. The average mining wage in 1996 was 
$47,612 (not including benefits)--far above the national 
average wage of $28,945. We believe that tax policy should 
foster the creation of more of these high-paying jobs. 
Unfortunately, the Administration's proposal places many of 
these jobs, principally in economically vulnerable rural areas 
in the West, at risk.

                       Mining and the Mining Law

    From our perspective, the President's depletion proposal 
has more to do with mining on public lands in the western 
states than it does with tax policy. The NMA and its member 
companies continue to advocate responsible amendments to the 
Mining Law, including a reasonable royalty provision. This 
reform effort has been stymied at every turn by anti-mining 
groups. Those opposing responsible amendment to the Mining Law 
seek changes that would make mining on public lands nearly 
impossible. The President's proposal to increase the tax burden 
on certain hardrock mines would appear to be part of a 
sustained and coordinated effort to accomplish that goal.
    It is a serious misconception to think that minerals mined 
on federal lands are free for the taking--that mining companies 
receive something for nothing and are therefore recipients of 
so-called ``corporate welfare.'' The NMA wishes to set the 
record straight.
    Minerals have no worth if left in the ground undiscovered 
in the hundreds of millions of acres of unused land controlled 
by the federal government. They only attain value after they 
are discovered and produced. And they won't be produced unless 
there is significant investment and a financial risk shouldered 
by the mining industry.
    The pamphlet prepared by the Joint Committee on Taxation 
describing the President's fiscal 1999 tax proposals (Joint 
Committee on Taxation, Description of Revenue Provisions 
Contained in the President's fiscal Year 1999 Budget Proposals 
(JCS-4-98), February 24, 1998) states that: Once a claimed 
mineral deposit is determined to be economically recoverable, 
and at least $500 of development work has been performed, the 
claim holder may apply for a ``patent'' to obtain full title to 
the land for $2.50 or $5.00 per acre.
    The Committee should note that considerable funds must be 
expended in order to demonstrate to the satisfaction of the 
federal government that the claim contains an ``economically 
recoverable'' mineral deposit. The Nevada office of the Bureau 
of Land Management reports that: In Nevada, mineral patent 
applications have contained from one to 500 claims/sites per 
application. At a minimum it will cost an applicant $37,900 in 
direct costs to process a single claim or mill site. Cost can 
and do go much higher.
    The $2.50 or $5.00 per acre fee note in the pamphlet is 
merely a patent application fee. The costs a mining company 
must incur to get to the patenting phase usually run in excess 
of $2,000 per acre, or $40,000 per 20-acre claim. It is 
impossible to obtain a patent simply by writing a check to the 
government for $2.50 or $5.00 per acre--a fact conveniently 
overlooked by mining's critics. Obtaining a patent is an 
expensive, time-consuming, laborious and by no means guaranteed 
process.
    With or without a patent, a significant amount of capital 
must then be invested to develop the mine and build the 
necessary infrastructure to process raw ore into an acceptable 
product. It is not uncommon to spend in excess of $400 million 
to bring a domestic world-scale mine into production. The cost 
of processing facilities is high: A state-of-the-art smelter 
can have capital costs approaching $1 billion. To argue that 
minerals are ``free for the taking'' and mining companies are 
recipients of so-called corporate welfare is fallacious at 
best.

             The Importance of the Domestic Mining Industry

    The President's proposal coupled with other legislative and 
regulatory initiatives is effectively placing much federally 
controlled land off-limits to mineral exploration and is making 
the United States an increasingly hostile business environment 
for mining investment. As mining companies must continuously 
search for new reserves or literally mine themselves out of 
business, this negative environment is increasingly forcing 
them to look overseas for new exploration projects.
    The NMA believes it is in the vital interest of the United 
States to have a viable domestic mining industry. A study 
prepared by the Western Economic Analysis Center reports that 
the domestic mining industry, directly and indirectly, accounts 
for significant economic activity--$524 billion in 1995 alone. 
It is beyond a doubt that continued economic growth and 
improvements in the standard of living for all Americans will 
depend upon a reliable supply of energy and raw materials. The 
U.S. mining industry has the potential to provide much of our 
resource needs--if it is allowed to do so.

                            Impact of Repeal

    Increasing the tax burden on the mining industry is 
effectively an increase in production costs. Because minerals 
are commodities traded in the international marketplace at 
prices determined by worldwide supply and demand factors, 
mining companies cannot recover higher costs by raising prices.
    This tax increase is likely to have the following short- 
and long-term disruptive effects on the industry:
     Reduce the operating lives of many mines by 
increasing the ore cut-off grade. Minerals that would otherwise 
have been economic to extract will remain in the ground and not 
be recovered, resulting in poor stewardship of our natural 
resources. Existing jobs, federal, state and local tax revenues 
will be lost.
     Higher taxes will reduce a company's ability to 
make the necessary investment in existing operations to improve 
production efficiencies and respond to constantly changing 
environmental, reclamation, health and safety standards.
     Investment in new projects will decline. This 
change to long-standing tax policy will adversely affect the 
economics of new projects. Many new projects will become 
uneconomic, resulting in lost opportunities for new jobs and 
tax revenues.
    Clearly, the long-term consequences of this tax increase 
are serious. Without continuous investment in new domestic 
projects to replace old mines, mineral production in the United 
States will decline. The increasing short-fall between the 
nation's demand for mineral products and domestic supply will 
then be satisfied by imports of minerals mined by overseas by 
foreign workers. U. S. exports will become jobs and many areas 
of the country will experience economic decline and an erosion 
of state and local tax bases.
    Despite the continued overall growth of the economy, the 
copper and gold metals mining industry (the primary target of 
the Administration's proposal) has entered into a serious 
cyclical decline. The price of gold is at its lowest point in 
18 years (having declined over 25% in the last year) and the 
price of copper has declined over 30% in less than one year. 
Many mining companies are struggling to remain profitable and 
keep mines open and miners working to weather this downturn. 
Indeed, several companies have already announced mine closures 
and significant layoffs in the past six months.

                        The Depletion Allowance

    The mining industry is characterized by relative rarity of 
commercially viable mineral deposits, high economic risks, 
geologic unknowns, high capital requirements and long lead 
times for development of new mines. The depletion allowance 
recognizes the unique nature of mineral extraction by providing 
a rational and realistic method of measuring the decreasing 
value of a deposit as minerals are extracted. As the 
replacement cost of a new mine is always higher in real terms 
than the mine it replaces, the allowance helps generate the 
capital needed to bring new mines into production.

                      The Need for Tax Reductions

    The mining industry (and other capital-intensive 
industries) already pay high average tax rates through the 
application of the corporate alternative minimum tax (AMT). The 
General Accounting Office in a 1995 study reported that the 
average effective tax rate for mining companies under the AMT 
is 32 percent. The AMT gives the United States the worst 
capital cost recovery system in the industrialized world. 
Rather than increasing the tax burden on mining, as proposed by 
the Administration, it should be reduced by reform of the 
corporate AMT.

                               Conclusion

    We urge the Committee and the Congress to reject this job-
killing and self-defeating tax increase targeted at the mining 
industry. Instead, Congress should pass tax legislation 
designed to foster investment and economic growth in mining and 
other capital intensive industries and should include reform of 
the corporate AMT.
      

                                

Statement of National Realty Committee

    National Realty Committee appreciates the opportunity to 
submit comments for the record of the February 25, 1998 hearing 
of the House Committee on Ways and Means regarding the revenue 
provisions of the Administration's fiscal year 1999 budget 
proposal.
    National Realty Committee serves as Real Estate's 
Roundtable in Washington on national issues affecting real 
estate. Its members are America's leading public and private 
real estate owners, advisors, builders, investors, lenders and 
managers. The Administration's budget contains proposals that 
could significantly affect the real estate industry, some 
positively and others negatively, and we look forward to 
working with the Committee as it deliberates on these 
proposals.

            Revenue Increases in President's Budget Proposal

Real Estate Investment Trust (REIT) Proposals

    The Administration's proposed fiscal year 1999 budget includes four 
proposals that could substantially affect important aspects regarding 
the formation, operation and management of Real Estate Investment 
Trusts (REITs). The securitization of real estate through REITs that 
has occurred in the 1990s has been an important factor in the recovery 
of the real estate industry which itself is making a significant 
contribution to the strength of the overall economy. We are greatly 
concerned with the impact the Administration's proposals could have on 
capital flows to real estate and the potential resulting negative 
effect on asset values and jobs. Therefore, we urge you to carefully 
review these proposals to determine fully the nature and scope of any 
true abuses concerning REITs and act only to the extent required to 
address those specific problems.
    Before discussing the Administration's individual proposals, we 
believe it would be useful to provide the Committee with some context 
and background concerning the important role of REITs in the real 
estate marketplace, their benefit to overall economic growth, and the 
general policy approach to this vehicle that we would urge.

The Real Estate Crisis of the Late 1980s and Early 1990s

    Today's real estate markets, as a whole, are in overall good 
health. Interest rates and inflation are low; availability of capital 
and credit is good; and demand for work and shopping space, in most 
regions, is relatively strong. In the late 1980s and early 1990s, 
however, the economy was teetering on a recession and the real estate 
industry itself was close to experiencing a depression. During this 
period, the demand for building space had fallen with the fortunes of 
the economy. Over-building that occurred in the 1980s flooded some 
markets, driving vacancy rates up even further. Exacerbating the 
situation was the ``credit crunch'' that the commercial real estate 
industry faced. Many owners of commercial real estate properties 
experienced difficulties in obtaining reasonable financing, including 
the refinancing of existing properties--whether or not the property was 
performing. This dearth of capital contributed to a severe nationwide 
drop of property values, dampened investment returns, increased 
bankruptcies and foreclosures, and caused tremendous job losses. In 
turn, this resulted in a material erosion in state and local tax bases, 
which adversely impacted community services.

The Role of REITs in the Recovery of Real Estate and the Economy

    One of the primary catalysts in real estate's recovery in the 1990s 
has been the emergence of the REIT as a broad-based public ownership 
entity. The REIT, along with the development and growth of the 
commercial mortgage-backed securities market, has provided real estate 
with access to much-needed funding via the public debt and equity 
markets. Such access to capital enabled billions of dollars of real 
estate to be recapitalized--thus stabilizing asset values nationwide 
and easing the tremendous negative pressure being placed on lenders' 
portfolios. These positive actions contributed significantly toward 
setting the nation on a course of job-creating economic growth.
    REITs, in effect, act as real estate mutual funds by securitizing 
real estate equity and providing investors with a liquid investment in 
a diversified pool of real estate assets. Like stock mutual funds, this 
lowers the risk to investors, which in turn lowers the cost of capital 
to the REIT. The growth of REITs also increased the number and types of 
real estate investors, thereby opening new capital sources to real 
estate and reassuring traditional lending sources.
    Today, REITs are the fastest growing form of real estate 
investment. In the last five years, the market value of REITs has 
increased from $10 billion to almost $150 billion. There are a total of 
210 publicly traded REITs, approximately 45 of which have 
capitalizations exceeding $1 billion. This represents an extraordinary 
growth rate that has been positive for real estate values, whether 
publicly-held or privately-held.
    Because real estate represents about 12 percent of America's gross 
domestic product, this in turn has produced positive ripple effects for 
the overall economy. Real estate accounts for nearly 9 million jobs in 
America. About $293 billion in tax revenues is generated annually by 
real estate, and almost 70% of all tax revenues raised by local 
governments come from real property taxes. Unquestionably, real estate 
is a vital and major contributor to the nation's economy and REITs play 
a significant, and growing, role in the real estate industry.
    In short, the real estate markets and the nation's economy are 
being well served by the current capital formation and operational 
flexibility of REITs. This flexibility should be preserved--
particularly in anticipation of an inevitable economic downturn during 
which challenges to capital formation will be magnified.

REITs Pay Significant Level of Tax Relative to Market Capitalization

    Contrary to the perception prevalent in a number of news articles 
and editorials, REITs are not a vehicle for tax avoidance. This 
misunderstanding presents a serious concern because of its potential to 
misinform policymakers and the public. Although REITs do not, 
themselves, pay Federal corporate level tax (so long as they distribute 
95 percent of their taxable income annually), they are responsible, 
directly and indirectly, for a significant amount of tax revenues 
relative to their market capitalization. In 1997, REITs distributed $8 
billion in dividends which are taxable to their shareholders for 
Federal and state income tax purposes. REITs themselves also pay 
substantial amounts in state and local taxes and payroll taxes.

Congress's Proper Approach toward REITs

    Over the years, REIT tax laws have been modified and refined by 
Congress and the Treasury Department to ensure that REITs are able 
effectively to fulfill their mission in a changing economic and 
business environment. Federal tax policy should continue to provide 
this type of flexibility and reflect an understanding of the benefits 
REITs provide to the vitality of today's real estate markets and the 
overall economy.
    Congress, and notably this Committee, has avoided any dramatic 
policy shifts affecting REITs, particularly during their recent 
proliferation and expansion. Your approach toward REIT policy has been 
measured and thoughtful, as evidenced by: (i) the liberalization of the 
independent contractor requirement by the Tax Reform Act of 1986, which 
enabled REITs to avoid the unnecessary expense of hiring independent 
contractors for routine management functions; (ii) the amendment of the 
closely held rules, in the Revenue Reconciliation Act of 1993, to allow 
a ``look through'' for pension funds investing in REITs; and (iii) the 
enactment of the REIT simplification provisions as part of the Taxpayer 
Relief Act of 1997. Collectively, these changes modernized the REIT tax 
regime, resulting in enhanced ability to raise capital, more efficient 
organization and improved flexibility to provide services to tenants, 
thereby maintaining the overall competitiveness of REITs.
    This carefully thought-through and deliberative course of action 
should be continued. Therefore, as you consider the Administration's 
REIT proposals, and REIT policies in general, we urge you to proceed 
carefully. REITs are an important capital source for real estate that 
should not be impaired. Although none of the individual REIT proposals 
in the President's budget proposal would alone cripple REITs, the 
policy goal embedded in them appears aimed at undermining the capital 
formation flexibility of REITs. We do not agree with that policy. We 
believe it is important for this Committee to continue its leading role 
in preserving the organizational, operational and capital formation 
flexibility currently afforded REITs. Our recommendations concerning 
the Administration's specific proposals follow.

President's Budget REIT Related Proposals

     Restrict impermissible businesses indirectly conducted by 
REITs. Current law prohibits REITs from owning more than 10% of the 
voting stock of another corporation (other than another REIT as a 
qualified REIT subsidiary). The Administration proposes that this 
ownership restriction be amended so that REITs be prohibited from 
holding stock representing more than 10 percent of the voting rights or 
value of the corporation.
    Recommendation: In our view, the Administration's proposal is 
unnecessarily heavy-handed. It would effectively end the use of all 
preferred stock subsidiaries in order to correct a narrow concern. The 
REIT structure established by Congress allows REITs to own securities 
which are not considered real estate assets, so long as such securities 
represent not more than 25 percent of the total REIT assets and certain 
limitations are met. The third party preferred stock subsidiary fits 
within this structure.
    The Administration contends that the preferred stock subsidiary is 
often significantly leveraged with debt held by the REIT, which 
generates interest deductions intended greatly to reduce or eliminate 
the taxable income of such subsidiary. However, these third party 
subsidiaries typically are service providers and do not, by their 
nature, require large amounts of operating capital and, thus, 
significant leveraging. In these cases, the Administration's concern is 
minimized, if non-existent.
    We would emphasize that there are a number of provisions already 
existing in the Internal Revenue Code that effectively prevent REITs 
from using these preferred stock subsidiaries in ways that avoid 
taxation on the subsidiary's earnings. Some of these provisions 
include: the rules under Section 482 affecting the allocation of income 
and deductions among taxpayers; Section 269 disallowing deductions or 
credits relating to acquisitions made to evade or avoid taxation; and 
the requirements under Section 162 for deduction of rental payments and 
business expenses. Further, although now discontinued, the IRS, 
beginning in 1988, issued favorable rulings on these subsidiaries. 
Congress also has been aware of these subsidiaries and found no reason 
to act upon them even though it recently enacted a number of REIT 
reforms.
    Since it is not clear that abuses exist in any magnitude, we must 
oppose this proposal. In the event there are abuses with preferred 
stock subsidiaries, they should be specified and corrective action 
taken only to the extent they cannot otherwise be addressed under 
existing anti-tax abuse laws. National Realty Committee looks forward 
to working with the Committee and the Administration in this regard.
     Modify the treatment of closely held REITs. Under this 
proposal--which would constitute an additional requirement for REIT 
qualification--any ``person'' (that is, corporation, partnership or 
trust) would be prevented from owning stock in a REIT if the person 
controls more than 50 percent of the total combined voting power of all 
classes of voting stock or more than 50 percent of the total value of 
shares of all classes of stock.
    Recommendation: It is fundamental to the concept of REITs that they 
be widely held entities, easily and economically accessible by small 
investors. National Realty Committee is in full agreement with this. 
The Administration's enunciated reason for proposing the additional 
qualification requirement is a concern about possible tax avoidance 
transactions involving the use of closely held REITs. However, the 
Administration's explanation of the proposal provides little 
description of the transactions at issue. Before National Realty 
Committee can constructively comment on this provision, and certainly 
before Congress should consider the proposal, further clarification 
should be provided as to the perceived abuses targeted by the proposal.
    So called ``incubator REITs'' sometimes have a majority shareholder 
corporation for a transition period in order to prepare the REIT for 
going public by allowing it to develop a track record. Corporate 
majority shareholders of private REITs are also used for legitimate 
state and local income and real property tax planning purposes and as a 
vehicle for legitimate foreign investment in real estate. We do not 
believe these structures lend themselves to tax abuse, and any proposal 
on this issue should clarify the same.
    Importantly, it also needs to be clarified that this proposal would 
not affect a REIT's ability to own interests in another REIT or to have 
a qualified REIT subsidiary. A special ``look-through'' rule (as in the 
case with respect to qualified trusts under section 401(a) of the Code) 
should apply in determining whether a REIT owning an interest in 
another REIT meets the 100 or more shareholders requirement.
    National Realty Committee believes that before this Committee takes 
any action, the tax avoidance transactions involving the use of closely 
held REITs generally referred to in the Administration's proposal need 
to be more clearly and specifically set forth. This will help qualify 
the issue and quantify the extent, if any, remedial action is needed. 
Also, it would help insure that legitimate transactions important to 
real estate capital formation not be unduly affected.
     Repeal tax-free conversions of C corporations to S 
corporations (or REITs). Under current law (Section 1374 of the Code), 
a C corporation that converts or merges into an S corporation does not 
pay tax on ``built-in'' gains (the excess of asset value at such time 
over tax basis), unless the asset is sold within 10 years of the 
conversion or merger. The Administration proposes repealing Section 
1374 for large corporations (valued at over $5 million), so that a 
converting or merging corporation would, immediately thereupon, pay a 
tax as if it had at that moment sold its assets and distributed the 
proceeds to its shareholders, producing an immediate second level of 
tax. The Administration's proposal also would apply to C corporations 
that convert into or merge with REITs.
    Recommendation: National Realty Committee, together with a broad 
coalition of industry and small business organizations, opposed this 
proposal when it was put forth by the Administration in each of the 
last two budget proposals. Our position is unchanged--the proposal 
should be rejected. The current rules taxing the ``built-in'' gain of 
assets sold within a 10-year period of electing S corporation or REIT 
status is a fair standard that effectively prevents tax avoidance. 
Imposing two levels of tax on built-in gains likely would affect the 
economics of most transactions so significantly that they simply would 
not go forward. Thus, many C corporations would be precluded from 
converting or merging into an S corporation or REIT. The effect would 
be to negate the revenue-raising impact of the provision and to impede 
the continuing recapitalization of commercial real estate through the 
access to public capital markets that REITs provide.
     Freeze the grandfathered status of stapled (also known as 
paired-share) REITs. This proposal would allow stapled REITs to 
continue to operate in their stapled form for properties held by the 
REIT as of ``the first date of congressional committee action on this 
proposal.'' Properties acquired on or after the first date of committee 
action would not be allowed to be operated by the company paired with 
the REIT.
    Recommendation: We believe the Committee should continue to follow 
for this specific company issue the historically deliberative and 
carefully thought-through approach it has followed in making REIT 
policy in general. We are opposed to any retroactive legislative 
measures that would undercut someone's reasonable reliance on existing 
law. This issue has a long and somewhat convoluted history and, as a 
result, most Members of Congress have a limited understanding of REITs 
and, more particularly, the stapled REITs. Therefore, before any action 
is taken on the Administration's proposal, we believe it advisable for 
the Committee to study further and hold hearings on this issue to 
determine what, if any, remedial changes are warranted to the stapled 
structure.

Other Real Estate-Related Revenue Provisions

     Eliminate non-business valuation discounts (for family 
limited partnerships). The budget proposal asserts that family limited 
partnerships are being used to take ``illusory'' valuation discounts on 
marketable assets. The proposal contends that taxpayers are making 
contributions of these assets to limited partnerships, gifting minority 
interests in the partnerships to family members, and then claiming 
valuation discounts based on the interest being a minority interest of 
a non-publicly traded business. The proposal would eliminate such 
valuation discounts except as they apply to ``active'' businesses.
    Recommendation: National Realty Committee opposes this proposal in 
concept because it increases the estate tax burden and specifically 
because it defines marketable assets as including ``real property.'' 
The reference to real property, which lacks any elaboration, could be 
interpreted broadly to include much of the nation's directly or 
indirectly family-owned real estate. In all events, further 
clarification by the Administration is needed to determine the 
definition of ``real property.''
    Nevertheless, National Realty Committee does not believe that real 
property or interests in real property should be included in a proposal 
targeted at truly passive investments, such as publicly traded stocks 
and bonds. We applaud the Committee for its work last year to reduce 
the estate and gift tax burden and its continuing efforts to that end. 
This proposal would take a number of steps backward and increase the 
estate tax burden. As a result, successors in family-owned real estate 
businesses could be faced with the troubling scenario of having to sell 
real property in the estate (often at distressed value prices) in order 
to pay death taxes.
    We also would point out that the Internal Revenue Service itself, 
in Revenue Ruling 93-12, and the courts throughout the Nation, in a 
large number of recent cases, have recognized that minority interests 
as limited partners in closely held limited partnerships do not have 
the same value, by any means, as would a tenant in common in the 
underlying assets, irrespective of the nature of the assets.
    Furthermore, on a related matter, it should be clarified that, for 
purposes of the estate tax exclusion for qualified family-owned 
businesses, owning rental real estate is considered a trade or business 
so long as the required ownership percentage requirements are met. This 
would place small, family-owned real estate businesses on a level 
playing field with other small businesses for purposes of the up to 
$1.3 million unified credit amount enacted last year.
     Disallow financial institutions' ability to deduct 
interest expense for tax-exempt investments. Under this proposal, a 
financial institution that invests in tax-exempt obligations would not 
be allowed to deduct a portion of its interest expense in proportion to 
its tax-exempt investments.
    Recommendation: National Realty Committee opposed a similar 
proposal last year and opposes this proposal because it would reduce 
corporate demand for tax-exempt securities, such as industrial 
development and housing bonds. Reducing corporate demand for these 
important investment vehicles would increase the borrowing costs of 
municipalities throughout the country--thus, hindering urban 
reinvestment activity--and it would discourage corporate investment in 
state and local housing bonds issued to finance housing for low and 
middle income families.
     Clarify the meaning of ``subject to'' liabilities under 
Section 357(c). For transfers of assets to corporations, the 
distinction between the assumption of a liability and the acquisition 
of an asset ``subject to'' a liability would be eliminated and a facts-
and-circumstances determination would be made. In general, if 
indebtedness is secured by more than one asset, and any of the assets 
securing the indebtedness are transferred subject to the indebtedness, 
the transferee shall be treated as assuming an allocable portion of the 
liability, based on relative fair market values.
    Recommendation: Historically, court cases have provided specific 
guidelines under Section 357. In National Realty Committee's view, 
introducing a facts-and-circumstances determination criterion without 
providing safe harbors would create considerable uncertainty and result 
in increased transaction costs. The Code as now written, combined with 
the present Regulations and judicial authority, should provide 
sufficient comfort to the Service.
     Modify the depreciation of tax-exempt use property. Under 
current law, ``tax-exempt use property'' is defined as property leased 
by a tax-exempt entity under lease terms designed to transfer the 
benefits of tax deductions that the entity would not be eligible for if 
it, in fact, owned the property. Currently, such property is 
depreciated using the straight-line method over a period equal to the 
greater of the property's class life (40 years for non-residential real 
property) or 125 percent of the lease term. The Administration contends 
that current law may allow depreciation deductions to accrue more 
rapidly than economic depreciation. Therefore, the budget proposes that 
tax-exempt property be depreciated using the straight-line method over 
a period equal to 150 percent of the property's class life (60 years). 
The proposal would affect property that is placed in service, becomes 
tax-exempt or becomes subject to a new lease after December 31, 1998.
    Recommendation: We believe the current depreciation rules 
adequately prevent tax abusive transactions involving the sale and 
leaseback of real property of tax-exempt organizations. The current law 
minimum 40-year depreciation period in no way provides a recovery of 
costs faster than economic depreciation. On its face, the proposal 
appears punitive and not grounded in sound economic or tax policy. The 
Administration needs to demonstrate its position more clearly and 
convincingly.

Tax Incentives in the Budget Proposal

     Tax credit for energy-efficient building equipment. The 
Administration's budget proposes a 20 percent tax credit for the 
purchase of certain highly-efficient building equipment, including fuel 
cells, electric heat pump water heaters, advanced natural gas and 
residential size electric heat pumps, and advanced central air 
conditioners. Specific technology criteria would have to be met to be 
eligible for the credit. The credit would apply to purchases made 
between 1999 and 2004.
    Recommendation: National Realty Committee believes the immediate 
objective of this proposal--encouraging energy efficiency in 
buildings--has merit. In preparing for the 21st century, the real 
estate industry, like other major industries, is looking for ways to 
improve its overall performance from an economic and environmental 
perspective. National Realty Committee has taken notice of statistics 
from the Department of Energy identifying office buildings as consuming 
about 27% of the nation's electrical supply. If this is an accurate 
assessment, we are surprised that, of the six specific tax credit 
proposals for energy efficient building equipment, only one (fuel 
cells) has any practical application to commercial office buildings. 
More specifically on the matter of the fuel cell credit, while the 
amount of the incentive is not insignificant, it is not yet sufficient 
to encourage the use of this technology except in rare circumstances.
    In addition to providing incentives to the acquisition of specific 
building technologies, the Administration's budget seeks to encourage 
the development of energy efficient homes. A credit for this purpose is 
targeted to single family homes where there are recognized standards by 
which the efficiency of these structures can be readily measured. Such 
standards also exist, however, for energy efficiency in commercial 
office buildings. Given the high energy usage by this division of the 
building sector, it makes sense to consider analogous credits for 
highly efficient commercial buildings.
     Expensing of brownfield remediation costs. The 
Administration proposes to make permanent the deduction for brownfield 
remediation costs. This deduction was enacted as part of last year's 
budget and tax law and is scheduled to expire after December 31, 2000.
    Recommendation: National Realty Committee supports this proposal. 
However, the deductibility of clean-up expenses applies only to 
brownfields in specifically targeted areas, such as empowerment zones. 
We understand the social and economic policy goals intended to be 
furthered by this targeted clean-up provision. However, there are 
almost 450 brownfields across the nation, most of which are outside of 
these targeted areas. Allowing some type of deductibility or 
amortization of clean-up costs for all of these brownfields would help 
restore brownfields across America to viable and productive use. We 
acknowledge that allowing full deductibility of these expenses could 
have a substantial revenue cost. Therefore, we propose modifying the 
Administration's proposal by treating the clean-up costs in non-
targeted areas as start up expenses under Section 195 of the Code, 
thereby allowing them to be amortized over 60 months. This would lessen 
the revenue cost to the Treasury, while providing a valuable incentive 
to nationwide brownfield restoration. We look forward to the 
opportunity to work with the Committee on this important social, 
economic and environmental issue.
     Low-income housing tax credit expansion. The budget 
proposes a major expansion of the low-income housing tax credit, which 
could facilitate the construction of 150,000-180,000 new affordable 
housing units over five years. Under the White House proposal, the 
annual state low-income housing credit limitation would be raised from 
$1.25 per capita to $1.75 per capita, beginning January 1, 1999.
    Recommendation: National Realty Committee supports this proposal. 
We also support related legislation, S. 1252 in the Senate and H.R. 
2990, introduced by Mr. Ensign and cosponsored by Mr. Rangel and 
several other Members of the Committee on a bipartisan basis. We are 
very encouraged by the consensus developing between the Administration 
and key Members of Congress on the need for increasing the amount of 
low income housing tax credits allocated to the states. Since its 
inception in 1986, this credit program has encouraged private ownership 
of affordable rental housing by authorizing state and local agencies to 
allocate tax credits to owners of low-income rental properties. The 
program has enabled the construction and rehabilitation of more than 
120,000 rental units annually and is used in approximately 35 percent 
of newly constructed rental units nationally. Demand for the housing 
credit nationwide has exceeded its supply, and this proposal will help 
states respond to the increasing demand for decent and affordable 
rental housing.

Conclusion

    Again, we thank Chairman Archer and the Committee for the 
opportunity to comment on the record regarding the revenue proposals in 
the President's fiscal 1999 budget. We are encouraged by the proposals 
to increase the low income housing tax credit, make permanent the 
deductibility of brownfield clean-up costs and implement credits for 
energy-efficient improvements for buildings. The REIT proposals cause 
us considerable concern, particularly with respect to preferred stock 
subsidiaries, closely held REITs and C corporation conversions and 
mergers, and we urge that you reject such proposals outright.
    We look forward to working with the Committee to ensure that the 
provisions of the Code dealing with REITs do not lead to abuses, yet 
allow REITs effectively to fulfill their mission in a continually 
changing economic and business environment.
    Finally, while we object to the proposal to eliminate realistic 
valuation discounts in the non-business, family limited partnership 
situation, we strongly believe that, in all events, including real 
property in such proposal is ill-advised and should be dropped from any 
further consideration.
      

                                

Statement of National Structured Settlements Trade Association

A Stringent Excise Tax on Secondary Market Companies That Purchase 
Structured Settlement Payments from Injured Victims Should Be Adopted, 
Subject to a Limited Exception for Genuine Court-Approved Hardship, to 
Protect Structured Settlements and the Injured Victims

    I. Background and Policy of the Structured Settlement Tax Rules

    The National Structured Settlements Trade Association 
(NSSTA) is an organization composed of more than 500 members 
which negotiate and implement structured settlements of tort 
and worker's compensation claims involving persons with 
serious, long-term physical injuries. Structured settlements 
provide the injured victim with the financial security of an 
assured payout over time. Founded in 1986, NSSTA's mission is 
to advance the use of structured settlements as a means of 
resolving physical injury claims.

A. Background

     Structured settlements in wide use today to 
resolve physical injury tort claims
    Structured settlements are used to compensate seriously-
injured, often profoundly disabled, tort victims. A lump sum 
recovery used to be the standard in tort cases. All too often, 
this lump sum was prematurely dissipated by the victim or his 
or her relatives. When the money was gone, the victim was left 
still disabled and still unable to work. In such cases, the 
State Medicaid system and welfare system were left holding the 
bag to care for this disabled person.
    Structured settlements provide a better approach. A 
voluntary agreement is reached between the parties under which 
the injured victim receives damages in the form of a stream of 
periodic payments tailored to his or her future medical 
expenses and basic living needs from a well-capitalized, 
financially-secure institution. Often this payment stream is 
for the rest of the victim's life to make sure that future 
medical expenses and the family's basic living needs will be 
met, and the victim will not outlive his or her compensation.
     Structured settlements provide crucial financial 
protection to seriously-injured tort victims
    --Protection against premature dissipation by injured 
victims unable to handle the financial responsibilities and 
risks of managing a large lump sum to cover a substantial, 
ongoing stream of medical and basic living expenses for a 
lengthy period.
    --Payout tailored to the needs of the particular victim.
    --Avoids shift of responsibility for care to the public 
sector.
     Congress has adopted special tax rules to 
encourage and govern structured settlements
    Congress has adopted a series of special rules in sections 
130, 104, 461(h), and 72 of the Internal Revenue Code to govern 
the use of structured settlements by providing that the full 
amount of the periodic payments constitutes tax-free damages to 
the victim and that the liability to make the periodic payments 
to the victim may be assigned to a structured settlement 
assignment company that will use a financially-secure annuity 
to fund the damage payments.
    In the Taxpayer Relief Act of 1997, in a provision co-
sponsored by a majority of the House Ways and Means Committee, 
Congress recently extended the structured settlement tax rules 
to the worker's compensation area to cover physical injuries 
suffered in the workplace.

B. Structured Settlement Tax Rules Were Adopted by Congress to 
Protect Victims from Pressure to Squander Their Recoveries

    Congressional Policy.--In introducing the legislation that 
enacted the structured settlement tax rules, Sen. Max Baucus 
(D-Mont.) pointed to the concern over squandering of a lump sum 
recovery by injured tort victims or their families:
    ``In the past, these awards have typically been paid by 
defendants to successful plaintiffs in the form of a single 
payment settlement. This approach has proven unsatisfactory, 
however, in many cases because it assumes that injured parties 
will wisely manage large sums of money so as to provide for 
their lifetime needs. In fact, many of these successful 
litigants, particularly minors, have dissipated their awards in 
a few years and are then without means of support.'' 
[Congressional Record (daily ed.) 12/10/81, at S15005.]
    By contrast, Sen. Baucus noted: ``Periodic payments 
settlements, on the other hand, provide plaintiffs with a 
steady income over a long period of time and insulate them from 
pressures to squander their awards.'' (Id.)
    Thus, the federal tax rules adopted by Congress to govern 
structured settlements reflect a policy of insulating injured 
victims and their families from pressures to squander their 
awards.
    In addition, Congress was concerned that the injured victim 
not have the ability to exercise such control over the periodic 
payments that he or she would be deemed to have received a lump 
sum recovery that was then invested on his or her behalf, 
destroying the fully tax-free nature of the periodic payments 
to the injured victim. The House Ways and Means and Senate 
Finance Committee Reports adopting the structured settlement 
tax rules both state: ``Thus, the periodic payments as personal 
injury damages are still excludable from income only if the 
recipient taxpayer is not in constructive receipt of or does 
not have the current economic benefit of the sum required to 
produce the periodic payments.'' (H.R. Rep. No. 97-832, 97th 
Cong., 2d Sess. (1982), 4; Sen. Rep. No. 97-646, 97th Cong., 2d 
Sess. (1982), 4.)
    Reflecting this Congressional policy of protecting injured 
victims from pressure to squander their recoveries and the need 
to avoid any risk of constructive receipt of a lump sum by the 
victim, the structured settlement tax rules prohibit the victim 
from being able to accelerate, defer, increase, or decrease the 
periodic payments. (I.R.C. Sec. 130(c)(2)(B)). In addition, the 
periodic payments must constitute tax-free damages in the hands 
of the recipient. (I.R.C. Sec. 130(c)(2)(D)).
    In compliance with these Congressional requirements and 
consistent with State insurance and exemption statutes, 
including ``spendthrift'' statutes that restrict alienation of 
rights to payments under annuities and under various types of 
claims (e.g., worker's compensation and wrongful death claims), 
structured settlement agreements customarily provide that the 
periodic payments to be rendered to the injured victim may not 
be accelerated, deferred, increased or decreased, anticipated, 
sold, assigned, pledged, or encumbered by the victim.
    As the Treasury Department has noted, ``Consistent with the 
condition that the injured person not be able to accelerate, 
defer, increase or decrease the periodic payments, [structured 
settlement] agreements with injured persons uniformly contain 
anti-assignment clauses.'' (U.S. Department of the Treasury 
General Explanations of the Administration's Revenue Proposals 
(Feb. 1998), at p. 122).

  II. Purchases of Structured Settlement Payments by Secondary Market 
 Companies Directly Undermine the Important Public Policies Served by 
                         Structured Settlements

A. Background

    Over the past year, there has been dramatic growth in a 
transaction, variously known as a ``factoring,'' ``secondary 
market,'' or ``gray market'' transaction, that effectively 
takes the structure out of structured settlements.
    In such a factoring transaction, the injured victim who is 
receiving periodic payments of damages for physical injuries 
under a structured settlement sells his or her rights to future 
periodic payments to a secondary market company. In exchange, 
the injured victim receives from the secondary market company a 
sharply discounted lump sum payment.
    This is a transaction that the injured victim enters into 
with a third party, completely outside of the structured 
settlement and generally without even the knowledge of the 
other parties to the structured settlement. The secondary 
market company is not in the structured settlement business.
    In an effort to avoid the anti-assignment provisions in the 
structured settlement agreements, the secondary market 
companies typically have the injured victim simply present the 
structured settlement company with a change of address to a 
post office box under the control of the secondary market 
company to accomplish the redirection of payments to the 
secondary market company. Thus, the structured settlement 
company obligated to make the periodic payment damages under 
the structured settlement is not a party to the factoring 
transaction and most often has no notice of it at all.

B. Rapid Growth in Secondary Market Purchases of Structured 
Settlement Payments

    Secondary market companies use extensive advertising and 
telemarketing, as well as direct appeals to plaintiffs' lawyers 
coupled with a finder's fee, to solicit new business. For 
example, one major secondary market company, J.G. Wentworth, 
stated in a recent SEC filing that during the first 9 months of 
1997 alone, it ran 56,000 television commercials. Wentworth 
runs a telemarketing call center with 200 telemarketing 
stations operating 24 hours a day, 6 days a week.
    The secondary market companies direct considerable 
advertising at the plaintiffs' bar, promising the injured 
victim's lawyer a second fee on the same case--this time by 
unwinding the structured settlement. For example, an ad by 
Stone Street Capital states:
    ``You helped your clients once by winning them a structured 
settlement. Now you can help them again by showing them how to 
convert all or a portion of their settlement to a lump-sum 
payment.
    ``For each of your clients who exercise this exciting new 
option, your firm will be compensated for legal fees by 
facilitating the standardized processing of an annuity purchase 
agreement. On average, these fees amount to about $2,000 per 
conversion. [Emphasis in original].''
    The secondary market business is a rapidly growing one. 
According to SEC filings, during the first 9 months of 1997 
J.G. Wentworth alone undertook 3,759 structured settlement 
purchase transactions. These purchased structured settlement 
payments had a total undiscounted maturity value of $163.6 
million and were purchased for $74.4 million. Blocks of 
purchased structured settlement payments are now being 
``securitized'' by the secondary market companies and marketed 
on Wall Street.

C. Public Policy Concerns Created by Secondary Market 
Transactions

    Secondary market purchases of structured settlement 
payments create serious problems affecting all participants in 
structured settlements.
     Secondary market purchases of structured 
settlement payments trigger the very same dissipation risks 
that structured settlements are designed to avoid
    By selling future structured settlement payments to the 
secondary market companies, the injured victim receives an 
immediate lump sum payment. Just as lump sum tort recoveries 
are frequently dissipated, all too often this lump sum from the 
secondary market company can be quickly dissipated, and the 
injured person finds himself or herself in the very predicament 
which the structured settlement was intended to avoid.
    Having factored away their only assured source of future 
financial support and then dissipating the cash received, these 
injured victims may face the prospect of public assistance to 
cover their future medical expenses and basic living needs.
     Secondary market purchases often are made at sharp 
discounts
    In many cases the injured victim's dissipation risks are 
magnified because the lump sum payment that the injured victim 
receives in the factoring transaction is so sharply discounted. 
While factoring transactions apparently reflect a range of 
discounts, it is not uncommon for an injured victim to receive 
a lump sum payment of less than 50 percent of the present value 
of the structured settlement payments being sold.
    In one recent case, a 20-year-old structured settlement 
recipient who was receiving monthly payments from a tort action 
when she was a child was persuaded to sell a series of her 
future payments for approximately 36 percent of their present 
discounted value. A few months later, she was persuaded to sell 
additional future payments for approximately 15 percent of 
their discounted present value.
    Based on this case and many similar examples, it is clear 
that in secondary market transactions structured settlement 
recipients often are persuaded to sell future payments for far 
less than the payments are worth.
     Secondary market transactions create serious 
Federal income tax uncertainties for the original parties to 
the structured settlement
    The structured settlement tax rules require that the 
periodic payments constitute tax-free damages on account of 
personal physical injuries in the hands of the recipient of 
those payments. (I.R.C. Sec. Sec. 130(c)(2)(D); 104(a)(2)). 
Following the factoring away by the injured victim, the 
periodic payments now would be received by the secondary market 
company and its investors and would not constitute tax-free 
damages in their hands. This creates serious Federal income tax 
uncertainties under the structured settlement tax rules for 
both the victim and the company funding the structured 
settlement.
    Injured victim
     The injured victim not only loses the benefit of 
the future tax-free damage payments, but also runs a risk of 
being taxed on the lump sum received from the secondary market 
company if such payment is treated as received on account of 
the sale of the victim's future payment rights and not on 
account of the original injury.
     If the structured settlement payments were freely 
assignable by the injured victim and a ready market of 
financial institutions was available to acquire such payments, 
the victim might be deemed in constructive receipt of the 
present value of the future payments just as if the payments 
could be accelerated. In that case, from the outset of the 
settlement a portion of each periodic payment would be treated 
as taxable earnings, rather than tax-free damages.
    Company funding the structured settlement.--Under the 
structured settlement tax rules, the settling defendant (or its 
liability insurer) assigns its periodic payment liability to a 
structured settlement company in exchange for a payment which 
is excluded from the structured settlement company's income if 
the structured settlement tax rules under I.R.C. Sec. 130 are 
satisfied and such payment is reinvested in either an annuity 
or U.S. Treasury obligations precisely matched in amount and 
timing to the periodic payment obligation to the injured 
victim. The structured settlement company's income from the 
payments under the annuity or Treasuries is matched by an 
offsetting deduction for the damage payment to the victim.
     The factoring transaction raises the concern that 
the structured settlement tax rules no longer may be satisfied 
and the risk that the structured settlement company may be 
required to recognize and pay tax on amounts previously 
excluded from its income or to pay tax on the ``inside build-
up'' under the annuity, for which there is no cash distribution 
to pay the tax.
     The structured settlement company may face an 
obligation to report the payments made to the secondary market 
company as taxable income even though in many cases the 
identity of the purchaser or even the existence of the 
factoring transaction itself is unknown.
     Secondary market transactions create risks of 
double liability for the structured settlement companies
    While factoring transactions normally involve only the 
injured victim and the secondary market company, the underlying 
structured settlements typically involve multiple parties such 
as family members, defendants, liability insurers, and state 
workers' compensation authorities in workers' compensation 
cases. Because structured settlement agreements prohibit 
transfers of payments, if the structured settlement company 
makes the payments--even unwittingly--to the secondary market 
company, the structured settlement company may become subject 
to later claims that it paid the wrong party and could still be 
required to make the payments as originally required under the 
settlement.
    In many cases this risk of double liability is magnified by 
state statutes that (i) in more than 20 states give statutory 
effect to contract provisions prohibiting transfers of annuity 
benefits and (ii) in nearly all States directly restrict or 
prohibit transfers of recoveries in various types of cases 
(e.g., workers' compensation, wrongful death, medical 
malpractice).
     The uncertainties created by secondary market 
transactions may discourage future use of structured 
settlements
    These tax risks and double liability risks raised by the 
factoring transaction are risks that the structured settlement 
company specifically sought to avoid through the anti-
assignment provisions in the structured settlement agreement 
and is not in a financial position to absorb, years after the 
original structured settlement transaction was entered into.
    These uncertainties and unforeseen risks could jeopardize 
the continued ability of structured settlement companies to 
fund settlements in the future. The structured settlement 
company's participation is necessary to enable structured 
settlements to be undertaken in the first instance by 
satisfying the objectives of both sides to the claim: the 
injured victim needs the long-term financial protection that 
the structured settlement company's funding arrangement 
provides, and the settling defendant wishes to close its books 
on the liability rather than bearing an ongoing payment 
obligation decades into the future.

III. A Stringent Excise Tax on Secondary Market Purchasers, Subject to 
  a Limited Exception for Genuine, Court-Approved Hardship, Protects 
 Structured Settlements, the Injured Recipients, and the Congressional 
                Policy Underlying Structured Settlements

A. Gravity of Problem Requires Strong Action by Congress

    In acting to address the concerns over secondary market 
companies that purchase structured settlement payments from 
injured victims the Treasury Department noted that: ``Congress 
enacted favorable tax rules intended to encourage the use of 
structured settlements--and conditioned such tax treatment on 
the injured person's inability to accelerate, defer, increase 
or decrease the periodic payments--because recipients of 
structured settlements are less likely than recipients of lump 
sum awards to consume their awards too quickly and require 
public assistance.'' (U.S. Department of the Treasury, General 
Explanations of the Administration's Revenue Proposals (Feb. 
1998), p. 122).
    Treasury then observed that by enticing injured victims to 
sell off their future structured settlement payments in 
exchange for a heavily discounted lump sum that may then be 
dissipated: ``These `factoring transactions' directly undermine 
the Congressional objective to create an incentive for injured 
persons to receive periodic payments as settlements of personal 
injury claims.'' (Id., at p. 122 [emphasis added].)
    The Joint Tax Committee's analysis of the issue echoes 
these concerns: ``Transfer of the payment stream under a 
structured settlement arrangement arguably subverts the purpose 
of the Code to promote structured settlements for injured 
persons. (Joint Committee on Taxation, Description of Revenue 
Provisions Contained in the President's Fiscal Year 1999 Budget 
Proposal (JCS-4-98), (February 24, 1998), p. 223).
    While noting that the States traditionally have been the 
province of consumer protection, the Joint Committee's analysis 
reasons that there is a clear role for the Federal tax law to 
address the policy concerns raised by sales of structured 
settlement payments: ``On the other hand, the tax law already 
provides an incentive for structured settlement arrangements, 
and if practices have evolved that are inconsistent with its 
purpose, addressing them should be viewed as proper.'' (Joint 
Committee Description, supra, at p. 223).

B. Administration Proposal

    The Treasury Department in the Administration's FY 1999 
Budget has proposed a 20-percent excise tax on secondary market 
companies that purchase structured settlement payments from 
injured victims.
    Under the Administration's proposal, ``any person 
purchasing (or otherwise acquiring for consideration) a 
structured settlement payment stream would be subject to a 20 
percent excise tax on the purchase price, unless such purchase 
is pursuant to a court order finding that the extraordinary and 
unanticipated needs of the original recipient render such a 
transaction desirable.'' (Treasury General Explanation, at p. 
122). The proposal would apply to transfers of structured 
settlement payments made after date of enactment.
    The Administration's proposal represents a serious, 
constructive step to address the policy concerns raised by the 
purchases of structured settlement payments and to protect 
injured victims.

C. An Even Stronger Solution Is Necessary to Fully Protect 
Structured Settlements and Injured Victims: A Stringent Excise 
Tax Rate on the Discount Subject Only To a Limited Exception 
for a Genuine, Court-Approved Hardship

    1. Stringent excise tax to address serious public policy 
concerns raised by factoring transactions
    In its analysis of the Administration's proposal, the Joint 
Committee notes the potential concern that in some cases the 
imposition of a 20-percent excise tax may result in the 
secondary market company reducing even further the already-
heavily discounted lump sum paid to the injured victim for his 
or her structured settlement payments. The Joint Committee 
notes that ``[o]ne possible response to the concern relating to 
excessively discounted payments might be to raise the excise 
tax to a level that is certain to stop the transfers (perhaps 
100 percent) . . . .'' (Joint Committee Description, supra, at 
p. 223).
    Secondary market purchases of structured settlement 
payments so directly subvert the Congressional policy 
underlying structured settlements and raise such serious 
concerns for structured settlements and the injured victims 
that it is appropriate to impose on the secondary market 
company a more stringent excise tax rate on the amount of the 
discount reflected in the secondary market purchase. Thus, 
unlike the Administration's proposed tax imposed on the 
purchase price, this excise tax imposed on the secondary market 
company would use a more stringent tax rate and would apply to 
the difference between the total face amount of the structured 
settlement payments purchased by the secondary market company 
and the heavily discounted lump sum paid to the injured victim. 
As a possible alternative, the more stringent excise tax rate 
could be applied against a tax base that is the greater of (i) 
the amount of the discount (the difference between the total 
face amount of payments purchased by the secondary market 
company and the lump sum paid to the victim), or (ii) the 
present value as determined under I.R.C. Sec. 7520 (interest 
rate for annuity valuation for estate tax purposes) of the face 
amount of the payments being purchased by the secondary market 
company.
    2. Limited exception for genuine, court-approved hardship
    This stringent excise tax would be coupled with a limited 
exception for genuine, court-approved financial hardship 
situations. Drawing upon the hardship standard enunciated in 
the Treasury proposal, the excise tax would apply to secondary 
market companies in all structured settlement purchase 
transactions except in the case of a transaction that is 
pursuant to a court order finding that ``the extraordinary, 
imminent, and unanticipated needs of the structured settlement 
recipient or his or her dependents render such a transaction 
appropriate and a further finding that the proposed transfer is 
not expected to subject the structured settlement recipient or 
his or her dependents to undue financial hardship in the 
future.''
    This exception is intended to apply only to a limited 
number of cases in which a genuinely ``extraordinary, imminent, 
and unanticipated'' hardship actually has arisen (e.g., serious 
medical emergency for a family member) has been demonstrated to 
the satisfaction of a court, as well as a showing that 
transferring away such payments will not leave the injured 
victim and his or her family exposed to undue financial 
hardship in the future when the structured settlement payments 
no longer are available.
    3. Need to protect the tax treatment of the original 
structured settlement
    In the limited instances of extraordinary and unanticipated 
hardship determined by court order to warrant relief, adverse 
tax consequences should not be visited upon the claimant or the 
other parties to the original structured settlement. 
Accordingly, the proposal would clarify in the statute or the 
legislative history that in those limited instances in which 
the extraordinary, imminent, and unanticipated hardship 
standard is found to be met by a court, the original tax 
treatment of the structured settlement under I.R.C. 
Sec. Sec. 104, 130, 72, and 461(h) would be left undisturbed.
    That is, the periodic payments already received by the 
claimant prior to any factoring transaction would remain tax-
free damages under Code section 104. The assignee's exclusion 
of income under Code section 130 arising from satisfaction of 
all of the section 130 qualified assignment rules at the time 
the structured settlement was entered into years earlier would 
not be challenged. Similarly, the settling defendant's 
deduction under Code section 461(h) of the amount paid to the 
assignee to assume the liability would not be challenged. 
Finally, the status under Code section 72 of the annuity being 
used to fund the periodic payments would remain undisturbed.
    Despite the anti-assignment provisions included in the 
structured settlement agreements and the applicability of a 
stringent excise tax on the secondary market company, there may 
be a limited number of non-hardship factoring transactions that 
still go forward. If the structured settlement tax rules under 
I.R.C. Sec. Sec. 130, 72, and 461(h) had been satisfied at the 
time of the structured settlement and the applicable structured 
settlement agreements included an anti-assignment provision, 
the original tax treatment of the other parties to the 
settlement--i.e., the settling defendant and the Code section 
130 assignee--should not be jeopardized by a third party 
transaction that occurs years later and likely unbeknownst to 
these other parties to the original settlement.
    Accordingly, the proposal also would clarify in the case of 
a non-hardship factoring transaction, that if the structured 
settlement tax rules under I.R.C. Sec. Sec. 130, 72, and 461(h) 
had been satisfied at the time of the structured settlement and 
the applicable structured settlement agreements included an 
anti-assignment provision, the section 130 exclusion of the 
assignee, the section 461(h) deduction of the settling 
defendant, and the Code section 72 status of the annuity being 
used to fund the periodic payments would remain undisturbed.
    Finally, the proposal would clarify the tax reporting 
obligations of the annuity issuer and section 130 assignee in 
the event of a factoring transaction. In the case of a 
factoring transaction, either on a court-approved hardship 
basis or a non-hardship basis, of which the annuity issuer has 
actual notice and knowledge, assuming that a tax reporting 
obligation otherwise would be applicable, the annuity issuer 
would be obligated to file an information report with the 
I.R.S. noting the fact of the transfer, the identity of the 
original payee, and the identity where known of the new 
recipient of the factored payments. No reporting obligation 
would exist where the annuity issuer (or section 130 assignee) 
had no knowledge of the factoring transaction.

                               Conclusion

    The imposition on secondary market companies of a stringent 
excise tax on the amount of the discount reflected in the 
purchase of structured settlement payments, subject to a 
limited exception for ``extraordinary, imminent, and 
unanticipated'' hardship, fully protects structured 
settlements, the injured victims, and the Congressional policy 
underlying structured settlements. The proposal should be 
enacted as part of any tax legislation considered by Congress 
this year.
      

                                

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Statement of Nationwide Insurance Enterprise

    The Nationwide Insurance Enterprise, headquartered in 
Columbus, Ohio, is a group of insurance companies providing a 
wide range of insurance products from personal automobile and 
homeowners insurance, to commercial coverage for small and 
large businesses, to health insurance, life insurance and 
annuities. Our companies are licensed to engage in the business 
of insurance in all 50 states. We are deeply concerned about 
the heavy tax increases on insurance contained in President 
Clinton's Budget Proposal for Fiscal Year 1999, and we submit 
this statement in opposition to these proposals.
    The Administration singles out for punitive tax increases 
both the insurance industry and those who acquire its vital 
products for their retirement savings and for protection of 
their assets and lives. We strongly urge that the Congress 
reject these misguided proposals.
    These proposals, and their anticipated revenue effects as 
determined by Joint Committee on Taxation for the years 1998-
08, are as follows:


Increase taxes on annuities by decreasing annuity tax    $ 8,532,000,000
 reserve deductions..................................
Penalize corporate-owned life insurance by reducing      $ 4,821,000,000
 interest deductions.................................
Tax exchanges of variable annuity contracts and          $ 3,982,000,000
 reallocations between investment options............
Increase property and casualty insurance company         $ 1,274,000,000
 taxes for companies that buy municipal bonds........
Increase taxes of life insurance and annuity               $ 442,000,000
 policyholders by disallowing part of their cost
 basis...............................................
Raise taxes on insurance companies that issue credit       $ 198,000,000
 life insurance contracts by requiring such companies
 to capitalize 7.7% of net premiums..................
                                                      ------------------
    Total............................................    $19,249,000,000



    In addition to the above proposals that directly hit 
insurance companies, their policyholders, or both, the 
Administration would discourage sales of life insurance by 
eliminating the ``Crummey'' rule which for many years has 
prevented the imposition of transfer taxes upon gifts of 
$10,000 a year or less if the donee were given a right to 
withdraw the amount transferred. Joint Committee on Taxation 
estimates that this proposal would increase revenues by $555 
million over a 10-year period.
    Our specific comments on the more significant proposals 
follow.

     Increase Taxes on Annuities by Decreasing Annuity Tax Reserve 
                               Deductions

    The Administration proposal would curtail the tax deduction 
for annuity contract reserves by limiting reserves to the 
lesser of (1) the present reserve, based on a state-law reserve 
method (CARVM), or (2) the contract's net cash surrender value 
plus a declining small percentage. In order to examine the 
impact of this change and why it should be rejected, it is 
important to understand the purpose of reserving, the 
requirements of state insurance laws to insure solvency, and 
the misunderstandings of the Administration about recent 
changes made by the National Association of Insurance 
Commissioners.
    Reserves are used to pay policyholders the benefits for 
which they contracted. Thus, an annuity reserve is the amount 
of money an insurer must set aside in escrow today to meet its 
obligations to contractholders, both today and in the future. 
Reserving at adequate levels is necessary to protect 
contractholders and to protect insurers against insolvency. 
Maintaining sufficient annuity reserves is even more necessary 
now that individuals live longer and the insurer's obligation 
is correspondingly greater.
    A tax deduction is allowed for reserves. Basically, a life 
insurance company pays taxes on its gross income less the 
amount used for reserves. The current deduction for annuity 
reserves is provided by Section 807 of the Internal Revenue 
Code. It is based on the minimum reserves state insurance 
regulators require companies to hold to meet their obligations 
to policyholders. As such, current law permits state 
regulators, rather than the IRS, to provide the basic method 
for determining reserves. The Administration's proposal is an 
unprecedented and inappropriate attempt to supplant the 
professional expertise and judgment of state insurance 
regulators over the reserves necessary to fulfill policyholder 
obligations.
    Under the current Code reserves for any annuity contract 
are the greater of the net surrender value of the contract or 
the reserve determined using the Commissioner's Annuities 
Reserve Valuation Method (CARVM) prescribed by the National 
Association of Insurance Commissioners (NAIC), but not more 
than the annual statement reserve. The Administration's 
proposal would change this calculation by making it the lesser 
of the net surrender value of the contract or the reserve as 
determined by CARVM.
    The Administration attempts to justify this change by 
noting that the NAIC adjusted its guidelines for calculating 
CARVM reserves for annuity contracts in 1997, characterizing 
the NAIC actions as ``conservative'' and as an inaccurate 
measurement of income. However, the NAIC made these adjustments 
to recognize all future benefits in computing reserves and to 
address minimum death benefits under deferred annuity 
contracts. The NAIC should be commended for trying to make sure 
that the reserves set aside to pay obligations to policyholders 
are sufficient to meet such obligations. This change in 
calculation by the NAIC was not intended to create excessive 
reserves for federal tax purposes, but instead to reflect 
proper reserving for future benefits due to policyholders.
    The Administration's proposal is both bad law and bad 
policy. Annuities are the only investment that assure 
individuals that they will not outlive their income. Raising 
taxes on reserves which are used to make payments under 
annuities will inevitably lead to higher prices for these 
essential products and thus undermine Americans' private 
retirement savings efforts.

Penalize Corporate-owned Life Insurance by Reducing Interest Deductions

    Another misguided Administration proposal would place an 
additional tax on companies that borrow for any purpose if 
those companies also own life insurance, including key employee 
insurance. This proposal is anti-business and fails to 
recognize the vital role of insurance in fostering the survival 
and growth of small and closely-held businesses.
    Under the proposal, the mere ownership of a whole life 
insurance policy on the president of a company could result in 
a tax penalty on unrelated borrowing. This additional tax would 
be imposed against loans that bear no relation to any borrowing 
from a life insurance policy but instead result from normal 
business borrowing for expansion and other fundamental 
purposes.
    In 1996 Congress reviewed the taxation of policy loans 
borrowed directly from life insurance policies and placed 
substantial restrictions on this type of borrowing, limiting it 
to coverage on key employees. The new proposal ignores this 
history and would craft a new and more draconian limitation. No 
principle supports this abandonment of the key person 
exception.
    Employers purchase life insurance for the same reason 
individuals purchase life insurance--to protect against the 
untimely loss of an income earner and to provide for long term 
financial needs. Just as businesses rely on insurance to 
protect against the loss of property, they need life insurance 
to minimize the cost of losing other valuable assets such as 
key employees, those responsible for the survival and success 
of the enterprise.
    Also corporate-owned life insurance helps employers finance 
employee benefits of all types. Corporations frequently use 
life insurance to fund various employee benefits, such as 
retiree health care and deferred compensation plans. The loss 
of interest deductions for unrelated borrowing would likely 
force many companies to reduce employee and retiree benefits 
currently funded through business life insurance.
    In short, this proposal would hurt small businesses and 
their employees, disrupt financial plans, impair employee 
benefits and should be rejected.

 Tax Exchanges of Variable Annuity Contracts and Reallocations Between 
                           Investment Options

    Under Section 1035 of the Internal Revenue Code, a 
policyholder can exchange without any tax any life insurance 
contract for another life insurance contract, a life insurance 
contract for an annuity, and an annuity for another annuity. 
This long-established rule is based on sound public policy: 
individuals should be able to take changed circumstances into 
account in their insurance and annuity programs but should not 
be taxed until they take their money out of their insurance or 
annuity.
    The current treatment of life insurance and annuity product 
exchanges rests on the basic proposition that the policyholder 
has continued his or her interest in one insurance product 
through the use of a new insurance product better suited for 
his or her current needs. Variable insurance products offer 
life insurance and annuity benefits which reflect the 
performance of financial markets, and thus are able to keep 
pace with inflation. Policyholders need to be able to modify 
their contracts in order to shift more conservative investment 
options as they grow older, accommodate to changes in their 
retirement and insurance protection needs, and respond to 
changes in the financial markets. The Administration's proposal 
is to treat such exchanges and reallocations as if the 
individuals sold all of these assets and withdrew from their 
plans in total. This is simply wrong.
    The Administration appears to believe that variable 
annuities are simply a type of mutual fund. This is far from 
the truth. Annuities are subject to severe tax restrictions 
under current law that mutual funds escape. These include 
penalties on early distribution, no basis step-up at death, 
severe diversification restrictions, and, most significant, 
taxation at full, rather than capital gains, rates.
    Suppose a worker contributed $5,000 to a variable annuity 
plan when he is 40 years old and chose a particular stock fund 
option. Supposed 10 years later his fund has grown to $12,000 
and he wants to switch to a bond fund option in the same 
annuity because he feared a stock market decline. The 
Administration would tax the entire accumulation above the 
original $5,000,1 which is $7,000, as ordinary income. The tax, 
at full rates, would be taken out of the worker's $12,000 in 
retirement funds simply because he shifted his investment 
option.
    It is ironic that these tax increases would fall on middle 
income households, especially on women. Recent surveys have 
shown that over 80% of deferred annuity contract policyholders, 
and 74% of variable annuity contract policyholders, have total 
household incomes under $75,000. Many of these policyholders 
work for employers who do not offer, or who have terminated, 
qualified retirement plans. Particularly, for such 
policyholders, annuities are the essential source of retirement 
savings.
    Annuity tax legislation was first enacted in the late 1930s 
to allow individuals to provide for themselves needed 
retirement income above that obtained through social security. 
The Administration's proposal would strike a heavy blow against 
that sound policy.

 Increase Taxes of Insurance and Annuity Policyholders by Disallowing 
                        Part of Their Cost Basis

    The Administration proposes to increase taxes on 
individually-owned life insurance and annuities by reducing the 
tax basis of these contracts. Specifically, the proposal would 
require policyholders to reduce their investment in the 
contract (premiums paid) by the amount of mortality or expense 
charges deemed to be associated with the contract. Under 
current law, policyholders pay tax on any gain in a life 
insurance or annuity contract if the contract is surrendered or 
amounts are distributed (other than at death under a life 
insurance contract). The amount of gain traditionally has been 
the excess of the amount received over the total premiums paid 
in (investment in the contract). There has never been a 
statutory or regulatory requirement that the investment in the 
contract must be reduced by the amount of contract mortality 
and expense charges. Current law for life insurance and 
annuities is consistent with the treatment of other assets, 
such as homes, cars, mutual funds and bank accounts, where no 
reduction is required for benefits resulting from ownership, 
e.g., the imputed rental value of a car or house.
    Apparently, the theory behind the proposed reduction in 
basis is that since the policyholder is obtaining the insurance 
coverage, its cost must be a benefit and should therefore 
reduce basis like any other benefit, such as partial 
withdrawals and policyholder dividends. However, using as a 
mortality charge the maximum permitted under Section 7702 is 
not justified. Also, it creates questions for contracts 
qualifying as life insurance under the cash value test. For 
annuities, reducing tax basis by a mortality charge makes even 
less sense. Except for guaranteed minimum death benefits, the 
only mortality component of these contracts is associated with 
payout and, unlike life insurance, is not actually realized by 
policyholders until annuity payments actually occur. In 
addition, the higher the worth of the guarantee, the higher the 
eventual payments. Since higher payments generate higher 
potential tax, reducing the basis for the underlying guarantee 
that produces such income appears to tax the same thing.
    In the case of expenses, expenses or costs of maintaining 
investments are generally added to basis if paid by investors. 
Since expense charges on life and annuity contracts are 
typically not paid in cash, they should not increase basis--
however, neither should they decrease it. If this treatment is 
adopted, logic would seem to require that it apply to expenses 
associated with any investment. If so, mutual fund management 
fees should reduce basis of such investments.
    Also, this ill-advised proposal would confuse policyholders 
and significantly increase their costs and time in maintaining 
correct information about the investment in their life 
insurance and annuity contracts. Life insurance companies would 
be required to keep two sets of books for cash value life 
insurance and annuity contracts, requiring extensive systems 
changes.
    Since mortality costs increase as an insured ages, this 
proposal would particularly harm older policyholders, some of 
whom plan to surrender their policies as their needs for life 
insurance death protection decreases. Since life insurance and 
annuities promote family financial security, it is 
irresponsible to enact a penalty on what the nation should 
encourage.

Increasing Property and Casualty Insurance Company Taxes for Companies 
                        that Buy Municipal Bonds

    By doubling present law's curtailment of deductions for 
loss reserves, the Administration proposes to extract an 
additional $400 million in income taxes from property and 
casualty insurance companies that invest in municipal bonds. 
This blow against an essential industry that is already fully 
taxed would harm insurers and their policyholders and would 
also force insurers to desert the market for tax exempt bonds. 
Serious damage to states and municipalities could result. As 
the Bond Market Association has pointed out, the exodus of the 
property/casualty industry from the municipal bond market would 
drive up borrowing costs for states and localities. Property/
casualty companies routinely purchase the majority of new 
issues of government grade bonds, bonds with maturities of 10-
20 years, general obligation and government revenue bonds, and 
municipal securities that help states and localities meet such 
vital needs as school construction, water, sewer facilities, 
roads and other projects. Higher borrowing costs for these 
infrastructure and governmental uses would either be passed on 
to state and local taxpayers, or would prevent certain needs 
from being met at all.

          Increase Gift Taxes by Eliminating ``Crummey'' Rule

    Current gift tax law permits a donor to transfer up to 
$10,000 per year to another person without any gift tax if the 
gift is of a present interest. Since the 1968 decision of 
Crummey v. Commissioner, the gift could be placed in a trust 
and still qualify as long as the donee had the right to 
withdraw the transferred amount. Thus, under a Crummey trust, a 
parent is able to transfer funds for the benefit of a child or 
grandchild in a responsible manner without the imposition of a 
gift tax.
    The Administration proposes to repeal the Crummey trust 
rule and limit the gift tax exemption to only outright 
transfers. This would hurt many parents who wish to establish 
trusts for specific needs of their children, such as home 
education, home purchases and future security.
    This proposal discourages responsible gifts and increases 
gift taxes. It marches backward from last year's determination 
by Congress that gift and estate taxes should be decreased and 
transfers of property from one generation to another should be 
encouraged.
      

                                

Statement of Washington Counsel, P.C., Attorneys-at-Law, and Ernst & 
Young LLP, on behalf of the Notice 98-11 Coalition

                              Introduction

    The Administration's FY99 Budget Proposal (``Budget 
Proposal'') includes an exceedingly broad request for 
regulatory authority to prescribe the ``appropriate tax 
results'' of ``hybrid transactions.'' Hybrid transactions are 
defined to include entities that are treated as corporations 
under one country's tax system and as branches or partnerships 
in another, as well as securities that are treated as debt or 
royalties in one country and as equity in another. Treasury's 
``General Explanation'' cites regulations to be issued pursuant 
to Notice 98-11 and Notice 98-5 (the ``Notices'') as areas in 
which the Treasury would be expected to use the requested 
regulatory authority.
    The Notice 98-11 Coalition (the ``Coalition'') is concerned 
that, under the guise of the Notices and the Budget Proposal, 
Treasury is seeking to launch a major new initiative in the 
international tax area that will undermine the ability of U.S. 
multinationals to compete in the global marketplace. In 
requesting the ability to unilaterally define ``appropriate 
results,'' Treasury is seeking the authority to make 
fundamental changes in existing law, a prerogative of the 
Congress. Moreover, the Notices and the Budget Proposals have 
created a chilling effect on the ability of U.S. multinationals 
to enter into transactions in the ordinary course of business.

  The Issues Raised By The Administration's Proposal On Hybrids Raise 
    Fundamental Tax Policy Concerns That Should be Addressed by The 
                               Congress.

    As recognized by the Internal Revenue Service (``IRS'') in 
describing the background of Notice 98-11, ``U.S. international 
tax policy seeks to balance the objective of neutrality of 
taxation as between domestic and foreign business enterprises 
(seeking neither to encourage nor to discourage one over the 
other, [referred to as ``capital export neutrality'']) with the 
need to keep U.S. business competitive.'' The legislative 
history of Subpart F \1\ is clear that capital export 
neutrality is not the only policy goal, but the IRS has only 
paid lip service to that fact. In reality, the Administration's 
position (as evidenced by the Notices and the Budget Proposal) 
would elevate the policy of capital export neutrality over 
international competitiveness. Even if capital export 
neutrality were the only consideration, it is questionable 
whether the expansion of Subpart F as envisioned by Notice 98-
11 is consistent with capital export neutrality.
---------------------------------------------------------------------------
    \1\ ``Subpart F'' refers to the anti-deferral regime prescribed by 
Sections 951-964 of the Internal Revenue Code of 1986, as amended (the 
``Code''); all references to ``Sections'' hereinafter are to the Code.
---------------------------------------------------------------------------
    The basic structure of the U.S. international tax regime 
dates from the early 1960s when the U.S. economy was so 
dominant that it accounted for over half of all multinational 
investment in the world. The decades that followed saw a 
migration from domestically-based to globally-competitive 
markets. With this transformation comes new challenges for 
Congressional policy makers interested in helping U.S. 
companies remain competitive. Indeed, the Congress has adopted 
trade laws that recognize both the need for expanded markets 
and the reduction of trade barriers. In like manner, it is for 
the Congress to determine whether to alter the extent to which 
international tax rules bolster or hinder the competitiveness 
of U.S. companies in global markets.
    The Congress is the only proper forum for determining 
whether to revisit the balance that has been struck between the 
competing U.S. tax goals of international competitiveness 
versus capital export neutrality. Further, by raising this 
issue by Notices and proposed legislation that grant Treasury 
open-ended authority to prescribe rules, Treasury is seeking to 
usurp the legislative process. Any change in law should be made 
through substantive statutes enacted prospectively by the 
Congress, not Notices issued retroactively by Treasury.

    Notice 98-11 and Notice 98-5 Represent Attempts By Treasury To 
   ``Legislate by Notice,'' Regulating Well Beyond the Interpretive 
                   Authority Granted By The Congress.

    As an example, many taxpayers in good faith structured 
specific foreign operations to take into account the final 
regulations issued on December 17, 1996, for the elective 
entity classification regime referred to as ``check-the-box.'' 
The check-the-box regulations sanctioned the creation of hybrid 
branches that are respected as separate entities for purposes 
of foreign tax law but not U.S. purposes. In Notice 98-11, 
however, Treasury indicates that regulations will prevent the 
use of check-the-box to create ``hybrid branches'' in the 
international context where the result ``is contrary to the 
policies and rules of Subpart F....'' Although an IRS 
``Notice'' does not involve the same depth of consideration as 
temporary or proposed regulations, the issuance of Notice 98-11 
had an immediate ``chilling effect'' by casting doubt on the 
ability of taxpayers to rely with certainty on their check-the-
box elections and the IRS's own check-the-box regulations, as 
well as the viability of structures that were put in place 
before the check-the-box regulations were finalized.
    The fundamental change announced in Notice 98-11 (that is, 
the treatment of hybrid branches for purposes of Subpart F) 
should be the prerogative of the Congress not the IRS. The 
check-the-box regulations did not enlarge Treasury's general 
interpretive authority. Treasury itself recognized that ``there 
[was] considerable flexibility under the [old] rules to 
effectively change the classification of an organization at 
will.'' Notice 95-14, 1995-1 C.B. 297, 298. The final check-
the-box regulations simply replaced the ``increasingly 
formalistic rules under the [old] regulations with a much 
simpler approach that generally is elective.'' P-S-43-95, 1996-
1 Adv. Sh. Ed. C.B. 937, 938. Similarly, as described by the 
staff of the Joint Committee on Taxation, the ``major change 
made by the check-the-box regulations is to allow tax 
classification ... to be explicitly elective....'' Joint 
Committee on Taxation, Review of Selected Entity Classification 
and Partnership Tax Issues (JCS-6-97), April 8, 1997, page 11. 
The Budget Proposal would, in effect, authorize Treasury to 
issue any regulations it believes are appropriate to prevent 
results that it deems to be inconsistent with Subpart F or any 
other provision of U.S. tax law. Accordingly, the combined 
effect of the Notices and the Budget Proposal is to prevent 
taxpayers from structuring many transactions that were clearly 
permitted before and after publication of the check-the-box 
regulations.
    Neither the Notices nor the Budget Proposal sets forth the 
expected content or scope of proposed regulations. Thus, 
taxpayers will not even know what the law actually is until 
regulations are written. \2\ The practical effect of the 
Administration's Budget Proposal would be to sanction 
``legislation by notice.'' Moreover, publication of vague 
Notices violates the spirit of the Taxpayer Bill of Rights 2 
(``TBOR2'') requirement that regulations generally be effective 
only on a date that a notice ``substantially describing the 
expected contents'' of regulations is released to the 
public.\3\
---------------------------------------------------------------------------
    \2\ Pending the issuance of regulations, taxpayers will not even be 
able to query the IRS on the possible consequences of a hybrid 
transaction--the IRS recently revised it's ``no rulings'' list to 
specifically include (1) the issue ``whether an entity is treated as 
fiscally transparent by a foreign jurisdiction for purposes of Section 
894,'' ``to reflect the fact that the [IRS] is studying the 
issue....;'' and (2) ``any transaction or series of transactions that 
is designed to achieve inconsistent tax consequences or classifications 
under the tax laws of the U.S. and the tax laws of a treaty partner.'' 
Rev. Proc. 98-7, 1998-1 I.R.B. 222.
    \3\ This prohibition, which is found in Section 7805(b)(1), only 
applies to regulations issued pursuant to statutes enacted after the 
1996 enactment of TBOR2.
---------------------------------------------------------------------------

     The Budget Proposal on Hybrids and the Related Notices Have a 
        Widespread Impact on Legitimate U.S. Economic Activity.

    The Coalition includes over thirty U.S. multinationals that 
are greatly concerned about the Treasury's position as 
evidenced by the Budget Proposal and the Related Notices. 
Because the Administration failed to articulate a comprehensive 
analytical framework for the results foreshadowed by the 
Notices, these companies have no way of determining the tax 
treatment of ongoing international operations that occur in the 
ordinary course of business (including transactions and 
structures that relied on the rules in effect prior to check-
the-box).
    The most immediate examples of this activity occurs in 
Europe. Consistent with the implementation of European Union 
(``EU'') directives, U.S. multinationals are reorganizing their 
European operations from what had been a country-by-country 
subsidiary model to a regionally focused cross-border business. 
This involves shifts of activities to better manage capacity, 
centralization of distribution activities and consolidation of 
regional support centers for functions such as cash management, 
billing, quality control, etc.. The move to a single European 
currency is further accelerating the trend and compelling 
additional consolidation of activity.
    Hybrid treatment for U.S. tax purposes of European 
subsidiaries is consistent with the manner in which companies 
are reorganizing their operations in Europe. The ability to 
elect hybrid treatment facilitates U.S. companies in achieving 
their desired regional operating structures, by allowing such 
conversions to be done free of U.S. tax consequences. It also 
enables U.S. companies to accomplish such reorganizations in a 
manner that is most tax effective in the foreign countries 
involved.
    The Notices seem to be grounded in the notion that U.S. 
multinationals should be penalized for employing tax planning 
strategies that reduce foreign income taxes. The result 
obtained in each of the examples described in the Notices is to 
impose a U.S. ``Soak Up Tax,'' whenever a U.S. taxpayer manages 
to reduce a foreign tax payment by use of hybrids. The 
rationale for this result is unclear, unless one believes that 
the United States should be the ``Tax Police'' for the world. 
There is no (apparent) overriding policy reason for inhibiting 
the ability of U.S. businesses to compete in foreign markets 
against foreign competitors, especially where there is no cost 
to the U.S. fisc (and potentially increased U.S. tax revenues, 
over time, due to reductions in foreign tax credits).

 Unless The Congress Acts, Taxpayers Will face Economic Losses Arising 
 From Their Detrimental Reliance On Express Provisions Of Current Law.

    Regulations to be issued pursuant to Notice 98-5 would be 
effective for taxes paid or accrued on or after December 23, 
1997. The general effective date stated in Notice 98-11 is 
January 16, 1998, with a June 30, 1998 effective date for 
hybrid branches that were in existence on January 16th.
    The relevant Notices place taxpayers in the untenable 
position of having to determine the tax treatment of 
transactions pursued in the ordinary course of business, in 
advance of receiving any specific guidance, and before having 
any opportunity to comment on (as yet undefined) proposals. 
Taxpayers who acted in reliance on existing law will suffer 
economic losses due to the perceived need to react to 
Treasury's stated intention to issue retroactive regulations.

The Administration's Proposal Will Add Complexity to the Tax Law in the 
  International Area, Contrary to Recent Congressional Simplification 
                                Efforts.

    While the Administration itself touted the check-the-box 
regulations as a major simplification initiative, the issuance 
of regulations pursuant to Notice 98-11 would add additional 
complexity because it would appear that foreign entities would 
be treated as branches for some purposes but not for others. As 
a result, taxpayers would be required to maintain two sets of 
U.S. tax books to account for the international operations of 
hybrid branches both as corporations for some U.S. tax purposes 
and as branches for others.
    The Notices and the Budget Proposal are contrary to recent 
Congressional efforts to simplify the anti-deferral provisions 
of the Code. For example, the Congress reduced complexity by 
repealing the Section 956A tax on excess passive earnings in 
1996. Again, in 1997, the Congress repealed the application of 
the Passive Foreign Investment Company regime to U.S. 
shareholders of Controlled Foreign Corporations because of the 
complexity involved in applying both regimes. Additionally, the 
Congress passed a host of other foreign tax simplifications in 
1997, including, as previously proposed by Ways and Means 
Committee members Houghton and Levin in H.R. 1783, provisions 
to reduce a buyer's Subpart F income by the amount of a 
seller's deemed dividend under Section 1248, repeal the 
separate foreign tax credit limitations for Section 902 
noncontrolled foreign corporations, and prevent the creation of 
deemed dividends under Subpart F on account of specified 
ordinary course transactions of securities dealers.

                               Conclusion

    The Notices and the Budget Proposal represent an attempt by 
Treasury to ``legislate by notice,'' violating the spirit of 
TBOR 2. The Notices and the Budget Proposal squarely present 
the issue whether the Congress or the Treasury should be the 
arbiter of U.S. tax policy in the international arena. The 
Congress should prevent Treasury from issuing broad Notices 
that have immediate effective dates, without articulating with 
any specificity the content of future regulations. Whether to 
change the application of Subpart F and other international tax 
rules to hybrids and other transactions goes to the heart of 
the competing considerations underlying the current 
international tax regime. The Congress is the proper forum for 
making such policy decisions.

This statement is presented by LaBrenda Garrett-Nelson and Mark 
Weinberger on behalf of Washington Counsel, P.C., and David 
Benson and Henry Ruempler on behalf of Ernst & Young LLP. The 
Coalition consists of over 30 U.S. multinational corporations 
representing a broad cross-section of American industries.
      

                                

Statement of Jared O. Blum, President, Polyisocyanurate Insulation 
Manufacturers Association

    The Polyisocyanurate Insulation Manufacturers Association 
(PIMA) is pleased to submit these written comments on the 
revenue provisions in the President's fiscal year 1999 Budget. 
PIMA is the trade association of the rigid polyiso foam 
insulation industry, a product that is used in over 60 percent 
of new commercial roof construction, in 40 percent of new 
residential construction, and in most re-insulation of existing 
commercial building roofs.

                            I. Introduction

    We support efforts to improve the energy efficiency of new 
buildings. Currently, residential and commercial buildings 
represent more than a third of the total U.S. energy 
consumption, and account for two thirds of all electricity used 
in the country. In addition, the energy consumed in buildings 
is responsible for 35 percent of total U.S. carbon dioxide 
(CO2) emissions (our most significant greenhouse 
gas) and substantial amounts of other pollutants as well (e.g., 
sulfur dioxide, nitrogen oxides, and particulate matter). 
Improving the energy efficiency of buildings is a cost 
effective strategy for reducing emissions of greenhouse gases 
and other harmful air pollutants and for improving the our 
country's energy security. The President's proposed energy tax 
credits are a step in the right direction, but we believe 
changes could be made that would significantly increase their 
impact.

     II. Tax Credit for the Purchase of New Energy Efficient Homes

    A tax credit for purchasing new energy efficient homes is 
an effective way to attract energy-efficient technologies and 
building practices into the market-place. However, we believe 
that requiring new homes to be at least 50 percent more 
efficient than the Model Energy Code (MEC) is a threshold that 
is too high and would undermine the intent of the credit. Few 
homes can be built to this standard cost-effectively, and those 
that are built would be expensive ``showcase'' homes. This 
outcome would have only a minor impact on changing long-term 
construction practices in the home building industry.
    Putting cutting-edge technology in a few showcase homes 
will do little to address the most important obstacle to 
building energy-efficient homes: market barriers to common, 
every day energy-efficient technologies. There are a wide array 
of energy-efficient technologies currently available on the 
market. However, a number of market barriers discourage the use 
of these technologies. One of these is the problem of split 
incentives where landlords have little reason to invest in 
efficiency measures when the energy bill is passed on to 
tenants, whereas tenants rarely make such investments because 
their tenure in the building is typically uncertain. Likewise, 
given far-from-perfect information among consumers, speculative 
builders are less likely to invest up front in premium-cost, 
high-efficiency measures because the builder will not pay for 
energy use in the building after its purchase. As a result, for 
both commercial and residential construction, the overriding 
incentive is to reduce up-front costs with little regard for 
operating costs. Tax incentives would help overcome these 
market barriers, but they need to be structured in a way that 
will attract less esoteric building technologies that will have 
greater market penetration and can be sustained after the tax 
credit has ended.
    A more realistic and achievable threshold would be a 30 
percent improvement over MEC. In addition, meeting this 
threshold, although lower than the 50 percent threshold, still 
represents a significant improvement over current building 
practices. Currently, there are several market programs 
intended to encourage the purchase of homes that are 30 percent 
more efficient than MEC, such as EPA's Energy Star Homes 
program and several utility programs. Even with these programs 
in place, however, fewer than 2 percent of the new homes built 
each year meet the 30 percent threshold. A tax credit for homes 
that are 30 percent more efficient than the MEC would 
complement EPA's Energy Star program, resulting in a greater 
market penetration of homes with superior energy-efficiency and 
achieving greater environmental benefits compared to a credit 
that uses a 50 percent threshold.
    Using a 30 percent threshold would have the practical 
effect of providing a tax cut for lower and middle income 
families, whereas the 50 percent threshold would effect only 
higher income families. This is because achieving a 50 percent 
increase in energy-efficiency would be common only in more 
expensive homes, whereas the technology required to achieve a 
30 percent improvement, such as better insulation, tighter 
ducts, high-efficiency heating and air conditioning, and high 
performance windows, can be used in homes in every price range. 
In addition, a tax credit for homes meeting the 30 percent 
threshold is more likely to make housing more affordable for 
middle and lower income families. Not only do these houses cost 
less to operate, but the additional upfront cost of the 
increased energy-efficiency will be offset by the tax credit.

        III. Tax Credits for Energy-Efficient Building Equipment

    The President has proposed tax credits to encourage the 
purchase of certain high-efficiency building technologies, many 
of which are used to heat or cool buildings. We are surprised 
that with this emphasis on the heating and cooling of buildings 
there was no consideration given to insulation. To achieve the 
full potential of these technologies, the building envelope 
must be adequately insulated. Providing a tax credit for the 
use of superior levels of insulation would help to achieve the 
greatest environmental benefit from the President's proposed 
policies.
    Currently, a large percentage of new commercial and 
residential buildings fail to comply with even the minimum 
state and local building energy codes, an important component 
of which is insulation. A 1995 study by the American Council 
for an Energy-Efficient Economy that reviewed code compliance 
studies performed by state and local jurisdictions, as well as 
by electric utilities, concluded that compliance rates are 
typically on the order of 50 to 80 percent. The Department of 
Energy's Pacific Northwest National Laboratory estimates an 
even lower rate of compliance of about 40 percent for both 
residential and commercial buildings. A tax credit for 
insulation would be a very effective incentive for builders not 
only to comply with building energy codes, but also to surpass 
the minimum standards for installing insulation.
    According to the Pacific Northwest National Laboratory, if 
compliance with state and local building energy codes were 
improved ten percent over what it would otherwise be, 41 
trillion Btus would be saved annually and carbon emissions 
would be reduced 900,000 tons per year by 2010. It is hoped 
that the effect of an insulation tax credit would do more than 
simply encourage builders to comply with state and local 
building energy codes, but these figures provide an idea of the 
magnitude of the benefits that could result from such a tax 
credit.
      

                                

Statement of Protective Life Insurance Company

    In accordance with the provisions of a February 18, 1998 
advisory from the Committee on Ways and Means of the United 
States House of Representatives, Protective Life Insurance 
Company (``Protective Life'') submits this written statement 
for the Committee's consideration in conjunction with its 
review of President Clinton's Fiscal Year 1999 Budget. This 
statement is limited in scope to a single topic concerning 
capitalization of policy acquisition expenses as applied to 
group credit life insurance. The Clinton Administration has 
proposed an amendment to section 848 of the Internal Revenue 
Code that would increase, from 2.05 to 7.7 percent of net 
premiums, the amount of group credit life policy acquisition 
expenses subject to the capitalization requirement. Protective 
Life opposes this proposal and offers the following comments 
for your consideration.
    Protective Life is the primary operating subsidiary of 
Protective Life Corporation (``PLC'') PLC is a publicly held 
holding company whose shares are registered with the New York 
Stock Exchange. At December 31, 1997, its assets were $10.5 
billion. PLC is headquartered in Birmingham, Alabama. PLC and 
its subsidiaries have offices in several other states, 
including California, Illinois, Ohio, Indiana, North Carolina, 
Tennessee and Alabama.
    Protective Life was founded in 1907 and is now a Tennessee 
domestic insurance company. Protective Life produces, 
distributes and administers various insurance products either 
directly or through its subsidiaries. Among these are life 
insurance products, including group credit life insurance. 
Group credit life products are generally offered to consumers 
who receive credit from facilities such as financial 
institutions and automobile dealers. The credit facilities 
generally purchase group credit life insurance from insurers 
such as Protective Life. At the same time, individuals 
associated with the credit facilities function as agents who 
enroll individual debtors i premiums received.
    Policy acquisition expenses arising from the sale of group 
credit life insurance are currently subject to a capitalization 
requirement that was instituted in 1990. The tax effect 
resulting from this requirement is commonly called the deferred 
acquisition cost, or DAC, tax. The DAC tax provisions require a 
ten-year amortization for policy acquisition expenses above the 
first $5 million in a taxable year. The first $5 million may be 
amortized over five years.
    Currently, the DAC tax applies to acquisition expenses up 
to 2.05 percent of the net premiums from the sale of group 
credit life insurance. This 2.05 percent level applies for all 
group life insurance contracts, which is defined to include 
group credit life insurance. Thus, the DAC tax requirement for 
group credit life insurance is currently capped at an amount 
equivalent to 2.05 percent of net premiums.
    As noted above, the Administration has proposed an 
amendment to the Code that would subject a greater proportion 
of group credit life policy acquisition expenses to the DAC tax 
capitalization requirement. This would be accomplished by 
shifting the cap from 2.05 to 7.7 percent of net premiums. This 
7.7 percent level is one that currently applies to all 
insurance contracts not falling with the definitions of either 
group life insurance or annuities. This includes individual 
life insurance.
    Protective Life understands that the Administration has 
based its proposal upon the fact that acquisition expenses for 
group credit life insurance are higher than most other group 
life insurance products and are comparable to the acquisition 
expenses for individual life insurance. This suggests a belief 
that group credit life insurance should not be treated as the 
group insurance that it is because it resembles individual life 
insurance in one respect. Protective Life respectfully submits 
that this reasoning fails to consider the several respects in 
which group credit life insurance differs from individual life 
insurance.
    State regulations effectively place a cap on credit 
insurance premium rates. Most states utilize so-called prima 
facie rate provisions that grant blanket approval for rates 
that do not exceed a certain level. Notably, these rates were 
established prior to the 1990 institution of the current 2.05 
percent DAC tax, which insurers were forced to absorb. Although 
an insurer can apply for approval to charge a higher rate, most 
state regulators restrict premium increases to those justified 
by an insurer's increased loss ratios, not increased expenses. 
Thus, premium revenues from the sale of credit insurance are 
effectively capped at the prima facie rates. Whereas sellers of 
individual life insurance products can adjust premiums to 
account for changes in the tax laws, sellers of group credit 
life insurance cannot. These sellers have already been forced 
to accept the 2.05 percent DAC tax, and are now faced with the 
possibility of having to absorb an increase up to a level 
equivalent to 7.7 percent of net premiums.
    For legislators seeking a politically acceptable source of 
increased tax revenues, the box into which the sellers of group 
credit life insurance have been placed could be viewed as a 
positive. Absent a change in state regulations increasing the 
prima facie rates, these insurers would effectively be barred 
from passing along to consumers the proposed increase in the 
DAC tax. This restriction, however, merely creates pressures in 
other respects, and thus threatens the continued marketability 
of quality group credit insurance products to all consumers. 
This is particularly significant in light of an important 
distinction between group credit life insurance and individual 
life insurance.
    Unlike most individual life insurance products, group 
credit life insurance tends to serve demographically lower 
income consumers. It provides an important source of protection 
against financial risks for individuals who are generally not 
in a position to purchase individual life insurance coverage. 
Obviously, if the prima facie rate structure were to change to 
account for the this tax would be felt primarily by these lower 
income consumers through an increase in the cost of group 
credit insurance.
    Alternatively, if group credit life insurers are forced to 
do business under the current rate structures, the proposed DAC 
tax increase might have a different adverse effect on these 
lower income consumers through limiting the quality or 
availability of this type of insurance. Unless insurers were to 
decrease the commissions paid to credit facilities functioning 
as agents, which is a highly unlikely scenario in the current 
competitive marketplace, these insurers would have to suffer 
further erosion of what are already thin margins of return. 
Several measures could be instituted to minimize the effects of 
this erosion, but none would benefit the consumer.
    Insurers would be pressured to decrease claims expenses 
through such mechanisms as greater reliance on restrictions for 
coverage or on policy exclusions. This would diminish the 
availability and quality of the products now offered to a wide 
range of lower income consumers. To maximize per-policy 
premiums, some insurers might shift the marketing of this 
product away from insurance sold in connection with smaller 
loans. Used automobile dealers and other credit facilities that 
routinely finance smaller dollar purchases might not be able to 
offer group credit life insurance. This would result in group 
credit life insurance becoming less available to the lowest of 
lower income consumers and those in the greatest financial need 
of this product. Finally, some insurers would simply 
discontinue the marketing of group credit insurance. This would 
likely limit the availability of the product or have other 
anti-competitive effects that could adversely affect lower 
income consumers.
    Despite policy acquisition expense data that have 
apparently caused the Administration to regard group credit 
life insurance as may more closely resembling individual life 
insurance than other group insurance, group credit life 
insurance cannot appropriately be regarded as comparable to 
individual life insurance. In Protective Life's experience, the 
average term of group credit life is significantly shorter than 
that of individual life insurance and may even be sorter than 
many other forms of group life insurance. Indeed, it is shorter 
than the five-year amortization period that applies under the 
DAC tax for the first $5 million in acquisition expenses 
incurred in a taxable year, and much shorter than the ten-year 
period that applies thereafter. Under these circumstances, 
there is no justification in the tax laws for requiring any 
group credit life acquisition expenses to be capitalized over a 
five-year period, much less over a ten-year period.
    Protective Life could mount an argument that the current 
2.05 percent DAC tax is unfair in light of the existing 
amortization periods and the average term of group credit life 
insurance, but it will save that argument for another day. For 
the present, it is sufficient to state that an increase in the 
DAC tax level from 2.05 to 7.7 percent is unjustified. Such an 
increase would have an undue, adverse effect on the continued 
availability of quality group credit life products to lower 
income consumers. Accordingly, the Administration's proposed 
change in the tax laws should be rejected.

            Respectfully submitted,
                                        Drayton Nabers, Jr.
                                              Chairman of the Board
      

                                

Statement of Hon. Jim Ramstad, a Representative in Congress from the 
State of Minnesota

    Mr. Chairman, thank you for convening this hearing to 
examine the revenue provisions in the President's proposed FY99 
budget.
    I must say I'm concerned by some of the so-called 
``unwarranted benefits'' targeted by the Administration. Some 
are recycled from past years, and some are new surprises.
    I'm troubled by the conflicting messages some of these 
proposals are sending. At at a time the Administration claims 
it wants to encourage long-term savings and retirement 
security, the very businesses and products that provide long-
term savings opportunities are being attacked. At a time we 
should be encouraging exports and improving the balance of 
trade, American businesses that export are being penalized. And 
at a time of devolution when we are asking more from state and 
local governments, we have a proposal that would likely raise 
their borrowing costs.
    Because I am so troubled by the inconsistencies, I'm 
grateful for this opportunity to hear from Mr. Summers about 
the Administration's proposals.
    Again, Mr. Chairman, thank you for providing us this forum 
to explore the Administration's budget proposals in detail.
      

                                

Statement of Grace Chen, Chief Executive Officer, e-CommLink, Inc., 
Houston, Texas, on behalf of the R&D Credit Coalition

    Mr. Chairman and members of the Committee, my name is Grace 
Chen, and I am the Chief Executive Officer of e-CommLink, Inc. 
of Houston, Texas. I thank you for the opportunity to submit 
this statement on behalf of the R&D Credit Coalition on the 
importance of making permanent the research and experimentation 
tax credit (commonly referred to as the ``R&D'' credit). The 
R&D Credit Coalition is a broad-based coalition of 30 trade 
associations and approximately 750 small, medium and large 
companies, all united in seeking the permanent extension of the 
R&D credit. The members of the R&D Credit Coalition represent 
many of the most dynamic and fastest growing companies in the 
nation and include the entire spectrum of R&D intensive 
industries: aerospace, biotechnology, chemicals, electronics, 
information technology, manufacturing, pharmaceuticals and 
software. (I have attached to this statement a letter from the 
members of the R&D Credit Coalition to President Clinton 
concerning including the R&D credit in the Administration's FY 
1999 Budget.)
    e-CommLink, Inc., founded in 1996, is a privately owned 
high technology company located in Houston, Texas. The company 
has developed a pioneering technology using Web-enabled middle 
processing applications to facilitate on-line information 
management and dynamic interactivity between vendors, 
customers, and business partners. This technology offers an 
economical and scaleable connectivity solution. Rapid new 
product development is essential to success in our industry. 
The company has grown to 45 employees and anticipates 
substantial growth in the future.
    I want to commend Representatives Nancy Johnson and Bob 
Matsui, and the original cosponsors of H.R. 2819, and Senators 
Hatch and Baucus, and the original cosponsors of S. 1464, for 
introducing legislation to permanently extend the R&D credit. I 
also want to commend President Clinton for including, and 
funding, an extension of the R&D tax credit in the 
Administration's FY 1999 Budget.
    This year the accounting firm of Coopers & Lybrand has 
completed a new study, Economic Benefits of the R&D Tax Credit, 
(January 1998), that dramatically illustrates the significant 
economic benefits provided by the credit and further reinforces 
the need to make the credit permanent. According to the study 
(executive summary attached) making the R&D credit permanent 
would stimulate substantial amounts of additional R&D, increase 
national productivity and economic growth almost immediately, 
and provide U.S. workers with higher wages and after-tax 
income. I hope the Congress will take swift action to 
permanently extend the R&D credit by enacting the provisions of 
H.R. 2819--S. 1464 before the credit expires once again on June 
30, 1998.

                   I. R&D Credit Legislative History

    The R&D credit was enacted in 1981 to provide an incentive 
for companies to increase their U.S. R&D activities. As 
originally passed, the R&D credit was to expire at the end of 
1985. Recognizing the importance and effectiveness of the 
provision, Congress decided to extend it. In fact, since 1981 
the credit has been extended eight times. In addition, the 
credit's focus has been sharpened by limiting both qualifying 
activities and eligible expenditures. With each extension, the 
Congress indicated its strong bipartisan support for the R&D 
credit.
    In 1986, the credit lapsed, but was retroactively extended 
and the rate cut from 25 percent to 20 percent. In 1988, the 
credit was extended for one year. However, the credit's 
effectiveness was further reduced by decreasing the deduction 
for R&D expenditures by 50% of the credit. In 1989, Congress 
extended the credit for another year and made changes that were 
intended to increase the incentive effect for established as 
well as start-up companies. In the 1990 Budget Reconciliation 
Act, the credit was extended again for 15 months through the 
end of 1991. The credit was again extended through June 30, 
1992, by the Tax Extension Act of 1991. In OBRA 1993, the 
credit was retroactively extended through June 30, 1995.
    In 1996, as part of the Small Business Job Protection Act 
of 1996, the credit was extended for eleven months, through May 
31, 1997, but was not extended to provide continuity over the 
period July 1, 1995 to June 30, 1996. This one-year period, 
July 1, 1995 to June 30, 1996, was the first gap in the 
credit's availability since its enactment in 1981.
    In 1996, the elective Alternative Incremental Research 
Credit (``AIRC'') was added to the credit, expanding the 
availability of the credit to R&D intensive industries which 
could not qualify for the credit under the regular criteria. 
The AIRC adds flexibility to the credit to address changes in 
business models and R&D spending patterns which are a normal 
part of a company's life cycle. The sponsors of H.R. 2819 and 
S. 1464 recognize the importance of the AIRC. Their 
legislation, in addition to making the credit permanent, 
provides for a modest increase in the AIRC rates that will 
bring the AIRC's incentive effect more into line with the 
incentive provided by the regular credit to other research-
intensive companies.
    Most recently, the Congress approved a thirteen month 
extension of the R&D credit that was enacted into law as part 
of the Taxpayer Relief Act of 1997. The credit was made 
available for expenditures incurred from June 1, 1997 through 
June 30, 1998, with no gap between this and the previous 
extension.
    According to the Tax Reform Act of 1986, the R&D credit was 
originally limited to a five-year term in order ``to enable the 
Congress to evaluate the operation of the credit.'' While it is 
understandable that the Congress in 1981 would want to adopt 
this new credit on a trial basis, the credit has long since 
proven over the sixteen years of its existence to be an 
excellent investment of government resources to provide an 
effective incentive for companies to increase their U.S.-based 
R&D.
    The historical pattern of temporarily extending the credit, 
combined with the first gap in the credit's availability, works 
to reduce the incentive effect of the credit. The U.S. research 
community needs a stable, consistent R&D policy in order to 
maximize its incentive value and its contribution to the 
nation's economic growth and sustain the basis for ongoing 
technology competitiveness in the global arena.

                    II. Why Do We Need A R&D Credit?

A. Credit offsets the tendency for under investment in R&D

    The single biggest factor driving productivity growth is 
innovation. As stated by the Office of Technology Assessment in 
1995: ``Much of the growth in national productivity ultimately 
derives from research and development conducted in private 
industry.'' Sixty-six to eighty percent of productivity growth 
since the Great Depression is attributable to innovation. In an 
industrialized society R&D is the primary means by which 
technological innovation is generated.
    Companies cannot capture fully the rewards of their 
innovations because they cannot control the indirect benefits 
of their technology on the economy. As a result, the rate of 
return to society from innovation is twice that which accrues 
to the individual company. This situation is aggravated by the 
high risk associated with R&D expenditures. As many as eighty 
percent of such projects are believed to be economic failures.
    Therefore, economists and technicians who have studied the 
issue are nearly unanimous that the government should intervene 
to increase R&D investment. The most recent study, conducted by 
the Tax Policy Economics Group of Coopers & Lybrand, concluded 
that ``absent the R&D credit, the marketplace, which normally 
dictates the correct allocation of resources among different 
economic activities, would fail to capture the extensive 
spillover benefits of R&D spending that raise productivity, 
lower prices, and improve international trade for all sectors 
of the economy.'' Stimulating private sector R&D is 
particularly critical in light of the decline in government 
funded R&D over the years. Direct government R&D funding has 
declined from 57% to 36% of total R&D spending in the U.S. from 
1970 to 1994. Over this same period, the private sector has 
become the dominant source of R&D funding, increasing from 40% 
to 60%.

B. The credit helps U.S. business remain competitive in a world 
marketplace

    The R&D credit has played a significant role in placing 
American businesses ahead of their international competition in 
developing and marketing new products. It has assisted in the 
development of new and innovative products; providing 
technological advancement, more and better U.S. jobs, and 
increased domestic productivity and economic growth. This is 
increasingly true in our knowledge and information-driven world 
marketplace.
    Research and development must meet the pace of competition. 
In many instances, the life cycle of new products is 
continually shrinking. As a result, the pressure of getting new 
products to market is intense. Without robust R&D incentives 
encouraging these efforts, the ability to compete in world 
markets is diminished.
    Continued private sector R&D is critical to the 
technological innovation and productivity advances that will 
maintain U.S. leadership in the world marketplace. Since 1981, 
when the credit was first adopted, there have been dramatic 
gains in R&D spending. Unfortunately, our nation's private 
sector investment in R&D (as a percentage of GDP) lags far 
below many of our major foreign competitors. For example, U.S. 
firms spend (as a percentage of GDP) only one-third as much as 
their German counterparts on R&D, and only about two-thirds as 
much as Japanese firms. This trend must not be allowed to 
continue if our nation is to remain competitive in the world 
marketplace.
    Moreover, we can no longer assume that American companies 
will automatically choose to site their R&D functions in the 
United States. Foreign governments are competing intensely for 
U.S. research investments by offering substantial tax and other 
financial incentives. Even without these tax incentives, the 
cost of performing R&D in many foreign jurisdictions is lower 
than the cost to perform equivalent R&D in the U.S.
    An OECD survey of sixteen member countries found that 
thirteen offer R&D tax incentives. Of the sixteen OECD nations 
surveyed, twelve provide a R&D tax credit or allow a deduction 
for more than 100% of R&D expenses. Six OECD nations provide 
accelerated depreciation for R&D capital. According to the OECD 
survey, the U.S. R&D tax credit as a percentage of industry-
funded R&D was third lowest among nine countries analyzed.
    Making the U.S. R&D credit permanent, however, would 
markedly improve U.S. competitiveness in world markets. The 
1998 Coopers & Lybrand study found that, with a permanent 
credit, annual exports of goods manufactured here would 
increase by more than $6 billion, and imports of goods 
manufactured elsewhere would decrease by nearly $3 billion. 
Congress and the Administration must make a strong and 
permanent commitment to attracting and retaining R&D investment 
in the United States. The best way to do that is to permanently 
extend the R&D credit.

C. The credit provides a targeted incentive for additional R&D 
investment, increasing the amount of capital available for 
innovative and risky ventures.

    The R&D credit reduces the cost of capital for businesses 
that increase their R&D spending, thus increasing capital 
available for risky research ventures.
    Products resulting from R&D must be evaluated for their 
financial viability. Market factors are providing increasing 
incentives for controlling the costs of business, including 
R&D. Based on the cost of R&D, the threshold for acceptable 
risk either rises or falls. By reducing the costs of R&D, you 
make it possible to increase R&D efforts. In most situations, 
the greater the scope of R&D activities, or risk, the greater 
the potential for return to investors, employees and society at 
large.
    The R&D credit is a vital tool to keep U.S. industry 
competitive because it frees-up capital to invest in leading 
edge technology and innovation. It makes available additional 
financial resources to companies seeking to accelerate research 
efforts. It lowers the economic risk to companies seeking to 
initiate new research, which will potentially lead to enhanced 
productivity and overall economic growth.

D. Private industrial R&D spending is very responsive to the 
R&D credit, making the credit a cost effective tool to 
encourage economic growth

    Economic studies of the credit, including the Coopers & 
Lybrand 1998 study, the KPMG Peat Marwick 1994 study, and the 
article by B. Hall entitled: ``R&D Tax Policy in the 1980s: 
Success or Failure?'' Tax Policy and the Economy (1993), have 
found that a one-dollar reduction in the after-tax price of R&D 
stimulates approximately one dollar of additional private R&D 
spending in the short-run, and about two dollars of additional 
R&D in the long run. The Coopers & Lybrand study predicts that 
a permanent R&D credit would lead U.S. companies to spend $41 
billion more (1998 dollars) on R&D for the period 1998-2010 
than they would in the absence of the credit. This increase in 
private U.S. R&D spending, the 1998 study found, would produce 
substantial and tangible benefits to the U.S. economy.
    Coopers & Lybrand estimated that this permanent extension 
would create nearly $58 billion of economic growth over the 
same 1998-2010 period, including $33 billion of additional 
domestic consumption and $12 billion of additional business 
investment. These benefits, the 1998 study found, stemmed from 
substantial productivity increases that could add more than $13 
billion per year of increased productive capacity to the U.S. 
economy. Enacting a permanent R&D credit would lead U.S. 
companies to perform significantly more R&D, substantially 
increase U.S. workers' productivity, and dramatically grow the 
domestic economy.

E. Research and Development is About Jobs and People

    Investment in R&D is ultimately an investment in people, 
their education, their jobs, their economic security, and their 
standard of living. Dollars spent on R&D are primarily spent on 
salaries for engineers, researchers and technicians.
    When taken to market as new products, incentives that 
support R&D translate to salaries of employees in 
manufacturing, administration and sales. Of exceptional 
importance to e-CommLink, Inc. and the other members of the R&D 
Credit Coalition, R&D success also means salaries to the people 
in our distribution channels who bring our products to our 
customers as well as service providers and developers of 
complementary products. And, our customers ultimately drive the 
entire process by the value they put on the benefit to them of 
advances in technology. Benefits that often translate into 
improving their ability to compete. By making other industries 
more competitive, research within one industry contributes to 
preserving and creating jobs across the entire economy.
    My experience has been that more than 75 percent of 
expenses qualifying for the R&D credit go to salaries for 
researchers and technicians, providing high-skilled, high-wage 
jobs to U.S. workers. Investment in R&D, in people working to 
develop new ideas, is one of the most effective strategies for 
U.S. economic growth and competitive vitality. Indeed, the 1998 
Coopers & Lybrand study shows improved worker productivity 
throughout the economy and the resulting wage gains going to 
hi-tech and low-tech workers alike. U.S. workers' personal 
income over the 1998-2010 period, the 1998 study predicts, 
would increase by more than $61 billion if the credit were 
permanently extended.

F. The R&D credit is a market driven incentive

    The R&D credit is a meaningful, market-driven tool to 
encourage private sector investment in research and development 
expenditures. Any taxpayer that increases their R&D spending 
and meets the technical requirements provided in the law can 
qualify for the credit. Instead of relying on government-
directed and controlled R&D spending, businesses of all sizes, 
and in all industries, can best determine what types of 
products and technology to invest in so that they can ensure 
their competitiveness in the world marketplace.

III. The R&D Credit Should Be Made Permanent To Have Maximum Incentive 
                                 Effect

    Research projects cannot be turned off and on like a light 
switch. If corporate managers are going to take the benefits of 
the R&D credit into account in planning future research 
projects, they need to know that the credit will be available 
to their companies for the years in which the research is to be 
performed. Research projects have long horizons and long 
gestation periods. Furthermore, firms generally face longer 
lags in adjusting their R&D investments compared, for example, 
to adjusting their investments in physical capital.
    In order to increase their R&D efforts, businesses must 
search for, hire, and train scientists, engineers and support 
staff. They must often invest in new physical plant and 
equipment. There is little doubt that a portion of the 
incentive effect of the credit has been lost over the past 
seventeen years as a result of the constant uncertainty over 
the continued availability of the credit.
    If the credit is to provide its maximum potential incentive 
for increased R&D activity, the practice of periodically 
extending the credit for short periods, and allowing it to 
lapse, must be eliminated, and the credit must be made 
permanent. Only then will the full potential of its incentive 
effect be felt across all the sectors of our economy.

                             IV. Conclusion

    Making the existing R&D credit permanent best serves the 
country's long term economic interests as it will eliminate the 
uncertainty over the credit's future and allow R&D performing 
businesses to make important long-term business decisions 
regarding research spending and investment. Private sector R&D 
stimulates investment in innovative products and processes that 
greatly contribute to overall economic growth, increased 
productivity, new and better U.S. jobs, and higher standards of 
living in the United States. Moreover, by creating an 
environment favorable to private sector R&D investment, jobs 
will remain in the United States. Investment in R&D is an 
investment in people. A permanent R&D credit is essential for 
the United States economy in order for its industries to 
compete globally, as international competitors have chosen to 
offer direct financial subsidies and reduced capital cost 
incentives to ``key'' industries. The R&D Credit Coalition 
strongly supports the permanent extension of the R&D credit and 
urges Congress to enact the provisions of H.R. 2819--S. 1464 
before the credit expires on June 30, 1998.

Attachments: Letter from members of R&D Credit Coalition to 
President Clinton
Executive Summary of 1998 Coopers & Lybrand study ``Economic 
Benefits of the R&D Tax Credit''
      

                                

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Statement of Tax Council

                              Introduction

    Mr. Chairman and Members of the Committee:
    The Tax Council is pleased to present its views on the 
Administration's Budget proposals and their impact on the 
international competitiveness of U.S. businesses and workers. 
The Tax Council is an association of senior level tax 
professionals representing over one hundred of the largest 
corporations in the United States, including companies involved 
in manufacturing, mining, energy, electronics, transportation, 
public utilities, consumer products and services, retailing, 
accounting, banking, and insurance. We are a nonprofit, 
business supported organization that has been active since 
1967. We are one of the few professional organizations that 
focus exclusively on federal tax policy issues for businesses, 
including sound federal tax policies that encourage both 
capital formation and capital preservation in order to increase 
the real productivity of the nation.
    The Tax Council applauds the House Ways & Means Committee 
for scheduling these hearings on the Administration's budget 
proposals involving taxes. We do not disagree with all of these 
proposals, for example, we support extension of the tax credit 
for research, as well as accelerating the effective date of the 
rules regarding look-through treatment for dividends received 
from ``10/50 Companies.'' These provisions will go a long way 
toward increasing our declining savings rate and improving the 
competitive position of U.S. multinational companies. However, 
in devising many of its other tax proposals, the Administration 
replaced sound tax policy with a short sighted call for more 
revenue.
    Many of the revenue raisers found in the latest Budget 
proposals introduced by the Administration lack a sound policy 
foundation. Although they may be successful in raising revenue, 
they do nothing to achieve the objective of retaining U.S. jobs 
and making the U.S. economy stronger. For example, provisions 
are found in the Budget to (1) extend Superfund taxes without 
attempting to improve the cleanup programs, (2) repeal the use 
of ``lower of cost or market'' inventory accounting, (3) 
arbitrarily change the sourcing of income rules on export sales 
by U.S. based manufacturers, (4) provide the Treasury Secretary 
with blanket authority to issue regulations in the 
international area that could conceivably allow it to attack 
legitimate tax planning by U.S. companies, for example, by 
severely restricting the ordinary business operations of 
foreign affiliates by no longer allowing a U.S. company to 
characterize its foreign affiliate as a branch for U.S. tax 
purposes, (5) inequitably limit the ability of so-called ``dual 
capacity taxpayers'' (i.e., multinationals engaged in vital 
petroleum exploration and production overseas) to take credit 
for certain taxes paid to foreign countries, and (6) restrict 
taxpayers from having the ability to mark-to-market certain 
customer trade receivables.
    In its efforts to balance the budget, the Administration is 
unwise to target publicly held U.S. multinationals doing 
business overseas, and the Tax Council urges that such 
proposals be seriously reconsidered. The predominant reason 
that businesses establish foreign operations is to serve local 
overseas markets so they are able to compete more efficiently. 
Investments abroad provide a platform for the growth of exports 
and indirectly create jobs in the U.S., along with improving 
the U.S. balance of payments. The creditability of foreign 
income taxes has existed in the Internal Revenue Code for over 
70 years as a way to help alleviate the double taxation of 
foreign income. Replacing such credits with less valuable 
deductions will greatly increase the costs of doing business 
overseas, resulting in a competitive disadvantage to U.S. 
multinationals versus foreign-based companies.
    In order that U.S. companies can better compete with 
foreign-based multinationals, the Administration should instead 
do all it can to make the U.S. tax code more friendly and 
consistent with the Administration's more enlightened trade 
policy. Rather than engaging in gimmicks that reward some 
industries and penalize others, the Administration's budget 
should be written with the goal of reintegrating sounder tax 
policy into decisions about the revenue needs of the 
government. Provisions that merely increase business taxes by 
eliminating legitimate business deductions should be avoided. 
Ordinary and necessary business expenses are integral to our 
current income based system, and arbitrarily denying a 
deduction for such expenses will only distort that system. 
Higher business taxes impact all Americans, directly or 
indirectly. For example, they result in higher prices for goods 
and services, stagnant or lower wages paid to employees in 
those businesses, and smaller returns to shareholders. Those 
shareholders may be the company's employees, or the pension 
plans of other middle class workers.
    Corporate tax incentives like the research tax credit have 
allowed companies to remain strong economic engines for our 
country, and have enabled them to fill even larger roles in the 
health and well being of their employees. For these reasons, 
sound and justifiable tax policy should be paramount when 
deciding on taxation of business--not mere revenue needs.

                         Positive Tax Proposals

    The Administration has proposed several tax provisions that 
will have a positive impact on the economy. Three good examples 
are:

          Accelerating Effective Date of 10/50 Company Change

    One proposal would accelerate the effective date of a tax 
change made in the 1997 Tax Relief Act affecting foreign joint 
ventures owned between ten and fifty percent by U.S. parents 
(so-called ``10/50 Companies''). This change will allow 10/50 
Companies to be treated just like controlled foreign 
corporations by allowing ``look-through'' treatment for foreign 
tax credit purposes for dividends from such joint ventures. The 
1997 Act, however, did not make the change effective for such 
dividends unless they were received after the year 2003 and, 
even then, required two sets of rules to apply for dividends 
from earnings and profits (``E&P'') generated before the year 
2003, and dividends from E&P accumulated after the year 2002. 
The Administration's proposal will, instead, apply the look-
through rules to all dividends received in tax years after 
1997, no matter when the E&P constituting the makeup of the 
dividend was accumulated.
    This change will result in a tremendous reduction in 
complexity and compliance burdens for U.S. multinationals doing 
business overseas through foreign joint ventures. It will also 
reduce the competitive bias against U.S. participation in such 
ventures by placing U.S. companies on a much more level playing 
field from a corporate tax standpoint. This proposal epitomizes 
the favored policy goal of simplicity in the tax laws, and will 
go a long way toward helping the U.S. economy by strengthening 
the competitive position of U.S. based multinationals.

                   Extending the Research Tax Credit

    The proposal to extend the research tax credit for another 
year is also to be applauded. The credit, which applies to 
amounts of qualified research in excess of a company's base 
amount, has served to promote research that otherwise may never 
have occurred. The buildup of ``knowledge capital'' is 
absolutely essential to enhance the competitive position of the 
U.S. in international markets--especially in what some refer to 
as the ``Information Age.'' Encouraging private sector research 
work through a tax credit has the decided advantage of keeping 
the government out of the business of picking specific winners 
or losers in providing direct research incentives. 
Nevertheless, The Tax Council recommends that both the 
Administration and Congress work together to make the research 
tax credit a more permanent part of the tax laws.

               Netting of Underpayments and Overpayments

    The proposal to require the IRS to net overpayments and 
underpayments for purposes of calculating interest (commonly 
referred to as ``global interest netting'') is a large step 
forward towards fairness and equity. A new interest rate would 
be added to Code Sec. 6621 that equalizes interest in cases of 
overlapping periods of mutual indebtedness for tax periods not 
barred by an expiring statute of limitations. In other words, 
no interest would accrue on a deficiency to the extent that a 
taxpayer is owed a refund in the same amount, during periods 
that both are outstanding. This proposal would apply only 
prospectively, to periods of overlapping mutual indebtedness 
occurring after the enactment date. We suggest that this change 
also be made effective retroactively, to apply to all open tax 
years, consistent with Congress' long-stated position on this 
issue.

                 Provisions that Should Be Reconsidered

    The Tax Council offers the following comments on certain 
specific tax increase proposals set forth in the 
Administration's budget:

                 Foreign Oil and Gas Income Tax Credits

    The Tax Council's policy position on foreign source income 
is clear--A full, effective foreign tax credit should be 
restored and the complexities of current law, particularly the 
multiplicity of separate ``baskets,'' should be eliminated.
    The President's budget proposal dealing with foreign oil 
and gas income moves in the opposite direction by limiting use 
of the foreign tax credit on such income. This selective attack 
on a single industry's utilization of the foreign tax credit is 
not justified. U.S. based oil companies are already at a 
competitive disadvantage under current law since most of their 
foreign based competition pay little or no home country tax on 
foreign oil and gas income. The proposal increases the risk of 
foreign oil and gas income being subject to double taxation 
which will severely hinder U.S. oil companies in the global oil 
and gas exploration, production, refining and marketing arena.

                    Repeal of the Export Source Rule

    Since 1922, regulations under Code Sec. 863(b) and its 
predecessors have contained a rule which allows the income from 
goods that are manufactured in the U.S. and sold abroad (with 
title passing outside the U.S.) to be treated as 50% U.S. 
source income and 50% foreign source income. This export source 
rule has been beneficial to companies who manufacture in the 
U.S. and export abroad because it increases their foreign 
source income and thereby increases their ability to utilize 
foreign tax credits more effectively. Because the U.S. tax law 
restricts the ability of companies to get credit for the 
foreign taxes which they pay (e.g., through the interest and 
R&D allocations), many multinational companies face double 
taxation on their overseas operations, i.e., taxation by both 
the U.S. and the foreign jurisdiction. The export source rule 
helps alleviate this double taxation burden and thereby 
encourages U.S.-based manufacturing by multinational exporters.
    The President proposes to eliminate the 50/50 rule and 
replace it with an ``activities based'' test, which would 
require exporters to allocate income from exports to foreign or 
domestic sources based upon how much of the activity producing 
the income takes place in the U.S. and how much takes place 
abroad. The justification given for eliminating the 50/50 rule 
is that it provides U.S. multinational exporters operating in 
high tax foreign countries a competitive advantage over U.S. 
exporters that conduct all their business activities in the 
U.S. The Administration also notes that the U.S. tax treaty 
network protects export sales from foreign taxation in 
countries where we have treaties, thereby reducing the need for 
the export source rule. Both of these arguments are seriously 
flawed.
    The export source rule does not provide a competitive 
advantage to multinational exporters vis-a-vis exporters with 
``domestic-only'' operations. Exporters with only domestic 
operations never incur foreign taxes and, thus, are not even 
subjected to the onerous penalty of double taxation. Also, 
domestic-only exporters are able to claim the full benefit of 
deductions for U.S. tax purposes for all their U.S. expenses, 
e.g., interest on borrowings and R&D costs, because they do not 
have to allocate any of those expenses against foreign source 
income. Thus, the export source rule does not create a 
competitive advantage; rather, it helps to ``level the playing 
field'' for U.S.-based multinational exporters. Our tax treaty 
network is certainly no substitute for the export source rule 
since it is not income from export sales, but rather foreign 
earnings, that are the main cause of the double taxation 
described above. To the extend the treaty system lowers foreign 
taxation, it can help to alleviate the double tax problem, but 
only with countries with which we have treaties, which tend to 
be the most highly industrialized nations of the world. We have 
few treaties with most of the developing nations, which are the 
primary targets for our export growth in the future.
    Exports are fundamental to our economic growth and our 
future standard of living. Over the past three years, exports 
have accounted for about one-third of total U.S. economic 
growth. The export source rule also operates to encourage 
companies to produce their goods in their U.S. plants rather 
than in their foreign facilities. Repeal on cutbacks in the 
export source rule will reduce exports and jeopardize high 
paying jobs in the United States. Given the danger that the 
current Asian crisis poses to our exports, repeal of the rule 
would be especially unwise and counterproductive.

                  Limiting Use of ``Hybrid'' Entities

    It is troubling that the Administration (i.e., Treasury) 
feels compelled to request congressional authority to issue 
potentially sweeping legislative regulations after non-specific 
tax guidance has been given. If Treasury has specific issues to 
address, it should do so through specific legislative 
proposals. This would permit normal congressional 
consideration, including hearings on such proposals.
    One such proposal would limit the ability of certain 
foreign and U.S. persons to enter into transactions that 
utilize so-called ``hybrid entities,'' which are entities that 
are treated as corporations in one jurisdiction, but, as 
branches or partnerships in another jurisdiction. Although most 
hybrid transactions do not attempt to generate tax results that 
are ``inconsistent with the purposes of U.S. tax law,'' the 
Administration feels that there are enough taxpayers taking 
unfair advantage of the current rules that it is necessary to 
codify and extend the earlier government issued tax guidance 
(Notices 98-5 and 98-11) on this subject.
    U.S. multinationals compete in an environment wherein 
foreign competitors use tax planning techniques to reduce 
foreign taxes without incurring home country tax. The use of 
``hybrid entities'' allows U.S. Multinationals to compete on a 
level playing field and promotes additional U.S. exports. The 
use of hybrids is consistent with the initial balance between 
competitiveness and export neutrality that was intended by 
Congress in enacting the ``Subpart F'' rules. Although Congress 
specifically enacted a branch rule for foreign base company 
sales under Code Sec. 954(d)(3), similar rules were not enacted 
for foreign personal holding company income. If enacted, these 
proposals would represent an unwarranted extension of 
legislative authority by Congress to the Executive Branch to 
impose new rules by regulation without Congressional debate.
    Notices 98-5 and 98-11 have a chilling effect on the 
ability of U.S. companies to structure their foreign operations 
consistent with the commercial objective of regionalizing their 
businesses. They also adversely impact companies' abilities to 
effectively reduce their overall costs by reducing local taxes 
in their overseas operations. The Notices are drafted so 
broadly and so vaguely that they confuse U.S. taxpayers and 
their advisors, and introduce a compelling need to seek 
clarification as to whether taxpayers can continue to rely on 
the simple ``check-the-box'' regulations issued just last year. 
All these effects are exacerbated by the Notices' immediate 
effective dates.
    The world has changed dramatically since enactment of the 
Subpart F rules in 1962. We feel that it would be more 
appropriate for Congress to request a study regarding the trade 
and tax policy issues associated with Notices 98-5 and 98-11. 
In this regard, a moratorium on further regulatory action by 
Treasury should be imposed until enactment of specific 
legislative proposals resulting from well reasoned analysis and 
debate.

                        Foreign Built-In Losses

    Another proposal would require the Treasury to issue 
regulations to prevent taxpayers from ``importing built-in 
losses incurred outside U.S. taxing jurisdictions to offset 
income or gain that would otherwise be subject to U.S. tax.'' 
The administration argues that although there are rules in the 
Code that limit a U.S. taxpayer's ability to avoid paying U.S. 
tax on built-in gain (e.g., Code Sec. Sec. 367(a), 864(c)(7), 
and 877), similar rules do not exist that prevent built-in 
losses from being used to shelter income otherwise subject to 
U.S. tax and, as a result, taxpayers are avoiding Subpart F 
income inclusions or capital gains tax. We believe that this 
directive, which is written extremely broadly, is unnecessary 
due to the existence of rules already available in the Code, 
e.g., the anti-abuse provisions of Code Sec. Sec. 269, 382, 
446(b), and 482. Both this proposal, and the one immediately 
above regarding the use of hybrid entities, would severely 
impact the ability of U.S. multinationals to compete on an 
equal footing against foreign-based companies.

                      Payments to 80/20 Companies

    Currently, a portion of interest or dividends paid by a 
domestic corporation to a foreign entity may be exempt from 
U.S. withholding tax provided the payor corporation is a so-
called ``80/20 Company,'' i.e., at least eighty percent of its 
gross income for the preceding three years is foreign source 
income attributable to the active conduct of a foreign trade or 
business. The Administration believes that the testing period 
is subject to manipulation and allows certain companies to 
improperly avoid U.S. withholding tax on certain distributions 
attributable to a U.S. subsidiary's U.S. source earnings. As a 
result, it proposes to arbitrarily change the 80/20 rules by 
applying the test on a group-wide (as opposed to individual 
company) basis. However, there is little evidence that these 
rules have been manipulated on a broad scale in the past and we 
do not believe such a drastic change is needed at this time.

                            Superfund Taxes

    The three taxes that fund Superfund (corporate 
environmental tax, petroleum excise tax, and chemical feed 
stock tax) all expired on December 31, 1995. The President's 
budget would reinstate the two excise taxes at their previous 
levels for the period after the date of enactment through 
September 30, 2008. The corporate environmental tax would be 
reinstated at its previous level for taxable years beginning 
after December 31, 1997 and before January 1, 2009. Moreover, 
the funding cap for the Oil Spill Tax would be increased from 
the current $1 Billion amount to the obscenely high level of $5 
Billion.
    These taxes, which were previously dedicated to Superfund, 
would instead be used to generate revenue to balance the 
budget. This use of taxes for deficit reduction purposes, when 
historically dedicated to funding specific programs should be 
rejected. The decision whether to re-impose these taxes 
dedicated to financing Superfund should instead be made as part 
of a comprehensive examination of reforming the entire 
Superfund program.

          Modifying the ``Substantial Understatement'' Penalty

    The Administration proposes to make any tax deficiency 
greater than $10 million ``substantial'' for purpose of the 
Code Sec. 6662 substantial understatement penalty, rather than 
applying the existing test that such tax deficiency must exceed 
ten percent of the taxpayer's liability for the year. The 
penalty is twenty percent of the tax underpayment, unless the 
taxpayer had ``substantial authority'' for the position 
producing the underpayment, or the relevant facts are disclosed 
on the return and there is a reasonable basis for the position.
    There is no basis for the Administration's assertion that 
large corporate taxpayers are ``playing the audit lottery'' 
because of the purportedly high threshold amount at which the 
substantial understatement penalty applies. Large publicly-held 
corporations spend enormous amounts on tax related advice and, 
for security law and other reasons, generally document the 
basis for every major tax return position. Unfortunately, 
because of the complexity of both modern business transactions 
and the tax laws, as well as the relative dearth of regulatory 
or other guidance, the proper tax treatment of many items in a 
large corporation's return is far from clear. Also unclear is 
whether the ``substantial authority'' standard is met where a 
position is supported by well-reasoned legal analysis but there 
are no relevant cases, rulings, or other precedents, a 
situation encountered all too frequently by the corporate 
taxpayers targeted by this proposal. Indeed, the standard's 
vagueness is apparently evidenced by the continuing failure of 
Treasury to comply with the mandate of Code Sec. 6662(d)(2)(D), 
requiring it to publish and periodically update a list of 
positions for which it is believes substantial authority is 
lacking.
    We believe that the ultimate impact of this proposal to 
expand the substantial understatement penalty will be an 
expansion of lengthy and costly litigation to properly 
interpret the substantial authority standard. Taxpayers seeking 
protection from this penalty by disclosing uncertain positions 
will face almost certain proposed adjustments from IRS agents, 
no matter how reasonable their position, resulting in lengthy 
administrative controversy and litigation. Moreover, there is 
no evidence that the existing penalty and interest provisions 
are inadequate, so we strongly urge Congress to reject this 
ill-advised proposal.

            Increased Penalties for Failure To File Returns

    The Administration proposes to increase penalties for 
failure to file information returns, including all standard 
1099 forms. IRS statistics bear out the fact that compliance 
levels for such returns are already extremely high. Any 
failures to file on a timely basis generally are due to the 
late reporting of year-end information or to other unavoidable 
problems. Under these circumstances, an increase in the penalty 
for failure to timely file returns would be unfair and would 
fail to recognize the substantial compliance efforts already 
made by American business.

                   Limiting Mark-to-Market Accounting

    Certain trade receivables would no longer be eligible for 
treatment under the mark-to-market accounting rules. Under 
those rules, certain taxpayers who purchase and sell their own 
trade receivables are exempt from the mark-to-market method of 
accounting unless they elect to be included. If they do, those 
taxpayers can currently write-off certain non-interest bearing 
receivables, and account, note, and trade receivables unrelated 
to the active business of a security dealer. There appear to be 
no tax policy reasons for prohibiting taxpayers from 
accelerating their bad debt deductions for these trade 
receivables, only government revenue considerations.

           Repealing Lower of Cost or Market Inventory Method

    Certain taxpayers can currently determine their inventory 
values by applying the lower of cost or market method, or by 
writing down the cost of goods that are not salable at normal 
prices, or not usable because of damage or other causes. The 
Administration is proposing to repeal these options and force 
taxpayers to recognize income from changing their method of 
accounting, on the specious grounds that writing down unusable 
or non-salable goods somehow ``understates taxable income.'' We 
strongly disagree with this unwarranted proposal. In addition, 
we believe that in the least, the lower of cost or market 
method should continue to be permissible when used for 
financial accounting purposes, to avoid the complexity of 
maintaining separate inventory accounting systems.

       Modifying Corporate-Owned Life Insurance (``COLI'') Rules

    The Administration proposes to substantially change the 
taxation of business-owned life insurance by disallowing a pro-
rata portion of a business' general deduction for interest 
expense. Moreover, the Administration has proposed retroactive 
application of the new tax to existing life insurance 
contracts. This proposal should not be adopted.
    Life insurance has long been used by businesses to protect 
against financial loss caused by the death of key employees and 
to finance the soaring cost of employee benefits, especially 
post-retirement health benefits. Life insurance provides a 
secure and stable source of financing for such employee 
benefits, and it is particularly well suited to this purpose 
because its long-term nature matches the correspondingly long-
term nature of the liabilities. The Administration's proposal 
would have a devastating effect on employee benefit programs 
and key-person protection by effectively taxing life insurance 
contracts out of existence. Businesses should not be 
discouraged from providing employee health benefits or from 
seeking to protect themselves from key-person losses.
    Moreover, the Administration's proposal would apply 
retroactively to existing life insurance contracts that were 
purchased by businesses in good faith, based on existing law. 
There can be no question of abuse: business use of life 
insurance is well known and the taxation of insurance contracts 
has been settled for many years. In addition, Congress has 
reviewed the taxation of business-owned life insurance in each 
of the last two years and, in each case, has carefully 
preserved the existing taxation of business-owned life 
insurance on the lives of employees. The Administration's 
proposal represents the worst kind of retroactive tax--it would 
not only cause the termination of most or all existing 
contracts, but, would also have the effect of taxing past 
earnings under those contracts.

                  Deferral of OID on Convertible Debt

    The Administration has included a number of past proposals 
aimed at financial instruments and the capital markets, which 
were fully rejected during the last session of Congress. These 
reintroduced proposals should again be rejected out of hand. 
One proposal would defer deductions by corporate issuers for 
interest accrued on convertible debt instruments with original 
issue discount (``OID'') until interest is paid in cash. The 
proposal would completely deny the corporation an interest 
deduction unless the investors are paid in cash (e.g., no 
deduction would be allowed if the investors convert their bonds 
into stock). Investors in such instruments would still be 
required to pay income tax currently on the accrued interest. 
In effect, the proposal defers or denies an interest deduction 
to the issuer, while requiring the holder to pay tax on the 
interest currently.
    The Tax Council opposes this proposal because it is 
contrary to sound tax policy and symmetry that matches accrual 
of interest income by holders of OID instruments with the 
ability of issuers to deduct accrued interest. There is no 
justifiable reason for treating the securities as debt for one 
side of the transaction and as equity for the other side. There 
is also no reason, economic or otherwise, to distinguish a 
settlement in cash from a settlement in stock.
    Moreover, the instruments in question are truly debt rather 
than equity. Recent statistics show that over 70 percent of all 
zero-coupon convertible debt instruments were retired with 
cash, while only 30 percent of these instruments were 
convertible to common stock. Re-characterizing these 
instruments as equity for some purposes is fundamentally 
incorrect and will put American companies at a distinct 
disadvantage to their foreign competitors, who are not bound by 
such restrictions. These hybrid instruments and convertible OID 
bond instruments have allowed many U.S. companies to raise tens 
of billions of dollars of investment capital used to stimulate 
the economy. Introducing this imbalance and complexity into the 
tax code will discourage the use of such instruments, limit 
capital raising options, and increase borrowing costs for 
corporations.

          Eliminating the ``DRD'' for Certain Preferred Stock

    Another proposal would deny the dividend received deduction 
(``DRD'') for certain types of preferred stock, which the 
Administration believes are more like debt than equity. 
Although concerned that dividend payments from such preferred 
stock more closely resembles interest payments than dividends, 
the proposal does not simultaneously propose to allow issuers 
of such securities to take interest expense deductions on such 
payments. Again, the Administration violates sound tax policy 
and, in this proposal, would deny these instruments the tax 
benefits of both equity and debt.
    The Tax Council opposes this proposal as not being in the 
best interests of either tax or public policy. Currently, the 
U.S. is the only major western industrialized nation that 
subjects corporate income to multiple levels of taxation. Over 
the years, the DRD has been decreased from 100% for dividends 
received by corporations that own over 80 percent of other 
corporations, to the current 70% for less than 20 percent owned 
corporations. As a result, corporate earnings have become 
subject to multiple levels of taxation, thus driving up the 
cost of doing business in the U.S. To further decrease the DRD 
would be another move in the wrong direction.

                         Pro Rata Disallowance

    Another proposal is also somewhat similar to the ``pro 
rata'' budget proposal that was rejected by Congress last year. 
It would effectively eliminate the ``two-percent de minimis 
rule'' and disallow a portion of interest expense deductions 
for certain entities that earn tax-exempt interest. While last 
year's proposal was designed to apply to corporations 
generally, this year's proposal would apply only to ``financial 
intermediaries.'' Under the proposal, financial intermediaries 
that earn tax-exempt interest would lose a portion of their 
interest expense deduction based on the ratio of average daily 
holdings of municipals to average daily total assets.
    The Tax Council strongly opposes the Administration's 
proposal to extend the ``pro rata'' disallowance of tax-exempt 
interest expense to financial intermediaries. These companies 
play an important role in the markets for municipal leases, 
housing bonds, and student loan bonds. By eliminating this 
significant source of demand for municipal securities, the 
Administration's proposal would force state and local 
governments to pay higher interest rates on the bonds they 
issue, significantly increasing their costs of capital. The 
cost of public facilities, such as school construction and 
housing projects, would be increased. This proposal is entirely 
inconsistent with tax incentive programs for some of the same 
state and local projects. At a time when the state and local 
governments are asked to do more, Congress should not make it 
more costly for them to achieve their goals.

Increasing the Proration Percentage for Property and Casualty (``P&C'') 
                          Insurance Companies

    In 1986, Congress enacted a provision taxing fifteen 
percent (the proration percentage) of otherwise tax exempt 
interest of P&C companies attributable to municipal obligations 
acquired after 1986. It is now proposed to increase this 
proration to thirty percent for obligations acquired after 
enactment. Although a number of specious arguments are made in 
support of this proposal, it appears to be primarily revenue 
driven. The Tax Council believes that States will continue to 
finance their activities through bonds, but this proposal will 
make it more costly for P&C companies to buy them. Thus, States 
must either raise their interest rates or find individuals to 
buy the bonds, resulting in an even greater revenue loss to the 
Treasury (individuals have no proration percentage).

  Tax Insurance Contract Exchanges or Reallocate Assets with Variable 
                          Insurance Contracts

    Annuity contract investments are a valuable retirement and 
investment tool. Currently, owners of variable annuity 
contracts can allocate their investments in a contract among 
different investment options (e.g. a bond fund, a stock fund, 
and a balanced fund). Owners may reallocate their account 
values within the contract among the various options without 
incurring a current tax so long as the investment remains 
committed to a retirement annuity. This flexibility provides an 
important savings incentive for retirement. A taxable event 
does occur when funds are taken out of an annuity. The 
Administration proposes to tax any exchange of a life 
insurance, endowment, or annuity contract, for a variable 
contract, or vice versa. In addition, any reallocation among 
accounts within the same variable life or annuity contract 
would result in a taxable event, even though no funds were 
taken out of the contract.
    The Tax Council adamantly opposes this provision as a tax 
increase on middle-class Americans and retirement savers. 
Moreover, this proposal completely contradicts the President's 
recent statements to ``Save Social Security First.'' Any new 
tax on private retirement savings puts further strain on the 
overall private and public retirement system. Variable life and 
annuity contracts are used respectively to insure against 
premature death and for long-term retirement savings. Like 
other retirement saving vehicles, including defined 
contribution and defined benefit plans, annuities allow savings 
to grow tax-free until they are needed for retirement. All 
retirement savers periodically shift their savings among 
different options as they grow older and more conservative, or 
as the market changes. Under this proposal, annuity owners who 
shift accounts would be taxed immediately, thereby forcing them 
to keep bad investments or pay a tax on undistributed funds.
    Recent surveys have shown that more than 80 percent of the 
owners of deferred annuity contracts have total annual 
household incomes of under $75,000. Such middle income savers 
rely on these well-designed products to encourage them to 
commit funds to retirement. At a time when Congress and the 
President are concerned about saving Social Security, the last 
thing that they should do is tax private retirement savings 
options.

   Reduction in Basis (``Investment in the Contract'') for Mortality-
                            Related Charges

    The Administration's proposal would reduce a policyholder's 
tax basis in an insurance or annuity contract for certain 
charges under the contract by subtracting mortality and 
associated expense charges. In the case of life insurance 
contracts, these charges include the cost of the insurance and 
related expenses. For deferred annuity contracts, the assumed 
mortality and expenses charges, which must be subtracted, are 
deemed to equal the contract's average cash value during the 
year multiplied by 1.25 percent. This proposal is nothing but a 
tax on private retirement savings. Increasing the cost of such 
savings vehicles by reducing a product's tax basis creates a 
disincentive to use these important savings tools. Life 
insurance and annuity contracts are designed to both accumulate 
retirement savings and insure against premature death (e.g. 
mortality-related risks). Taxes on income from the savings 
element of such contracts should not be increased just because 
those contracts also provide insurance protection.
    This provision will likewise result in a tax increase on 
middle-class Americans and retirement savers. In addition, the 
proposal is inconsistent with general tax rules relating to the 
determination of tax basis and will further increase the 
complexity of the tax code with no recognizable benefit. Under 
the proposal, life insurance companies would be required to 
maintain additional records to keep track of two different 
basis amounts for annuity contracts. This will undoubtedly 
result in increased administrative burdens and compliance 
costs, which most likely will be passed on to Americans trying 
to save for retirement.

           Modifying the Reserve Rules for Annuity Contracts

    Currently, reserves for annuity contracts equal the greater 
of the contract's net surrender value or an amount based on the 
Commissioner's Annuities Reserve Valuation Method (``CARVM''). 
Under the Administration's proposal, reserves for all annuity 
contracts with cash surrender values would equal the lesser of 
the amount computed under CARVM or the contract's ``adjusted 
account value.'' The adjusted account value would equal the net 
cash surrender value plus a specified percent (e.g., plus 5.5% 
in the first year).
    The Tax Council opposes this proposal as another attack on 
middle-class Americans and retirement savers who use annuity 
contracts as their preferred savings vehicle. The proposal 
would make it unduly expensive for insurance companies to 
administer an annuity contract in its early years. While aimed 
at accounting and reserve methods of insurers, the real targets 
are the users of these products who will eventually bear the 
increased costs and burdens resulting from such a change. By 
increasing the costs of annuity contracts, use of such vehicles 
will be reduced, thereby straining the entire public and 
private retirement system. At a time when Americans are trying 
to increase retirement savings, this proposal moves in the 
opposite direction and makes it more costly for them to achieve 
their goal.

                            Effective Dates

    Before concluding, we would like to make one last comment 
regarding the effective dates of tax proposals. The Tax Council 
believes that it is bad tax policy to make significant tax 
changes in a retroactive manner that impose additional burdens 
on businesses. Businesses should be able to rely on the tax 
rules in place when making economic decisions, and expect that 
those rules will not change while their investments are still 
ongoing. It seems plainly unfair to encourage businesses to 
make economic decisions based on a certain set of rules, but 
then change those rules midstream after the taxpayer has made 
significant investments in reliance thereon.

                               Conclusion

    The Tax Council strongly urges Congress not to adopt the 
provisions identified above when formulating its own proposals, 
since they are based on unsound tax policy. Congress, in 
considering the Administration's budget, should elevate sound 
and justifiable tax policy over mere revenue needs. Revenue can 
be generated consistent with sound tax policy, and that is the 
approach that should be followed as the budget process moves 
forward.
      

                                

Statement of Martin A. Regalia, Ph.D., Vice President and Chief 
Economist, U.S. Chamber of Commerce

    The U.S. Chamber appreciates this opportunity to express 
our views on the revenue provisions in President Clinton's 
Fiscal Year 1999 budget proposal. The U.S. Chamber is the 
world's largest business federation, representing more than 
three million businesses and organizations of every size, 
sector and region. This breadth of membership places the U.S. 
Chamber in a unique position to speak for the business 
community.

          The President's Budget Would Increase Business Taxes

    President Clinton's budget proposal contains numerous new 
spending initiatives, and pays for them by increasing taxes on 
businesses. It would increase gross taxes on American 
businesses by $106 billion over five years (including $65.5 
billion in receipts from tobacco legislation), and raise 
government receipts, as a percentage of GDP, from an already-
high 19.8 percent to 20.1 percent.
    The President's proposal contains dozens of provisions 
which would raise taxes on the business community. Many of 
these provisions were included in his earlier budget proposals 
and were summarily rejected by Congress, while others are being 
offered for the very first time.
    The proposal also asserts that many of these provisions are 
needed to close unwarranted tax benefits or ``loopholes.'' 
However, these so-called loopholes are, in fact, legitimate, 
equitable, and longstanding business tax provisions, and should 
remain in the Internal Revenue Code.
    The most onerous provisions in the President's budget 
proposal would:

Replace the Export Source Rule with an Activity-Based Rule

    Currently, U.S.-based multinational exporters can treat 50 
percent of their export income as U.S. source income and 50 
percent as foreign source income. This rule is beneficial to 
companies that manufacture products in the U.S. and export 
abroad because it increases their ability to utilize foreign 
tax credits and, therefore, alleviate double taxation.
    The President's proposal would replace the existing export 
source rule with an economic activity-based rule. The proposed 
rule could increase U.S. taxes on these companies, and, 
therefore, encourage them to produce their goods overseas, 
rather than in this country. Since exports have played an 
important role in our nation's recent economic growth, any 
proposal weakening the longstanding export source rule could 
have a significant, negative effect on our economy.

Convert Airport Trust Fund Taxes to a Cost-Based User Fee 
System

    Currently, excise taxes are imposed on commercial and 
noncommercial aviation to finance programs administered through 
the Airport and Airway Trust Fund. These taxes were modified 
and extended through September 30, 2007 by the Taxpayer Relief 
Act of 1997 (``1997 Act'').
    The President's proposal would phase-out these excise taxes 
beginning in Fiscal Year 1999 through Fiscal Year 2003, and 
replace them with cost-based user fees. While the proposal does 
not contain details of this provision, it is estimated to raise 
almost $6 billion over the next five years. A $6 billion tax 
increase on the business community and the public-at-large, 
especially before the issue of whether existing excise taxes 
should be replaced by cost-based user fees is fully debated, is 
unacceptable and should be thwarted immediately.

Modify the Reserve Rules for Annuity Contracts

    Under current law, life insurance reserves for any annuity 
contract equal the greater of the contract's net surrender 
value or an amount determined using the Commissioner's 
Annuities Reserve Valuation Method (``CARVM''). Under the 
President's proposal, reserves for any annuity contract with a 
cash surrender value would equal the lesser of the amount 
computed under CARVM or the contract's ``adjusted account 
value.'' The adjusted account value for a contract would equal 
the net cash surrender value of the contract, plus a percentage 
of the net cash surrender value of the contract (e.g., 5.5 
percent in the first year, 5.0 percent in the second year).
    This provision would make it unduly expensive for insurance 
companies to administer annuity contracts in their early years. 
Ultimately, individuals saving for retirement would have to 
absorb the increased costs and burdens associated with the 
proposed change in reserve rules. At a time when Americans need 
to increase retirement savings, this proposal moves in the 
opposite direction by making saving more costly and burdensome.

Reinstate the Superfund Excise Taxes

    The four taxes that funded the Hazardous Substance 
Superfund Trust Fund (``Superfund'') expired on December 31, 
1995. The President's proposal would reinstate the three 
expired excise taxes from the date of enactment through 
September 30, 2008, and the expired corporate environmental 
income tax for tax years beginning after December 31, 1997, and 
before January 1, 2009.
    The business community believes that the various Superfund 
taxes should be thoroughly examined and evaluated before they 
are reinstated. Furthermore, if these taxes are reinstated, 
they should be part of a comprehensive plan to reform the 
entire Superfund program.

Modify the Corporate-Owned Life Insurance Rules

    The President's proposal would impose additional taxes on 
businesses that borrow for any purpose if they also own life 
insurance, including key employee life insurance. Specifically, 
the provision would eliminate the exception under the pro-rata-
interest-disallowance rule for employees, officers and 
directors. The exception for 20-percent owners would be 
retained, however.
    This provision could have a devastating effect on life 
insurance products that protect businesses, especially small 
businesses, against financial loss caused by the death of key 
employees and allows them to provide benefits, including 
retiree health benefits, to their employees. Furthermore, the 
provision would unfairly apply retroactively to existing life 
insurance contracts that were purchased under current law.

Repeal the ``Lower-of-Cost-or-Market'' Inventory Accounting 
Method

    Currently, taxpayers that maintain their inventories under 
the ``first-in-first-out'' (``FIFO'') method may determine the 
value of ending inventory under a ``lower-cost-or-market'' 
method. Under this method, the value of ending inventory is 
written down if its market value is less than its cost. 
Similarly, under the subnormal goods method, any goods that are 
unsalable at normal prices, or unusable because of damage or 
other causes, may be written down to reflect their lower market 
values.
    The President's proposal would repeal these valuation 
methods for taxpayers whose average annual gross receipts over 
a three-year period exceed $5 million. This provision could 
increase taxes on those businesses that use FIFO, or cause them 
to switch to the ``last-in-first-out'' method of valuation for 
both tax and financial statement purposes.

Eliminate Various Estate Tax Planning Techniques

    Instead of further reducing the estate and gift tax burden 
on Americans, as Congress did last year in the 1997 Act, the 
President's proposal would increase estate taxes on the middle-
class by eliminating or curtailing the use of several popular 
estate tax planning devices.
    Specifically, the proposal would: (1) repeal the 
``Crummey'' rule which would stifle the use of insurance 
trusts; (2) eliminate ``valuation discounts'' for minority-
owned interests of family limited partnerships (except for 
active businesses); and (3) reduce the attractiveness of 
``personal residence trusts'' by requiring the trust to make 
certain payments to the homeowner or else value the retained 
interest at zero. If enacted, these provisions would make it 
more difficult for business owners to develop estate plans 
which would keep their businesses intact, and their employees 
working, after their deaths.

Modify the Exchange Rules for Insurance and Annuity Contracts

    Life insurance and annuity contracts have proven to be 
valuable retirement and savings devices. Under current law, one 
can exchange a life insurance, endowment or annuity contract 
for a variable contract, or vice versa, without triggering tax. 
Likewise, one can reallocate investment assets within a 
variable life or annuity contract without incurring tax.
    The President's proposal would repeal the tax-free status 
of the above-mentioned exchanges, even if no funds are actually 
withdrawn from the contracts. This provision would impose an 
additional tax on many Americans who are trying to save for 
retirement. The tax-free benefits of life insurance and annuity 
contracts should be maintained in order to encourage greater 
personal saving and responsibility.

Eliminate the Dividends-Received Deduction for Certain 
Preferred Stock

    Currently, a corporation can deduct 100 percent of the 
``qualifying'' dividends it receives from a domestic 
corporation if it owns over 80 percent of the stock of the 
dividend-paying corporation. The percentage is reduced to 80 
percent if the corporation owns at least 20 percent, but no 
more than 80 percent, of the stock of the dividend-paying 
corporation, and to 70 percent if the corporation owns less 
than 20 percent of the stock of such corporation.
    The President's proposal would eliminate the dividends-
received deduction for certain types of preferred stock, 
subjecting corporate earnings to even higher amounts of tax. 
The dividends-received deduction should be increased, not 
decreased, in order to lessen the effects of multiple taxation 
on corporations and shareholders.

Repeal Tax-Free Conversions of ``Large'' C Corporations to S 
Corporations

    Under current law, the ``built-in'' gains of assets of a C 
corporation that converts, or merges, into an S corporation is 
not subject to tax so long as such assets are not disposed of 
within 10 years after conversion. The President's proposal 
would repeal these tax-free conversions for ``large'' S 
corporations, defined as those corporations whose stock has a 
value of more than $5 million at the time of conversion.
    As a result, this provision would require immediate gain 
recognition by such ``large'' corporations with respect to 
their appreciated assets, as well as by their shareholders with 
respect to their stock upon conversion to S-corporation status. 
If enacted, this provision would decrease the desirability of 
the Subchapter S election for those C corporations that are 
eligible to convert.

Require Employers to Deposit Unemployment Taxes Monthly

    Generally, employers deposit their federal and state 
unemployment tax liabilities quarterly. The President's 
proposal would require that most employers, beginning in 2004, 
pay their federal and state unemployment taxes on a monthly 
basis. This provision would significantly increase the 
administrative burden on businesses by increasing the number of 
annual unemployment tax deposits from four to 12.

                More Tax Relief is Needed for Businesses

    Instead of increasing taxes on the business community, the 
President's budget proposal should lead the way in reducing 
business taxes. The U.S. Chamber believes tax relief is needed 
in the following areas:

Alternative Minimum Tax (``AMT'')

    While the 1997 Act exempted ``small'' corporations from AMT 
and provided some relief for other corporations, repeal of the 
harmful corporate and individual AMT is needed. If repeal is 
not feasible, significant reforms should be enacted. Such 
reforms should include: providing a ``small business'' 
exemption for individuals; completely eliminating the 
depreciation adjustment; increasing the individual AMT 
exemption amounts; allowing taxpayers to offset their current 
year AMT liabilities with their accumulated minimum tax 
credits; and making the AMT system less complicated and easier 
to comply with.

Capital Gains Tax

    While the 1997 Act reduced the maximum capital gains tax 
rate for individuals from 28 percent to 20 percent (10 percent 
for those in the 15-percent income-tax bracket), it also 
lengthened the holding period for long-term capital gains from 
12 months to 18 months. This holding period should revert back 
to 12 months, and rates should be further reduced, if possible. 
In addition, capital gains tax relief is still needed for 
corporations, whose capital gains continue to be taxed at 
regular income tax rates.

Equipment Expensing

    In 1998, businesses can generally expense up to $18,500 of 
equipment purchased. This amount will gradually increase to 
$25,000 by 2003. This expensing limit needs to be further 
increased, and at a faster pace, in order to promote capital 
investment, economic prosperity, and job growth.

Estate and Gift Tax

    While the 1997 Act provided some estate tax relief, the 
federal estate tax should be completely repealed. If repeal is 
not feasible, significant reforms should be implemented. Such 
reforms include further increasing the unified credit, reducing 
overall tax rates, increasing and expanding the newly created 
``family-owned business interest'' exclusion to encapsulate 
more businesses, and broadening the installment payment rules.

Foreign Tax Rules

    While the 1997 Act included some foreign tax relief and 
simplification measures, our foreign tax rules need to be 
further simplified and reformed so American businesses can 
better compete in today's global marketplace.

Individual Retirement Accounts (``IRAs'')

    While the 1997 Act expanded deductible IRAs and creates 
nondeductible Roth IRAs, both types of IRAs need to be further 
expanded (e.g., increase contribution limits, eliminate phase-
out ranges) in order to promote saving and personal 
responsibility.

Internal Revenue Service (``IRS'') Restructuring and Reform

    The overall management, oversight and culture at the IRS 
needs to be changed in order to make it a more efficient, 
accountable and taxpayer-friendly organization. We support 
legislation which the House overwhelmingly passed in November 
and look forward to working with Congress towards its 
enactment.

Research and Experimentation Tax Credit

    While the 1997 Act extended this credit through June 30, 
1998, it needs to be extended permanently, and further 
expanded, so businesses can better rely on and utilize the 
credit.

S Corporation Reform

    While the Small Business Jobs Protection Act of 1996 
contained many needed reforms for S corporations, such as 
increasing the maximum number of shareholders from 35 to 75, 
there are many other important reforms which still need to be 
enacted, such as allowing preferred stock to be issued and 
creating family attribution rules.

Self-Employed Health Insurance Deduction

    This deduction is scheduled to increase from 40 percent in 
1997 to 100 percent in 2007. We believe this timetable should 
be accelerated to give self-employed individuals a full 
deduction as soon as possible.

Work Opportunity Tax Credit

    This credit, which encourages employers to hire individuals 
from several targeted groups, needs to be permanently extended 
beyond its June 30, 1998 sunset date.

Worker Classification Rules

    The current worker classification rules are too subjective 
and restrictive, and need to be simplified and clarified. We 
support the creation of a more objective safe harbor for 
independent contractors, while leaving the current 20-factor 
test and Section 530 safe harbors intact.

                               Conclusion

    The revenue-raising provisions contained in President 
Clinton's Fiscal Year 1999 budget proposal would further 
increase taxes on businesses and reduce savings and investment. 
The U.S. Chamber urges that these provisions be rejected as bad 
tax policy, and not included in final budget legislation for 
Fiscal Year 1999.
    Hidden among the dozens of tax increases in the President's 
proposal are a few provisions which would marginally benefit 
businesses. For example, the proposal would temporarily extend 
the research and experimentation tax credit, work opportunity 
tax credit and the employer-provided educational assistance 
exclusion, enhance taxpayers' rights, and extend and modify the 
Puerto Rico Tax Credit.
    These provisions, however, would not provide businesses 
with significant or long-term tax relief. For example, the tax 
extender provisions would not be made permanent, and are 
overshadowed by the numerous tax increasing provisions. 
Furthermore, needed relief in other areas, such as the 
alternative minimum tax and the estate and gift tax, is not 
provided for anywhere in his proposal.
    Our long-term economic health depends on sound economic and 
tax policies. The federal tax burden on American businesses is 
too high and needs to be significantly reduced. In addition, 
our tax code wrongly favors consumption over savings and 
investment. As we prepare for the economic challenges of the 
next century, we must orient our current tax policies in a way 
that encourages more savings, investment, productivity growth, 
and, ultimately, economic growth.
      

                                

Statement of United States Council for International Business (USCIB)

                              Introduction

    The United States Council for International Business 
(USCIB) is pleased to take this opportunity to comment with 
respect to the international provisions included among the tax 
proposals offered in the Administration's budget statement.
    The USCIB advances the global interest of American business 
both at home and abroad. It is the American affiliate of the 
International Chamber of commerce (ICC), the Business and 
Industry Advisory Committee (BIAC) to the OECD, and the 
International Organisation of Employers (IOE). As such, it 
officially represents U.S. business positions in the main 
intergovernmental bodies, and vis-a-vis foreign business and 
their governments.
    We noted, and appreciate, in the international area the 
proposal to accelerate the implementation date of the ``look-
through'' treatment for dividend from 10/50 companies. Too many 
of the international tax proposals, however, reflect a 
misguided emphasis on raising revenue at the expense of sound 
tax policy. Most of the revenue raisers found in the budget 
proposals which affect the international area lack a sound 
policy foundation. Although they may be successful in raising 
revenue, they do nothing to achieve the objective of expanding 
and/or retaining U.S. jobs to make the U.S. economy stronger. 
Examples, include the proposals (1) to arbitrarily change the 
sourcing of income rules on export sales by U.S. based 
manufacturers, (2) to provide the Treasury Secretary with 
blanket authority to issue regulations in the international 
area that could conceivably allow it to attack legitimate tax 
planning by U.S. companies, (for example, by severely 
restricting the ordinary business operations of foreign 
affiliates through no longer allowing a U.S. company to 
characterize its foreign affiliate as a branch for U.S. tax 
purposes), and (3) to limit the ability of so-called ``dual 
capacity taxpayers'' (i.e., multinationals engaged in vital 
petroleum exploration and production overseas) to take credit 
for certain taxes paid to foreign countries. These proposals, 
if enacted, would be totally counter productive.
    The Administration is unwise, in its efforts to balance the 
budget, to target U.S. multinationals doing business overseas, 
and we urge that such proposals be reconsidered and withdrawn. 
The predominant reason that businesses establish overseas 
operations is to serve local markets to be able to compete more 
effectively. Investments abroad provide a platform for the 
growth of exports and, indirectly, create jobs in the U.S., not 
to mention improving the U.S. balance of payments. The 
creditability of foreign income taxes has existed in the 
Internal Revenue code for almost 80 years to alleviate the 
double taxation of foreign income. Replacing such credits with 
less valuable deductions will greatly increase the costs of 
doing business overseas, resulting in a competitive 
disadvantage to U.S. multinationals vis-a-vis foreign-based 
companies.
    So that U.S. companies can better compete with foreign-
based multinationals, the Administration should, instead, do 
all it can to make the U.S. tax law more user friendly, 
consistent with the Administration's more enlightened trade 
policy. Rather than engaging in gimmicks that reward some 
industries and penalize others, the Administration's budget 
should be written with the goal of reintegrating sounder tax 
policy into decisions regarding the revenue needs of the 
government. Provisions that merely increase business taxes by 
eliminating legitimate business deductions should be avoided. 
Ordinary and necessary business expenses are integral to our 
current income tax system, and arbitrarily denying a deduction 
for such an expense will only distort that system. Higher 
business taxes impact all Americans, directly or indirectly. 
For example, they result in higher prices for goods and 
services, stagnant or lower wages paid to employees in those 
businesses, and smaller returns to shareholders. Those 
shareholders may be the company's employees, or the pension 
plans of other workers. We comment below on the specific 
proposals impacting the international area.

        Accelerating the Effective Date of 10/50 Company Change

    We commend the Administration for its proposal to 
accelerate the effective date of a tax change made in the 1997 
Tax Relief Act affecting foreign joint ventures owned between 
ten and fifty percent by U.S. parents (so-call ``10/50 
Companies''). This change will allow 10/50 Companies to be 
treated just like controlled foreign corporations, by allowing 
``look-through'' treatment for foreign tax credit purposes for 
dividends from such joint ventures. The 1997 Act, however, did 
not make the change effective to dividends for such entities 
unless they were received after the year 2003 and, even then, 
required separate rules to apply, on the one hand, to dividends 
from earning and profits (``E&P'') generated before the year 
2003, and, on the other hand, to dividends from E&P accumulated 
after the year 2002. The Administration's proposal will, 
instead, apply the look-through rules to all dividends received 
in tax years after 1997, no matter when the E&P constituting 
the dividend was earned and accumulated.
    This change will result in an enormous reduction in 
complexity and compliance burdens for U.S. multinationals doing 
business overseas through foreign joint ventures. It will also 
reduce the competitive bias against U.S. participation in such 
ventures by placing U.S. companies on a much more level playing 
field from a corporate tax standpoint. The proposal is the type 
of provision that promotes the desirable policy goal of 
simplicity in the tax law.

       Foreign Tax Credits relating to Foreign Oil And Gas Income

    The USCIB strongly believes that, in general, a full 
foreign tax credit should be restored and the complexities of 
current law, particularly the multiplicity of separate 
``baskets,'' should be eliminated.
    Unfortunately, the proposal relating to foreign oil and gas 
income moves quite in the opposite direction, by limiting use 
of the foreign tax credit on foreign oil and gas income. This 
selective attack on a single industry's utilization of the 
foreign tax credit is not justified. U.S. based oil companies 
are already at a competitive disadvantage under current law 
since most of their foreign based competition pay little or no 
home country tax on foreign oil and gas income. The proposal 
increases the risk of foreign oil and gas income being 
subjected to double taxation which will severely hinder U.S. 
oil companies in their global oil and gas exploration, 
production, refining and marketing activities.

                    Repeal of the Export Source Rule

    The regulations under Code 863(b) (and its predecessors) 
have long contained a rule which allows the income from goods 
that are manufactured in the U.S. and sold abroad (with title 
passing outside the U.S.) to be treated as 50% U.S. source 
income and 50% foreign source income. This export source rule 
has been beneficial to companies who manufacture in the U.S. 
and export abroad because it increases their foreign source 
income and thereby increases their ability to utilize foreign 
tax credits. Because the U.S. tax law restricts the ability of 
companies to fully utilize credits for the foreign income taxes 
which they incur (e.g., through the interest and R&D 
allocations), many multinational companies face double taxation 
on their overseas operations. The export source rule helps 
alleviate this double taxation burden and thereby encourages 
U.S.-based manufacturing by multinational exporters.
    The proposal would eliminate the 50/50 rule and replace it 
with an ``activities based'' test, which would require 
exporters to allocate income from exports to foreign or 
domestic sources based upon how much of the activity producing 
the income takes place in the U.S. and abroad, respectively. 
The justification given for eliminating the 50/50 rule is that 
it provides U.S. multinational exporters operating in high tax 
foreign countries a competitive advantage over U.S. exporters 
that conduct all their business activities in the U.S. The 
administration also notes that the U.S. tax treaty network 
protects export sales from foreign taxation in countries where 
we have treaties, thereby reducing the need for the export 
source rule. Both of these arguments are erroneous.
    The export source rule does not provide a competitive 
advantage to multinational exporter vis-a-vis exporters with 
``domestic-only'' operations. Exporters with only domestic 
operations never incur foreign taxes and, thus, are not 
subjected to the onerous penalty of double taxation. Also, 
domestic-only exporters are able to claim the full benefit of 
deductions for U.S. tax purposes for all their U.S. expenses, 
e.g., interest on borrowings and R&D costs, because they do not 
have to allocate any of those expenses against foreign source 
income. Thus, the export source rule does not create a 
competitive advantage; rather, it helps to ``level the playing 
field'' for U.S.-based multinational exporters. Our tax treaty 
network, although of great significance to U.S. businesses 
operating abroad is certainly no substitute, for the export 
source rule since it is not earnings from export sales, but 
rather other foreign earnings, that are the main cause of the 
double taxation described above. To the extent that the treaty 
network lowers foreign taxes, it can help to alleviate the 
double tax problem, but only with countries with which we have 
treaties, which tends to be the other industrialized nations of 
the world. We have few treaties with the developing nations, 
which will undoubtedly be the primary targets areas for our 
export growth in the future.
    Exports are fundamental to our economic growth and our 
future standard of living. Over the past three years, exports 
have accounted for about one-third of total U.S. economic 
growth. The export source rule also operates to encourage 
companies to produce their goods in their U.S. plants rather 
than in their foreign facilities. Repeal of, or a cutback in, 
the export source rule will reduce exports and jeopardize high 
paying jobs in the United States. Given the danger that the 
current Asian crisis poses to our exports, repeal of the rule 
would be especially unwise and counterproductive.

                  Limiting Use Of ``Hybrid'' Entities

    We deplore the fact that the Administration (i.e., 
Treasury) feels compelled to request congressional authority to 
issue potentially sweeping legislative regulations after non-
specific tax guidance has been given. If Treasury has specific 
issues to address, it should do so through specific legislative 
proposals. This would permit normal congressional 
consideration, including hearings on such proposals.
    We refer in particular to the proposal which would limit 
the ability of certain foreign and U.S. persons to enter into 
transactions that utilize so-called ``hybrid entities,'' which 
are entities that are treated as corporations in one 
jurisdiction but as branches or partnerships in another 
jurisdiction. Although most hybrid transactions do not attempt 
to generate tax results that are ``inconsistent with the 
purposes of U.S. tax law,'' the Administration feels that there 
are enough taxpayers taking unfair advantage of the current 
rules that it is necessary to codify and extend earlier 
government issued tax guidance on this subject (i.e., Notice 
98-5 and 98-11).
    U.S. multinationals compete in an environment in which 
foreign competitors use tax planning techniques to reduce 
foreign taxes without incurring home country tax. The use of 
``hybrid entities'' allows U.S. multinationals to compete on a 
level playing field and, in fact, promotes additional U.S. 
exports. The use of hybrids is consistent with the initial 
balance between competitiveness and export neutrality that was 
intended by Congress in enacting the ``Subpart F'' rules. 
Although Congress specifically enacted a branch rule for 
foreign base company sales under Code 954(d)(3), similar rules 
were not enacted for foreign personal holding company income. 
If enacted, these proposals would represent an unwarranted 
extension of legislative authority by Congress to the Executive 
Branch to impose new rules by regulation without Congressional 
debate.
    Notices 98-5 and 98-11 have chilling effect on the ability 
of U.S. companies to structure their foreign operations 
consistent with the commercial objective of regionalizing their 
businesses. They also adversely impact the ability of U.S. 
multinationals to effectively reduce their overall costs by 
reducing local taxes in their overseas operations. The Notices 
are drafted so broadly and so vaguely that they will confuse 
U.S. taxpayers and their advisors, and introduce a compelling 
need to seek clarification as to whether taxpayers can continue 
to rely on the simple ``check-the-box'' regulations issued just 
last year. All these effects are exacerbated by the Notices' 
immediate effective dates.
    The world has changed dramatically since enactment of the 
Subpart F rules in 1962. We feel that it would be more 
appropriate for Congress to request a study regarding the trade 
and tax policy issues associated with Notices 98-5 and 98-11. 
In this regard, a moratorium on further regulatory action by 
Treasury should be imposed until enactment of specific 
legislative proposals resulting from a well reasoned analysis 
and debate.

       Foreign Tax Credits Relating to Foreign Oil and Gas Income

    Another proposal would require the Treasury to issue 
regulations to prevent taxpayers from ``importing built-in 
losses incurred outside U.S. taxing jurisdictions to offset 
income or gain that would otherwise be subject to U.S. tax.'' 
The administration argues that although there are rules in the 
Code that limit a U.S. taxpayer's ability to avoid paying U.S. 
tax on built-in gains (e.g., Code 367(a), 8664(c)(7), and 877), 
similar rules do not exist that prevent built-in losses from 
being used to shelter income otherwise subject to U.S. tax, 
and, as a result, taxpayers are avoiding subpart F income 
inclusions or capital gains tax. We believe that this 
directive, which is written extremely broadly, is unnecessary 
due to the existence of rules already available in the code, 
e.g., the anti-abuse provisions of Code 269, 382, 446(b), and 
482. This is another example of the type of provision that 
would seriously erode U.S. competitiveness.

                      Payments To 80/20 Companies

    Under current rules, a portion of the interest or dividends 
paid by a domestic corporation to a foreign entity may be 
exempt from U.S. withholding tax provided the payor corporation 
is a so-called ``80/20 Company,'' i.e., at least eighty percent 
of its gross income for the preceding three years is foreign 
source income generated in the active conduct of a foreign 
trade or business. The Administration believes that the testing 
period is subject to manipulation and allows certain companies 
to improperly avoid U.S. withholding tax on certain 
distributions attributable to a U.S. subsidiary's U.S. source 
earnings. As a result, it proposes to arbitrarily change the 
80/20 rules by applying the test on a group-wide (as opposed to 
individual company) basis. However, there is little evidence 
that these rules have been manipulated on a broad scale in the 
past, and, accordingly, we do not believe such a drastic change 
is needed.

                                  
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